Closed end funds: when is a discount not a discount?
As I was looking around the investing universe for possible underpriced securities over the past couple of months I happened upon a number of closed-end funds trading at significant discounts to net asset value (NAV). Now, usually I wouldn’t consider these appropriate for my ‘value’ portfolio as the upside potential is generally in the single to low double digits percentage-wise, mostly from a narrowing of the discount, plus there needs to be some kind of catalyst to make the discount disappear. Furthermore, in my experience CEFs trading at a discount are more a phenomenon of bear markets rather than bull markets. Last year, however, a number of fixed income CEFs began trading at significant discounts to NAV after the tapering announcement in June by the Fed sent the bond market South. This included not only municipal income CEFs but also funds invested in mortgage securities. The discounts widened to almost double digits in December as investors with significant taxable gains in equities looked to offset those gains with something, anything, in their portfolio that was trading at a loss. Barron’s highlighted this at the beginning of December (not exactly a secret source). I did take a position in a couple of these CEFs in another portfolio, and so far the funds have done well, rising 4-5% in January. However, this was pure chance because the thesis that the discount would narrow has been proved WRONG, at least to date. If anything, discounts have widened. But the funny thing is, NAVs have increased even more, more than offsetting the growing discount. So you see, you can be wrong and still make money, or, another way of looking at it is, you can’t tell if you’re right with your investment thesis just because you DO make money. Beware of false positives!
So what does this have to do with the little riddle in the title “when is a discount not a discount”? Nothing yet… What I wanted to bring up, after my first point above, is that CEFs can be tricky little buggers. They don’t always do the things they are supposed to do. I’ve been following the Special Opportunities Fund, a closed end fund managed by Bulldog Investors, because it follows a strict investment strategy in a little sandbox all its own, i.e. taking advantage of CEF discounts through activist investing. Generally they invest in closed end funds trading at a discount then try to get management to take some action, like a share tender, that will narrow the discount. They have been quite successful over the past 20+ years and have outpaced the indexes by several percentage points a year. I have been keeping an eye on the fund because it has been trading at a discount to NAV recently and I had been thinking of investing. Wow, a discount on top of a discount! Sounds interesting…
My balloon was punctured this week. The discount I thought SPE was trading at was really not a discount at all. Last Friday (1/24) the fund closed at $17.11 per share and the reported NAV was $18.54 for an apparent discount of 7.7%. Monday the Fund announced that it was redeeming its convertible preferred shares in March for those who don’t convert beforehand. The fund shares immediately tanked over 5% (and have continued down since). Huh? Convertible preferred shares? Who knew? Because the converts are trading at a premium to face value (because if converted they are more valuable than their liquidation value) but are accounted for only at liquidation value in the NAV calculation, the conversion will result in dilution of the total asset value and thus the NAV per share. I’m assuming, of course, close to 100% conversion because only someone on mental vacation will trade in a preferred share trading over $60 for its $50 liquidation value. So dilution from the convertible preferred will result in the per-share NAV declining close to 7% for the common, and there goes the discount to NAV that appeared to exist last week. Now, I’m not exactly sure why they chose to call the convertible preferreds now, except that perhaps they didn’t want the apparent discount to NAV to grow and create some future shareholder issues. But it just goes to show you that you need to read the fine print when dealing with closed end funds. And I still consider Bulldog one of the most upfront of closed end fund managers.
PS. SPE’s annual and semi-annual reports are a good source of investment ideas for those interested in some arcane securities.