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Sifting through the froth

Mon, Dec 9, 1:34 PM ET, by , BlackRock

2019 has been a strong year for closed-end funds (“CEFs”), with double-digit net asset value (“NAV”) returns in many sectors (Exhibit 1). Additionally, discounts have narrowed over the course of the year, driving market price outperformance versus NAVs. Positive market price returns may lead to fewer opportunities for investors to employ tax loss selling strategies in 2019. However, given the income focus of many CEFs, and the large distributions they pay out, the current market value may be lower than an investor's cost basis, resulting in a capital loss. Moreover, CEFs held for more than one year may be in a capital loss position. Although tax loss selling may be limited compared to 2018, the fourth quarter has historically exhibited discount widening prior to year-end as investors seek to harvest capital losses to help reduce current year tax liabilities. That being said, BlackRock believes the dearth of yield opportunities across the globe will keep demand for CEFs high and could lead to tighter discounts in the near future.

The January effect

Based on historical trends, investors that have purchased CEFs in the latter part of the fourth quarter have generally realized the benefits of tax loss selling through the short-term effect of discount narrowing (market price outperforms NAV) most prevalent in the month of January.  Notably, CEF discounts have narrowed in January in 16 out of the last 20 years.  This consistency may be attributed to the 'January Effect'.  According to this theory, pent up demand following tax loss selling may be the factor driving the outperformance as investors re-enter the market after selling positions in prior months to harvest taxes and rebalance their portfolios.  Based on historical trends, BlackRock believes that tax loss selling may present an opportunity to reap the rewards of a temporary mispricing in the CEF market.

Potential long-term value amid short term headwinds

Energy funds:

The Energy sector has experienced elevated volatility over the past year and demand for the asset class has waned, causing Energy CEF discounts to widen beyond their historical average (currently -9.8% versus -6.6% 10-year average). Notably, Energy CEFs have traded to premiums over the past 10 years when market sentiment was positive for the asset class.

Oil prices, which are an important driver of energy equity valuations, have been sensitive to global growth expectations and geopolitical risks in 2019, ranging from $46 to $66 per barrel (currently $54 per barrel). BlackRock believes that the marginal cost per barrel is currently between $60-$70 and expect oil prices to average within this range during 2020, barring a sharp economic slowdown. We believe that recent selling in Energy CEFs may be overdone and wide discounts may present an opportunity for long-term investors seeking growth. Also, with increasing geopolitical risk and instability, energy equities may offer a good hedge against potential tail risk events heading into 2020.

 

 

Bank loan funds:

Market sentiment for floating rate assets has been negative in 2019 with the Fed reversing course and cutting interest rates to stabilize the U.S. economy. With investors less concerned about rising interest rates, demand for Bank Loan funds has declined as illustrated by widening CEF discounts and mutual fund outflows ($28bn in net outflows in bank loan mutual funds year to date as of 9/30/19). Currently, Bank Loan CEFs trade at an average discount of -8.3% according to Lipper. For context, Bank Loan CEF's have historically traded at an average discount of -4.3% over the last 10 years and have moved to premiums when the asset class is in demand. BlackRock believes that current discount levels may present an opportunity for long-term investors seeking income. While rates have fallen (bank loan yields generally increase with rising interest rates), overall, loan fundamentals remain firm.  BlackRock believes bank loans continue to provide attractive risk-adjusted income at this point in the cycle, especially in the context of strong active management.

 

Tax loss selling into year-end may continue to pressure CEF discounts in the short term, however, these wide discounts may offer long term investors the potential to benefit from price appreciation in addition to attractive levels of income.

This material is for informational purposes only and is not intended to be relied upon as research or investment or tax advice, and is not a recommendation, offer or solicitation to purchase or sell any securities or to adopt any investment strategy, nor shall any securities be offered or sold to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. There is no assurance that a Fund will achieve its investment objective. Investing in a Fund involves numerous risks, including investment risks and the possible loss of principal amount invested. The Funds are not complete investment programs and you may lose money investing in a Fund. An investment in a Fund may not be appropriate for all investors.  Performance results reflect past performance and are no guarantee of future results. Current performance may be lower or higher than the performance data quoted. All returns assume reinvestment of all dividends and/or distributions at the price of the Fund on the ex-dividend date. The dividend yield, market value and net asset value of a Fund's shares will fluctuate with market conditions. Closed-end funds may trade at a premium to NAV but often trade at a discount. The amounts and sources of Fund distributions reported in any notices to shareholders are only estimates and are not being provided for tax reporting purposes. The actual amounts and sources of the amounts for tax reporting purposes will depend upon a Fund's investment experience during the remainder of its fiscal year and may be subject to change based on tax regulations. A Fund will send a Form 1099-DIV for the calendar year that will tell shareholders how to report these distributions for federal income tax purposes. Some Funds make distributions of ordinary income and capital gains at calendar year end. Those distributions temporarily cause extraordinarily high yields. There is no assurance that a Fund will repeat that yield in the future. Subsequent monthly distributions that do not include ordinary income or capital gains in the form of dividends will likely be lower. Some investors may be subject to the alternative minimum tax (AMT). The Funds are actively managed and their characteristics will vary. Stock and bond values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves special risks including, but not limited to political risks, currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Principal of mortgage- or asset-backed securities normally may be prepaid at any time, reducing the yield and market value of those securities. Obligations of U.S. government agencies are supported by varying degrees of credit but generally are not backed by the full faith and credit of the US government. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher rated securities. Investments in emerging markets may be considered speculative and are more likely to experience hyperinflation and currency devaluations, which adversely affect returns. In addition, many emerging securities markets have lower trading volumes and less liquidity. A Fund may use derivatives to hedge its investments or to seek to enhance returns. Derivatives entail risks relating to liquidity, leverage and credit that may reduce returns and increase volatility. Refer to a Fund's prospectus for more information. © 2019 BlackRock, Inc. All Rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners.

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