The benefits of buying CEFs at a discount can be obvious; the increased yield benefit and the potential compression of a funds discount after purchase are two them. Buying an asset at 80 to 90 cents on the dollar provides investors significant positive return convexity.
During the financial chaos of ’08 & ’09 many CEFs slashed their dividends as they no longer had capital gains to payout distributions. As the markets have rebounded, some of those same funds who slashed dividends and worked through their tax losses, now carry unrealized gains. If those funds realize those gains they must pay out at least 90% of them. Funds can do this in different ways, but one way may be to increase their dividend yield. Additionally, the continued pressure from institutional and activist investors is also supportive of higher dividends going forward. We remain in an environment where investors demand and chase yield.
Now, here’s where the discount comes in. If I (the Fund) am trading at a significant discount, lets say greater than 10%, any distribution of assets I make is akin to a partial tender at NAV. As an investor (you) receive distributions at NAV.
Not every CEF with a low yield and big discount fits this thesis. Many CEFs may not work through their tax losses for years to come, see TY. Funds like ADX might be ruled out as they have a low portfolio turnover. A funds holdings are an important consideration as well. Do you want to own a fund like BTO which is comprised of Banks and Thrifts? The trick is to find funds who have benefited from the recent upswing in the markets, are no longer in the red, and plan to realize gains in 2010 which they must pay out to avoid paying taxes.
The screen below highlights CEFs at a 10% or greater discount with yields less than 2%.