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Closed end funds: when is a discount not a discount?

January 30, 2014

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.

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4 Comments
  1. Hi there,

    long time reader here.. great post as always! I noticed the convertibles a while back and it was the only thing keeping me from buying the common stock. Given there conversion and the now healthily discount to NAV for SPE.. I think it could be interesting. Andy and Phil are are great value guys.. a good bit of the CEF is doing SPAC arb and they are going to do a “international SPE” spin-off soon.. a small allocation of warranted.

    NAV (Jan 24th) 138,142,319
    Common Shares (Jan 24th) 7,451,042
    NAV per Share (Jan 24th) 18.54
    Preferred Shares 734,847
    Preferred (Liquidation Preferance) $50.00
    Preferred Liability (On Balance Sheet) 36,742,350

    Convertion Ratio 3.716
    Total Shares Issued/Converted 2,730,691
    TOTAL SHARES (NEW) 10,181,733
    NAV (NEW) 174,884,669
    NAV per share (NEW) 17.18
    Price 15.7
    Dicount to NAV 8.60%

    • Thanks for the comment Thomas. My only thought on the discount is that this week being a down week we’ll have to wait for Friday’s NAV to have a real estimate of the discount. I have a feeling it will be less than the 8.6% you calculate above. Of course we’ll also have to factor in whether there have been any conversions in the meantime, but the press release stated that they would be providing share counts on a weekly basis, so this should be no problem.

  2. Hey Jay,

    Thanks for your the great blog. Love reading your posts. Yes the discount will be a bit off from last Friday but my thought on SPE is much bigger picture than that.. I held off of SPE for a really long time because of the converts and now with them out of the way.. I’m really excited to be able to invest along side Phil and Andy at an OK discount.. they are terrific investors.. and over time I have no doubt they will outperform the market.

    Best, Thomas

    • Thomas,
      You are a better investor (or investigator) than I! I have been vaguely following SPE for a while after reading an interview with Phil and had put the name in my ‘to-look-at’ file with thoughts of investing. I never really did a full analysis of the fund as I don’t usually invest in closed end funds unless I see a significant discount and some catalyst (and I’m no Bulldog). So it goes without saying that I hadn’t even seen the convertible preferreds hiding in plain sight. But I don’t think I was the only one surprised given the downdraft in the share price after the recent press release.

      OK so as of Friday it looks to me like the discount is just under 7% on a fully diluted basis. I am wondering if the preferred holders, in their rush to exit the shares on conversion (am I dreaming?), might not provide us with an interesting entry point. What I mean is, if the holders of preferreds mostly decide to exit the position because they are looking for an investment that provides income as well as appreciation (isn’t that why they invested in the preferreds in the first place?), we could see further weakness in the common share price over the next couple of months. After all, there are another 2.4 million common shares potentially coming onto the market with the conversion, increasing the shares outstanding by a whopping 30%+.

      I agree with you that this fund is a keeper. Not only great past performance based on convincing value strategy but great reinvestment terms too. If the discount grows to 10-15% in the next couple of months I think I will join you in allocating a portion of my cash to SPE.

      Thanks again for your comments. Jay

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