A decade ago, Michael Foster turned to closed-end funds (CEFs) to secure an 8% income stream from his portfolio, giving him the confidence to leave his academic job. Surprised by the lack of popularity of these high-yield investments, Foster began writing about CEFs and sought to understand why they were not receiving more attention. After speaking with economists, bankers, fund managers, and other experts, he concluded that CEFs should indeed be more popular, and a major market shock could make them more attractive to investors.
In 2022, a market crash prompted many retail investors to exit the market and move their assets into money-market funds. Even after the S&P 500 fully recovered in the first quarter of 2024, cash from apprehensive investors remains on the sidelines. Despite some cashing out of CEFs, their fundamental asset values have continued to rise, leading to a recovery in CEF returns across various sectors. However, retail investors are still hesitant due to media-driven fears, creating an opportunity for hedge funds and activists to potentially take advantage of the situation.
Although CEFs historically traded at an average discount to net asset value (NAV) of about 5%, the current average discount is around 7%. A year ago, discounts were over 9%, prompting activists to enter the market. Today, the discounts are shrinking rapidly, with some CEFs, like the PIMCO Dynamic Income Fund (PDI), trading at significant premiums to NAV. This shift in valuation has resulted in impressive returns for some funds, such as PDI, which has delivered a 17.4% return, resembling stock gains more than bond fund profits.
With many good funds remaining undervalued, opportunities like those seen with the BlackRock Science and Technology Trust (BST) are becoming harder to find. BST, which experienced heavy discounts in the mid-2010s due to economic concerns, eventually transitioned to a premium valuation in 2018 as tech stocks continued to perform well. Despite fluctuations in demand driven by factors such as the Federal Reserve, inflation, and the pandemic, BST now trades around par, indicating potential for further premium pricing if retail investors return to the CEF market.
The current trend of rising average CEF discounts suggests that there is potential for more premium pricing as investors become more confident in CEFs. For example, investors buying into BST at its current discounted price could potentially see a 13% capital gains return on top of the fund’s 7.9% yield if it rises to a 10% premium. With signs indicating a possible resurgence in interest in CEFs, there may be opportunities for investors to capitalize on the potential for increased premiums in the future. Michael Foster serves as the Lead Research Analyst for Contrarian Outlook, providing valuable insight and recommendations for income-seeking investors.
