Let’s Learn About CEFs: How They Generate All That Distributable Cash

ETFS

I’ve been wanting to get to this subject, because it’s personally been one of the mysteries of CEFs to me.

As stated in the first two articles in this series (first article, second article), I am focusing on equity CEFs – that is, funds that mostly own stocks.

That means these CEFs have stock portfolios, just as I do.

My public Dividend Growth Portfolio [DGP] holds 26 stocks. They are all dividend growth stocks, and the combined yield of that portfolio is 3.3%. The DGP has existed for over 11 years.

Let’s say I want to turn that portfolio into a CEF generating 8% “yield” rather than the 3.3% that it generates on its own.

Or speaking more personally, say the portfolio is my retirement account, and I want to draw 8% per year from it instead of the 3.3% that I collect in dividends. How would I safely do that?

Off the top of my head, three possible methods come to mind:

  1. I could use leverage. That is, I could borrow money from my broker via a margin account, and purchase more shares of everything. My total asset value would go up, and my income would go up. But I would also be in debt, and some of the additional income would go toward servicing that debt.
  2. I could trade options. Many income-oriented investors trade options around their positions to generate extra income beyond what their stocks naturally yield.
  3. I could trade in the account, selling off assets to generate the extra money I need for my desired annual payout of 8%. I might even tell someone at a cocktail party that my stock portfolio “yields” 8%, even though I sold stuff to generate some of that distribution amount.

It turns out that real CEFs do all three of these to generate distributable cash beyond what their assets actually yield. Let’s examine these methods in more detail.

Leverage

Leverage means using borrowed money. The borrowing can come from traditional debt or from issuing preferred shares.

As described in CEF Connect, leverage is usually a strategic and intentional part of a fund’s design and structure. The intent is to create positive longer-term returns from short-term borrowing. If it works out, successful leverage creates additional income or return to help increase distributions to common shareholders.

There are several building blocks of CEF leverage.

  1. Structural leverage means leverage created by the fund’s issuing of preferred shares and/or capital borrowing. In this illustration, CEF Connect calls this “regulatory leverage.”



2. Effective leverage adds any additional leverage created by the fund investing in leveraged securities.



The Investment Company Act of 1940 limits how much leverage a CEF can have.

  • Debt is limited to one-third of the fund’s overall assets.
  • The issuance of preferred shares is limited to half of the fund’s overall assets.

Remember that a CEF’s assets don’t rise and fall the way mutual fund assets do, because the CEF is not issuing or redeeming shares daily. Its asset base is comparatively stable. That makes staying within the allowable leverage limits relatively easy for CEFs.

Leverage literally acts as a lever. It creates a multiplier for the fund’s performance in both positive and negative directions. It increases a fund’s volatility or risk. There is no guarantee that a fund’s leverage strategy will be successful.

Nearly three-quarters of CEFs use leverage.



Let’s look at an example of leverage in a specific CEF. I have been using DNP Select Income fund (DNP) as an example in these articles to help illustrate general principles.

Here is how CEF Connect depicts DNP’s leverage:



And here is how DNP depicts its leverage in its April 30, 2019 semi-annual report.



Let’s match things up. The top two red dots on the DNP report are debt. They total $698 M (rounded) which matches CEF Connect’s line for structural leverage.

The bottom red dot is $298 M for preferred shares. That also matches CEF Connect’s depiction. (Technically, CEF Connect’s use of decimal points is inaccurate, because those digits are not “00” according to DNP’s report.)

So DNP’s total leverage is $996 M. DNP reported its total assets as $3,985 M. That would make its leverage ratio 25%. CEF Connect shows it as 25.9%; I am not sure why there is a disconnect there.

Anyway, we can see that DNP has created leverage both via issuing preferred shares and by borrowing.

A fund’s leverage is successful if, after accounting for the costs of leverage (interest and dividends paid to preferred shareholders), the common shareholders receive higher distributions and/or total returns than they would have received without the fund’s leverage.

There is, of course, no assurance that a fund’s leveraging strategy will work. Leverage magnifies returns in both directions.

  • If the underlying portfolio return is positive, a leveraged fund typically will have higher returns than an unleveraged fund with the same portfolio.
  • Conversely, if the underlying portfolio’s return is negative, a leveraged fund will have greater losses than an unleveraged version.

Trading Options

Some funds generate additional income by trading options. Usually the option strategy employed is to sell covered calls. In fact, “covered calls” is a specific category of equity CEFs.

Here is CEF Connect’s screener, set up to find funds that employ a covered-call strategy.



The screener turns up 27 funds:



Other sources say that there are around 30 covered-call funds. Thus, the number of covered-call funds is just a fraction of the total number of funds, which is about 650.

Note that at least two of the covered-call funds also use leverage according to the CEF Connect information. (I did not check that against the funds’ actual reports.)

Writing covered calls is considered a conservative options operation. This is the definition of the strategy from Investopedia.

A covered call refers to [a] transaction…in which the investor [in our case, the CEF] selling call options owns the equivalent amount of the underlying security. To execute this an investor holding a long position in an asset…writes (sells) call options on that same asset to generate an income stream. The investor’s long position in the asset is the “cover” because it means the seller can deliver the shares if the buyer of the call option chooses to exercise.

