Because closed-end funds are prized for their high distribution rates, income investors put a lot of weight on changes in fund distributions in their allocation decisions. A number of funds have, what is called a managed distribution policy or MDP, under which distributions are not directly linked to underlying income or realized capital gains. A smaller subset of funds have a policy that ties its distributions directly or indirectly to the fund’s net asset value and which allows investors to anticipate changes in distributions. This can give them a leg up in a market that is not always very efficient.
Why Care About Distributions
An important question to ask is why care about distributions? After all, in an efficient market the size of a fund’s distributions should not matter very much. Here, there are arguments on both sides of the issue.
Many investors prefer higher distributions because they either need those distributions to fund living expenses or approach investing through a “cold hard cash” over total return perspective.
There are also reasons to worry about overly large distributions relative to the fund’s NAV. Funds with high distribution rates often fail to “earn” them through time and find it prudent to cut distributions, causing a widening in the fund’s discount and a double-whammy for investors. Fund that insist on overdistributing, typically find it necessary to raise additional capital using rights offerings which not only often cause the fund’s discount to widen but are also dilutive to the NAV (not to be confused with ownership dilution which no retail investor should ever care about). And funds that return more capital to investors have less capital at their disposal which is presumably bad for those investors who believe in the fund’s ability to generate alpha. In fact, these investors should want the fund to retain all of its earnings (though, in practice, this would raise fund level tax issues).
The key dynamic that is relevant for this article is that CEF discounts are typically a function of fund distribution rates. This means that when funds cut their distributions, the discount tends to widen and vice-versa. The poster child for this dynamic is shown in the chart below with the red lines indicating distribution cuts. If investors are able to forecast distribution changes with some accuracy, it allows them to stay ahead of the game to some extent.
Source: Systematic Income
There are just about as many flavors of CEF managed distributions as there are fund sponsors. In fact, the phrase managed distribution is not unique in referring to the same concept with some fund sponsors using the phrase “stable distribution policy” or “fixed distribution policy” to refer to much the same dynamic.
Typically, the managed distribution policy refers to the policy of keeping the distribution at a fixed amount per share. For example, BlackRock, John Hancock, First Trust and Cohen & Steers funds adopt this approach. If there is insufficient income to pay the fixed distribution, the funds falls back on long-term capital gains and then on return of capital. These fund sponsors often offer little guidance as to what would cause distributions to change.
Nuveen offers only slightly more guidance on its managed distribution policy for its equity-linked funds, saying that the goal of its policy is to convert “expected long-term return potential into regular distributions” and that the distributions correspond to “projected total return from its investment strategy over an extended period of time”.
Funds that follow this policy are the following:
- Nuveen Real Asset Income and Growth Fund (JRI)
- Nuveen Real Estate Income Fund (JRS)
- Nuveen S&P 500 BuyWrite Income Fund (BXMX)
- Nuveen Dow 30SM Dynamic Overwrite Fund (DIAX)
- Nuveen Core Equity Alpha Fund (JCE)
- Nuveen Diversified Dividend & Income Fund (JDD)
- Nuveen Tax-Advantaged Total Return Strategy Fund (JTA)
- Nuveen Tax-Advantaged Dividend Growth Fund (JTD)
- Nuveen Nasdaq 100 Dynamic Overwrite Fund (QQQX)
The policy sounds pretty innocuous in itself, however, we get a better sense of how distributions are managed by Nuveen if we take a look at a few charts.
The left-axis shows the NAV in blue and the right-axis shows the distribution in green. We can see that the two follow each other fairly well in the case of JRS.
The same is true for BXMX – distributions are cut when the fund’s NAV suffers a sharp fall and rise when the NAV comes back.
Source: Systematic Income
The rest of the funds follow more or less the same pattern.
Funds that we would watch here are BXMX and QQQX as their NAVs are trading around levels where this pattern suggests the distribution is likely to rise back up.
Calamos run a half-dozen or so CEFs, all of which, have the same managed distribution policy. The policy, somewhat unusually, takes pride of place at the beginning of the shareholder reports. It says that their goal is to “provide consistent monthly distributions” that are “sustainable for the long term” and “influenced by market conditions, including the interest rate environment, the individual performance of securities held by the funds, our view of retaining leverage…”.
Let’s see what this means in practice using one of the funds.
Source: Systematic Income
We can see that Calamos have tended to raise the distribution alongside a rising NAV, relying in large on realized gains to finance them. Because the sectors that Calamos is overweight like convertibles and tech have traded very strongly, we would expect a number of funds to be close to a distribution rise. Funds that we would be on the lookout for rising distributions are CHI and CHY, in particular.
For example, this is the trading pattern of distributions and NAV for CHY. NAV is now well above the level that drove the distribution cut and is approaching the level which was followed by a distribution increase.
Source: Systematic Income
We can also see that the fund’s discount has tended to follow distribution changes – tightening on an increase and widening on a cut.
Source: Systematic Income
RiverNorth runs a handful of CEFs. Although only two of these CEFs appear to have explicit managed distribution policies all of them tend to have stable distributions for extended periods with occasional changes.
