Looking to buy assets at a discount? Consider closed-end funds

Stephen Minar, Director at BlackRock, discusses year-end tax loss selling and why closed-end fund discounts may present an attractive entry point

Historically, fourth quarter tax loss selling of closed-end funds (“CEFs”) has been prevalent in the market. CEFs may be more susceptible to tax loss selling given they trade on a stock exchange and market prices can deviate from underlying net asset values (“NAVs”).  A “discount” arises when a Fund’s market price is below the NAV.  When discounts widen (market price under-performs NAV), investors may choose to realize a capital loss by selling the fund (tax loss selling), which results in additional supply and may further widen a fund’s discount. Discount widening may be amplified in asset classes that experience elevated levels of under-performance in a given year.

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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 out-performance as investors re-enter the market after selling positions in prior months to harvest taxes and re-balance their portfolios.  Based on historical trends, BlackRock believes that tax loss selling may present an opportunity to reap the rewards of a temporary mis-pricing in the CEF market.

A look ahead

After a volatile October, discount widening has magnified negative 2018 returns in certain categories.  BlackRock believes that, consistent with historical trends, this negative YTD performance may contribute to amplified tax loss selling during the fourth quarter of 2018 as investors potentially seek to realize capital losses as they plan for the upcoming tax season.  While BlackRock believes investors should take a long-term view when investing in CEFs, the resulting supply-demand imbalance and historically wide discount levels may provide an advantageous entry point for short or long term investors alike.

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Long term value but short term headwinds

Historically wide discounts for leveraged muni CEFs may present a rare opportunity for long-term investors seeking high levels of tax-exempt income.  Currently, leveraged national municipal CEFs trade at an average discount of -11.3% according to Lipper. For context, leveraged muni CEFs have traded at a narrower discount level on 99% of trading days over the last 20 years and have averaged a -3.5% discount over that time period.  At BlackRock, we believe these conditions are cyclical and discounts this wide are not likely to persist longer term.  In fact, many leveraged muni CEFs traded at premiums over the past year.

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

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Stephen Minar, is a Director on the Closed-End Funds team at BlackRock.

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