PDT - PDT And HTD: Exploiting Discounts In Closed-End Funds

2023-11-28 07:26:26 ET

Summary

• John Hancock Premium Dividend Fund cut its distribution earlier this year, leading to a sell-off, but the discount/premiums of closed-end funds can be exploited by investors.
• PDT's discount has narrowed since the distribution cut pushed it to a wide discount; it remains at a fairly attractive discount level even after it has narrowed.
• Swapping back to John Hancock Tax-Advantaged Dividend Income Fund from PDT could make sense here, but I wouldn't expect the results to be as swift with no major catalyst.

Written by Nick Ackerman, co-produced by Stanford Chemist.

Earlier this year, the John Hancock Premium Dividend Fund ( PDT ) cut its distribution, which was met with a substantial sell-off of the fund. However, thanks to being a closed-end fund, this was an action that could be exploited for investors due to the discount/premiums that CEFs trade at.

The utility and preferred exposure this fund invests in aren't having the best year, to be sure, as the fund is down in 2023. However, by following valuations on funds, we can often limit the downside. The main highlight of this article is how this can benefit investors and revisiting how a swap to PDT worked out earlier this year.

Since our last update , PDT has narrowed its discount, and that has helped drive the fund's total returns. The fund's discount still remains fairly attractive today on a relative basis if we look at the fund's historical level.

In this case, PDT was trading at a premium, and then it swiftly went to a deep discount after announcing the distribution cut on June 1, 2023. A premium hasn't been too rare for this fund. In fact, over the last five years, the fund's average still stands at a premium of ~6%. Though, given the fund did cut its distribution, investors may be unwilling to let this fund get to a premium again.

HTD To PDT Swap Results

Fortunately for us, PDT actually has a sister fund that is invested with a similar investment policy and objective, creating significant overlap. That is the John Hancock Tax-Advantaged Dividend Income Fund ( HTD ). If we look at the fund's historical returns, the total NAV returns have been highly correlated even over a couple of decades.

Technically, HTD has been the better longer-term investment, but since HTD's launch in early 2004, it hasn't meant a material amount on an annualized basis. Worth noting is that PDT is the older fund of the two by a significant length as well - going back to its launch in late 1989.

With all that being said, we can utilize these types of funds in our favor for a rotation or swap strategy to take advantage of abnormally large discounts/premiums in highly similar funds. When PDT cut its distribution and dropped to a double-digit discount, it created a situation where PDT became the more attractively valued fund relative to HTD. This was after quite a few years of the opposite being true, where PDT was consistently trading at a premium while HTD mostly traded at a discount.

Every month, I share what moves I made in the prior month in terms of buying closed-end funds or selling them. This HTD to PDT trade was no different and one that I highlighted and executed in August . To be more specific, it was on August 24, 2023, when I made this move.

Since then, both funds have put up nearly identical total NAV return results - as expected for such a short period of time. However, we can clearly see each fund's total share price results are vastly different. This would also be expected, which is why I made the move, but this happened fairly quickly - quicker than it usually does.

To be fair, I don't post my monthly buy article until the first of each month for members. Sometimes, that can mean that opportunities can't be taken advantage of as quickly, but sometimes, that's a good thing.

In this case, it meant that if an investor didn't read about the idea until September 1 and then executed on that day after doing their own due diligence, it would have meant an even greater differential spread. The differential when I made the move was 10.32 points, whereas on September 1, there was an 11.3-point difference in total share price returns.

Of course, the ultimate driving factor during this period was the discount that each fund was and is now trading at since the underlying portfolios performed almost identically. HTD ended up going to a significantly wider discount during this period, while PDT narrowed its discount once again.

I can't be entirely sure why HTD saw its discount widen during this time, but even if it had maintained its discount, PDT would have still been the fund to choose. PDT would have still seen better total returns on a share basis because of its discount narrowing - the results just wouldn't have been so dramatic.

Speculation on my end could be that investors anticipated that HTD could possibly cut its distribution because PDT did. Both funds had been maintaining their payouts since their cuts during the global financial crisis. So, the cut for PDT could have been an unexpected move for some investors. PDT's current NAV distribution rate is at 8.72%, while HTD's is lower at 8.13%. If I had to take a guess, I don't see HTD cutting their distribution at this time.

Conclusion

With all this being said, today, the opposite is now true, where HTD is the better value. That could set up a situation where swapping back to HTD makes a lot of sense here.

A few things that I would note, though.

First, it may not work out as quickly; this was a particularly fast reaction by the market, swinging it in my favor.

Second, there was a clear catalyst for seeing PDT's discount widen materially, and that was the distribution cut. This was likely a factor in the greater volatility in the wildly swinging discount we saw. Thus helping the trade perform favorably in the first place in such a short period of time.

Third, the discount for HTD had been deeper historically, so on a relative basis, it might not be as cheap as investors have regularly discounted it more than PDT. In my opinion, it doesn't seem warranted, as the total NAV results of each fund have been so similar. That said, both funds are still trading below their average discounts of the last decade. Even if investors are repricing PDT lower, it's still a fairly attractive discount.

Finally, the usual caveat between implementing rotation trades is that while historically, the funds have correlated closely, they are still two separate entities. That means the management team may choose to invest one wildly different, and therefore, we could see the results diverge dramatically going forward even if historically that hasn't happened. Basically, the standard "past results don't guarantee future results" is highly applicable here.

With those factors to consider, it would seem that there wouldn't really be the same urgency to get this swap executed. However, I would be leaning toward swapping back to HTD, personally.

Both funds would be fine to hold for the long term, but overall, this is yet another example of how investors can exploit discounts/premiums in closed-end funds. By watching valuations and watching out for various catalysts to spur volatility in those discounts/premiums, we can potentially enhance returns or reduce losses.

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