The two funds with the explicit distribution policies are the multi-sector funds:
RIV’s policy is a bit cryptic – it says that the distributions are “reset annually to a percentage of the average of the Fund’s NAV per share as reported for the final five trading days of the preceding calendar year.” This is a pretty silly formulation because the percentage is unstated. Imagine, a highly convoluted formula that has a entirely discretionary fudge factor that drives the entire calculation. If we back out what this percentage was for 2020, it was 12.67%. For the year 2019, it was 12.72%. If the percentage is kept the same from 2020 then the 2021 distributions should drop to 0.1580 from 0.18 – a drop of about 12%. However, because the fund overdistributes, the drop could be slightly worse if asset prices remain where they are.
OPP’s distribution commentary is odd in a different way. The shareholder report says that the fund maintains a “level distribution policy” where the distribution is “equal to 12.5% of the average of the funds NAV per share for the final five trading days of 2018, which amounted to $17.60. The Fund makes monthly distributions to common shareholders set at a level monthly rate of $0.18 per common share. “. Basic algebra can tell us that 12.5% x $17.60 / 12 = 0.1833, rather than 0.18. And indeed the fund distributed $0.1833 in 2019. The calculation for 2020, based on the last five trading days in 2019 was indeed 0.18 (or to be precise, 0.179917). It’s not clear why RiverNorth don’t clean up their docs here to avoid mixing up information from two different years. The fund also states that prior to 2018 it had a “managed distribution policy” set at a fixed rate of $0.15. It’s odd for the fund to call a fixed distribution “managed” but an annually-reset distribution “level”. If anything, these terms should be reversed. In any case, these terms don’t have any legal bearing so, apart from being confusing and sloppy, it doesn’t matter a whole lot. At the current NAV the new distribution would be around 0.1554 in 2021, or a drop of about 14%.
These distribution changes are unlikely to be fully priced in to current discount valuation so we would sidestep these funds until their distributions adjust.
A number of Wells-Fargo CEFs have a managed distribution policy where they pay out a fixed rate based on the fund’s average monthly NAV over the prior 12 months. Prior to a few years ago the funds did not have a managed distribution policy.
- Income Opportunities Fund (EAD)
- Multi-Sector Income Fund (ERC)
- Utilities and High Income Fund (ERH)
- Global Dividend Opportunity Fund (EOD)
Let’s see what this looks like in practice. We can see that the ERC distribution stared rising monthly once the 2015 year-end sell-off left the 12-month rolling window and started to come down again with the poor NAV performance in the second-half of 2018. Most recently, distributions have again begun to fall due to the drawdown in March.
What this means is that once March disappears from the 12-month rolling window these funds should see their distributions start to increase again.
Another reason to like the funds from a tactical perspective is that their distribution drops appear to coincide with underperformance in discounts. For example, EAD is now trading at a significant discount differential to the high-yield sector despite a still-higher current yield than the sector average and stronger NAV performance across different time-frames.
ERH also looks attractive here with a current yield comparable to the sector average and a strong relative NAV performance across different horizons within the sector.
A number of MFS CEFs have a managed distribution policy that is set based on a fixed rate of the fund’s average monthly NAV. These funds are:
- Intermediate High Income Fund (CIF)
- Charter Income Trust (MCR)
- Special Value Trust (MFV)
- Government Markets Income Trust (MGF)
- Intermediate Income Trust (MIN)
- Multimarket Income Trust (MMT)
Let’s see what this looks like in practice.
The chart shows that the distributions follow the NAV quite closely which makes sense given the way they are set.
What’s interesting about MFS funds is that the discounts tend to track the distributions pretty well also. In an efficient market, this wouldn’t be the case – the discount would be set based on the general expectation of the evolution of the fund’s NAV over the longer-term. However, because CEF discounts tend to be a function of the fund’s distribution rate – if the distribution rate moves up due to a distribution increase, the discount is likely to tighten.
Is there a way to take advantage of this? The answer is most likely yes. First, we know what the funds’ distributions are going to be prior to their declarations at the start of the month. And while it’s possible that the behavior of discounts is efficient enough to adjust for this through the month, this seems unlikely. Secondly, because MFS funds tend to overdistribute, their NAVs and, hence, distributions will tend to move lower through time, all else equal. This is more likely when valuations are on the expensive side which is not far from current levels. This means that we should start to see these funds’ distribution increases to taper off and discounts are likely to widen from here. Thirdly, when markets sell off and underlying valuations are cheap these funds will be attractive holds due to cheap valuations, discounts that are likely to be wide in aggregate across the CEF space as well as the likely discount tightenings due as NAVs mean revert and move higher. Because the MFS funds tend to skew in a higher-quality direction they offer attractive options during drawdowns for investors who don’t like to venture out into the higher-volatility CEF space.
Odds and Ends
A number of funds have adopted a managed distribution policy which pays a fixed percentage of the rolling average of the fund’s prior four quarter-end NAVs. Some of these funds are:
- Royce Value Trist (RVT)
- Royce Micro-Cap Trust (RMT)
- Aberdeen India Fund (IFN)
- Sprott Focus Trust (FUND)
All of these funds are trading at discount percentiles below the sector average, indicating that they may be under pressure by the NAV performance in March and may get a pop once their distributions stabilize and rise in Q2 of next year.
Big moves in asset prices have made themselves felt across the CEF space in a number of different ways. One indirect impact has been on those CEFs whose distribution policy is linked to their historic NAVs. Those funds with a 12-month lookback window should see the NAV drops that we saw in March roll off, allowing them to increase distributions. And because some of these funds are trading at attractive discount valuations due to the recent distribution drops, they offer an attractive relative value opportunities in their sectors.
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