Money Matters: Discount-narrowing techniques used by CEFs

James Quackenbush, The Daily Record Newswire

Investors are constantly looking for undervalued investments that overtime will become more fairly valued and offer superior investment returns.  One investment vehicle that is frequently undervalued relative to its underlying assets are Closed-end funds (CEFs).

CEFs are investment companies that issue a limited number of shares to investors through an initial public offering (IPO) and then use investment capital raised from the IPO to invest in a portfolio of securities, typically stocks, bonds or a combination of both. After the IPO, shares of the CEF are bought and sold on a stock exchange (secondary market), and the market price of the shares is determined by supply and demand reflected by the secondary market price, not by net asset value (NAV).

Since CEFs trade on a stock exchange, some funds may become vastly undervalued, trading at discounts of 15 to even 20 percent of their NAV price. When CEFs persistently trade at large discounts to NAV, the board of directors of the fund can implement discount management programs to help reduce or even eliminate the discount at which the fund is trading.

These programs consist of implementing a managed distribution policy, conducting tender offers, and performing an open-market share repurchase program. When these techniques are used by management of the CEF, existing shareholders will typically benefit through the increase demand for the fund, which will increase the price of the fund’s shares and diminish the fund’s discount from NAV.

One of the most effective discount-narrowing methods used by CEFs is to offer shareholders a managed distribution policy. A managed distribution policy is the fund’s commitment to shareholders to provide a predictable amount of cash flows through the form of cash distributions.

Normally, a fund will commit to an annual distribution rate of 6, 8 or 10 percent of the fund’s assets, typically distributed on a monthly or quarterly basis. The payout will generally be comprised of dividend income, interest income, capital gains generated from the fund’s investment portfolio, and, in some cases, return of capital. However, when a CEF adopts a distribution policy, the payout rate can be misinterpreted as yield. During years when a fund has depleted all dividend and capital gains but still wants to maintain their stated distribution obligation, the fund will resort to paying out return of capital to meet the distribution requirement.

The portion of a payout that comes from return of capital is actually the fund giving shareholders part of their original investment back, which cannot be considered yield. However, when a fund is purchased at a discount, the portion of the payout that is return of capital is receiving full dollar value for an investment that was originally purchased at a discount, adding extra value for shareholders.

Another discount-narrowing method used by CEF management is to offer shareholders a liquidity event known as a tender offer. Tender offers allow shareholders that are trapped in a fund with a wide discount the opportunity to sell a portion of their shares at or near NAV.

Tender offers can vary in structure but in essence the fund management will offer to buy (tender) a percentage of the outstanding shares of a CEF near the current NAV price. In many cases the fund will tender shares for cash but in some circumstances shareholders may receive securities held within the fund instead.

For example, for a fund trading at a 15 percent discount to NAV, management could provide an offer to tender 20 percent of the outstanding shares at NAV. If the NAV price of a fund is at $20 and the secondary market is trading at $17.50, shareholders that participated in the tender offer would receive $20 per share and quickly received an extra $2.50 per share over the secondary market trading price.

Lastly, management of a CEF can facilitate an open-market share repurchase program to help narrow the trading discount of a fund. A share repurchase program allows the fund company to repurchase their own shares in the secondary market if the fund is trading at a discount level that management feels will add value for existing shareholders.

Usually management of a CEF will consent to purchase a percentage of the outstanding shares on the secondary market over a specified period of time if the fund is trading at a discount wider than a stated discount — typically if the fund is trading wider than a 10 percent discount. When an open-market repurchase program is adapted, it is intended to increase the fund’s net asset value per share and also providing additional liquidity in the secondary market, which will help narrow the discount at which the fund is trading.

Additionally, shares that are purchased by management are retired, reducing the amount of outstanding shares of the fund, which increases shareholder value.

While CEF may, from time to time trade at wide discounts to their NAV, management of the funds have discount narrowing techniques that can be used to address persistently wide discounts. When these techniques are used, it usually results in decreasing the discrepancy between the price a CEF is trading for in the secondary market relative to the fund’s NAV. It also demonstrates that the management of the CEF is monitoring the trading discount of the fund and is willing to take steps to address the trading discount if needed.


James Quackenbush is a senior domestic equity analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.


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