What You Need To Know About CEFs And Rising Rates
By Genia Turanova | August 08, 2017 |

It wasn't a surprise that the U.S. Federal Reserve didn't hike interest rates its July meeting. 

The Fed already hiked short-term interest rates twice this year, raising rates by a quarter percentage point in March and again in June. 

After years of near-zero interest rate policies, the benchmark rate has now been hiked to a range between 1% and 1.25%. Of course, rates are still low by any historical measure. But they are significantly higher than just a year ago.

Also important is the speed with which short-term interest rates have increased over the past year. The two charts below show how fast a three-month Treasury note rate and a one-year rate have jumped: 

3-Month Treasury 

1-Year Treasury

Unfortunately for income investors, these rate increases are being felt especially in closed-end funds, or funds that issue a fixed number of shares and can also borrow in order to enhance dividends and returns. 

The mechanism is quite simple. Higher short-term rates are making the cost of leverage more expensive. And because many closed-end funds use leverage to enhance returns and dividends, the costs for these closed-end funds are also going up. 

Why CEFs Are Still Viable Investments
This isn't entirely unexpected. I discussed this likely dynamic with my Daily Paycheck readers back in October, when I warned that further rate hikes are likely to result in distribution decreases. 

However, forewarned is forearmed. I've been watching the closed-end fund space closely, and when one fund that I truly liked dropped more than 10% on what I thought was a prudent dividend cut, I thought investors were handed a gift. I did more research, and as a result, I made added it to the Daily Paycheck portfolios in August. 

Meanwhile, short-term rates are still on the rise. The market, as I write this, assigns about a 50% probability of at least one rate hike by year-end. 

Thankfully, the entire closed-end fund universe as a group still offers reasonable value. As of July 28, closed-end funds were selling at an average 3.5% discount to their net asset value (NAV), with equity funds offering the bigger bargain -- a 4.8% discount, and bond funds selling at a 2.5% discount. 

On average, therefore, investors don't overpay when they buy a closed-end fund. This seems to reflect at least one more near-term interest rate increase and a subsequent rise in leverage costs. Still, given that the average fund still sells at a discount, this likely rate hike is priced in. 

Of course, as is always the case, the average hides a variety of extremes. Even the dozen or so funds in the Daily Paycheck portfolios run the gamut from a 1% premium to an 8% discount.

Don't Fear The ROC
Quite often, the market assigns a discount to closed-end funds because these funds classify all or part of their distribution as return on capital (ROC), which is quite often destructive to NAV. Investors, for many reasons, do not like ROC and treat it with suspicion. 

For one thing, it can be difficult to predict ahead of time whether or not a fund will end up classifying part of its distributions as a ROC. 

What gives?

Sometimes investors can only guess why a fund classifies part of its distribution as ROC. The management of the closed-end knows the reason; investors don't. 

So, let's review. 

CEF distributions can have only the following sources: 

-- Interest payments or dividends from fixed income or equity portfolio holdings;

-- Realized capital gains;

-- and return of capital (ROC). 

In turn, ROC can be pass-through (such as from master limited partnerships), "constructive" (such as from unrealized capital gains), or destructive (this is the dreaded one, where investors are literally receiving their own capital back). A fund manager may decide to make a "constructive" return of capital distribution when a fund portfolio has unrealized capital gains. 

It's probably why one of the lessons I learned from "Bond King" Bill Gross was to not be afraid of a ROC, per se. Yes, if misused by a fund manager it can be destructive to shareholder capital -- but in the capable hands of a good closed-end fund manager, it's another tool. 

Still, because closed-end funds are not transparent, it's often impossible to say with certainty whether a specific fund's ROC is constructive or destructive to shareholders' capital. Treating any ROC with some degree of suspicion is probably the best course of action.

But there's a positive side, too: as a rule, distributions classified as ROC are not subject to current tax. The tax cost basis for shareholders receiving a return of capital distribution will be reduced by the amount of the distribution. 

One last point: there is a rule of thumb to help investors in figuring out whether a fund in question engages in destructive return of capital policies. A steadily decreasing NAV generally indicates that the fund has been distributing more than it earned. An increasing NAV, however, is a good thing, an indication that the fund is earning its distributions. This rule is not infallible, but I have found it helpful at times. 

P.S. Experience counts. Even though, as I just discussed, previous performance does not provide any guarantees for the future, analyzing the past helps in another important way. In many cases, it's the best window into a fund management's thought process and the fund's overall potential. As Shakespeare said, "What's past is prologue."

By studying the past, we can glimpse into the future by getting at least some insight into the ways a fund handles bull or bear markets, favorable or adverse environments, and volatility, to name a few.

And the future of one CEF in particular is looking bright. With capable management, a 6.9% forward yield, and an attractive risk profile for the tough times ahead, the fund is still trading at a discount to its NAV. 

While revealing the name of this fund here would be unfair to my Daily Paycheck subscribers, I can tell you it's slated to join my high-income portfolio. It'll become part of a simple strategy that's paying my readers thousands of dollars each month. 

If the thought of an extra $1,543... $2,184... even $4,200 each month in cash sounds good to you, this special report shows you how to get it...

This article originally appeared on StreetAuthority.