The writer (seller) of a call is paid a fee. The option premium enhances the seller’s income.

Writing covered calls works well when the stocks trade sideways. You keep the option premium, and the stock is not called away.

If the stock’s price goes skyward, the strategy can underperform, because the holder of the call will exercise their right and call the stock at the contract price. In other words, the seller of the call can get the stock from you for less money than the stock is selling for on the market. That’s why the seller paid a premium for the call, in order to get that opportunity.

If the underlying stock falls in price, the option won’t be exercised, and the option premiums provide some buffer to the return picture.

Trading in the Account

The third way to generate more distributable cash is to trade within the account. From what I can tell, all equity CEFs do this.

Let’s look at the account as if it were your own retirement account, like my DGP, which yields 3.3%. Let’s say I want to actually withdraw the equivalent of 8% from the account this year.

I can do that easily, because the account’s value has been going up during the long bull market that began in 2009. My asset base is worth way more now than when I started the account in 2008. So to reach my cash flow goal this year, I would sell 4.7% of the value of the securities and add that money to the 3.3% yield that they organically provide me.

I created this slide to illustrate how selling assets from a stock portfolio creates a cash flow that could be called “income”:



For CEF veterans, please excuse my use of simple language to describe what’s going on. The takeaway from the slide is that while I got 8% “income” or “yield” from the operation, over half of it came from the proceeds of selling some of my assets.

The basic math is no different for a CEF. Remember, at the cocktail party, I told someone that my portfolio yielded 8%, but to them it’s just a black box. Let’s look inside the black box and see what happened.



Inside the CEF, things changed significantly by its having sold assets to make larger distributions.

For one thing, the NAV of the CEF will be impacted by what was sold. Unless the prices of its assets went up enough to cover the distribution, the NAV will go down. Clearly, realizing capital gains by selling assets works well in a rising market.

Also, note the last bullet point. Even if prices of its stocks rise enough to keep the fund’s NAV even, the fund still owns fewer shares. That means that its organic income-generating capacity drops, because the CEF’s stocks declare dividends per-share. Fewer shares = less dividends that the fund receives.

I have greatly simplified this overview, because I want to illustrate the basic principles. For example, I did not take into account the assets’ dividend increases, which the fund will receive. Those might make up, at least partly, for the fewer shares that the fund owns.

Effect on NAV

Since all CEFs trade their assets, one would expect the negative effects of trading to show up in their NAVs. To be specific, one would not expect their NAVs to keep up with the general market, nor of the specific securities they own.

Here is a graph of the NAV since inception of our example fund, DNP Select Income (DNP), which is the largest utility CEF. DNP’s results are compared to SPY, an ETF that tracks the S&P 500. The graph goes back to SPY’s inception date in 1994 (so about 25 years are covered).



Our theoretical prediction is confirmed by the graph. SPY’s growth in NAV over 25 years is orders of magnitude larger than DNP’s.

Of course, this is but one example. Let’s look at another, Reave’s Utility Income Fund (UTG), the second-largest utility fund.



The YChart is constrained by the length of time that the shortest-lived fund has existed. In this case, that is UTG, which began trading in 2004. UTG’s record of increasing its NAV is much closer to SPY’s, but over a much shorter time-span.

Looking Ahead

This article is meant to be an overview of a complex subject. I know that I used simplifications and shortcuts in explaining basic principles, but I hope that readers get the gist of how equity CEFs produce much more distributable income than they collect in dividends from the stocks and other assets that they own.

In researching this article, I began to look at the detailed operations of a couple of CEFs – their business plans, if you will. I will do more of this in the future.

As I said in the first article, I am coming at CEFs from the point of view of a stock investor. I see each CEF as a business, much as I view McDonald’s (MCD) or Apple (AAPL): They make stuff and/or provide services, and to succeed, they have business models and strategies, and they must execute them well.

I consider understanding a company’s business model (on a macro level) to be a baseline requirement for investing in a stock.

I am approaching CEFs the same way: I would like to understand (at a macro level) the business models of CEFs that I might one day be interested in purchasing.

CEF business models are all centered around financial strategies that could be termed financial engineering. That’s why I spent time in this article on the basic ways that equity CEFs create more distributable money than they collect in dividends from their assets.

Summary

  • There are three main ways that equity CEFs generate distributable cash beyond what they receive in income from the stocks that they own: They use leverage; write options; and sell off assets.
  • Most CEFs use leverage: More than 70%.
  • Not many CEFs write options: Fewer than 50 (less than 8%).
  • All CEFs trade and sell assets to generate capital that they can distribute to common shareholders.
  • Since equity CEF yields far exceed the yields of the assets they hold, one would expect that the “extra” money comes from NAVs that do not keep up with the market. A couple of examples suggest that this is true.

Please use the comments to correct any mistakes I have made, pose questions, and share your own knowledge.

The next article will stay with the topic of CEF income, and it will explore the various ways that income is characterized by CEFs: As short- or long-term capital gains, qualified or unqualified dividend income, ordinary income, return of capital, and the like.

Disclosure: I am/we are long MCD, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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