2019 has been a strong year for closed-end funds (“CEFs”), with double-digit net asset value (“NAV”) returns in many sectors (Exhibit 1). Additionally, discounts have narrowed over the course of the year, driving market price outperformance versus NAVs. Positive market price returns may lead to fewer opportunities for investors to employ tax loss selling strategies in 2019. However, given the income focus of many CEFs, and the large distributions they pay out, the current market value may be lower than an investor’s cost basis, resulting in a capital loss. Moreover, CEFs held for more than one year may be in a capital loss position. Although tax loss selling may be limited compared to 2018, the fourth quarter has historically exhibited discount widening prior to year-end as investors seek to harvest capital losses to help reduce current year tax liabilities. That being said, BlackRock believes the dearth of yield opportunities across the globe will keep demand for CEFs high and could lead to tighter discounts in the near future.
The January effect
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 outperformance as investors re-enter the market after selling positions in prior months to harvest taxes and rebalance their portfolios. Based on historical trends, BlackRock believes that tax loss selling may present an opportunity to reap the rewards of a temporary mispricing in the CEF market.
Potential long-term value amid short term headwinds
The Energy sector has experienced elevated volatility over the past year and demand for the asset class has waned, causing Energy CEF discounts to widen beyond their historical average (currently -9.8% versus -6.6% 10-year average). Notably, Energy CEFs have traded to premiums over the past 10 years when market sentiment was positive for the asset class.
Oil prices, which are an important driver of energy equity valuations, have been sensitive to global growth expectations and geopolitical risks in 2019, ranging from $46 to $66 per barrel (currently $54 per barrel). BlackRock believes that the marginal cost per barrel is currently between $60-$70 and expect oil prices to average within this range during 2020, barring a sharp economic slowdown. We believe that recent selling in Energy CEFs may be overdone and wide discounts may present an opportunity for long-term investors seeking growth. Also, with increasing geopolitical risk and instability, energy equities may offer a good hedge against potential tail risk events heading into 2020.
Bank loan funds:
Market sentiment for floating rate assets has been negative in 2019 with the Fed reversing course and cutting interest rates to stabilize the U.S. economy. With investors less concerned about rising interest rates, demand for Bank Loan funds has declined as illustrated by widening CEF discounts and mutual fund outflows ($28bn in net outflows in bank loan mutual funds year to date as of 9/30/19). Currently, Bank Loan CEFs trade at an average discount of -8.3% according to Lipper. For context, Bank Loan CEF’s have historically traded at an average discount of -4.3% over the last 10 years and have moved to premiums when the asset class is in demand. BlackRock believes that current discount levels may present an opportunity for long-term investors seeking income. While rates have fallen (bank loan yields generally increase with rising interest rates), overall, loan fundamentals remain firm. BlackRock believes bank loans continue to provide attractive risk-adjusted income at this point in the cycle, especially in the context of strong active management.
Tax loss selling into year-end may continue to pressure CEF discounts in the short term, however, these wide discounts may offer long term investors the potential to benefit from price appreciation in addition to attractive levels of income.