High Yields, High Risk
Take two securities, one yielding 10% and the other 2%. Assume that’s all we know about them. What, if anything, can we conclude about their relative riskiness?
The answer matters a great deal, and most investors get it right only after paying a lot of “tuition” in the capital markets.
In my experience, the novice thinks like this: Sure they could both drop in price, but at least the 10% one will still have the yield, which will support equity value.
The experienced investor knows 10% yields are usually that high for a reason. Why are people demanding 10% annually to invest in this? Most often that will be the wiser thought and better risk barometer.
I bring all of this up because in my haste to discuss the new portfolio last week I neglected to offer any risk analysis. Let’s fix that right now by considering the downside of the high-yielding closed-end funds profiled here.
The biggest risk factor is that these are leveraged plays on the current bull market, borrowing to invest in a strategy that magnifies gains as well as losses. As such, these funds will pay a steep price when the market corrects and a steeper one when the current expansion finally comes to a close.
I don’t think we’re anywhere near that point yet. But note that the lion’s share of the distributions comes from accumulated capital gains. A protracted or severe market decline could jeopardize these payouts and would certainly make investors much more skittish.
Lately, risk appetite has been on the rise. By one estimate, the median discount to net asset value narrowed from 9.2% to 5.6% during the first four months of this year for closed-end funds long U.S. equities. For foreign equity closed-end funds, the discount shrank from 12.8% to 9.1%.
The good news is that the discount shrank because prices have been bid up and not because the asset value fell, as BlackRock’s closed-end fund review shows.
By now domestic equity closed-end funds are only 4% or so cheaper than their assets, on the whole. That’s richer than they’ve traded in years but only a little pricier than the 20-year average discount.
As the bull market progresses we might see more funds trading at a premium to NAV the way some of the popular credit vehicles do already. So while the trend is currently our friend it’s worth remembering that smaller discounts leave less of a safety margin for when the going gets tough.
The Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund (ETO) fund closed at a marginal premium to NAV on Tuesday. It’s averaged a discount of 1.9% over the last six months and 3.6% over three years.
Over the last six months, 82% of the distributions were classified as capital gains. But it’s important to understand that distributions under what Eaton Vance calls its “managed distribution plan” are a marketing tool and not an approximation of the fund’s performance.
For the fiscal year ended in October ETO made $2.16 per share in distributions largely at the expense of its net asset value, which shrank by $2.10 per share.
Assuming you reinvested distributions, the actual investment return on net asset value was 0.25%, after subtracting 1.76% for expenses, mostly for Eaton Vance’s management fee and interest costs.
Now, last year was particularly lean and this one’s gone much better so far. As of October, the fund had averaged annual investment returns of nearly 11% over five years and 6% over a decade.
Still, it’s worth excerpting the manager’s “managed distribution plan” disclaimers here:
A Fund’s distributions in any period may be more or less than the net return earned by the Fund on its investments, and therefore should not be used as a measure of performance or confused with “yield” or “income.” Distributions in excess of Fund returns will cause its net asset value to erode. Investors should not draw any conclusions about a Fund’s investment performance from the amount of its distribution or from the terms of its managed distribution plan. The Fund’s Board may amend or terminate the managed distribution plan at any time without prior notice to Fund shareholders.
And, in fact, ETO cut its monthly payout by 35% after 2008. Just two months ago Eaton Vance trimmed the distributions of two other global income funds. Other closed-end managers have cut the payouts of their muni funds amid rising borrowing costs and the general drift to lower coupons.
The good news is that investing performance has improved this year for ETO as well as the Eaton Vance Tax-Advantaged Dividend Income Fund (NYSE: EVT) and the PIMCO Dynamic Credit and Mortgage Income Fund (PCI). All three are likely to keep delivering distribution yields of 8-9% for the foreseeable future. Unfortunately, foreseeable future never lasts as long as one might hope in this business.
By all means, let’s collect the income (and make sure to reinvest it if at all possible.) It’s also probably fair to assume the current payout levels would survive, say, a 10% market correction, though the NAV and the share price would suffer, of course.
But I know that I won’t wait too long before jettisoning these funds from the portfolio if and when the market mood turns, on reasonable odds of buying them back cheaper later. Leverage is a double-edged sword and in hostile markets it can cut to the bone.