Category Archives: closed end funds

Credit Suisse High Yield Bond Rights Offering (DHY)

Many investors wonder what to do when a closed-end fund undergoes a rights offering. These offerings dilute existing shareholders that do not exercise the rights, since they add shares outstanding and the offering price is usually at a discount to the current market price.

The Credit Suisse High Yield Bond Fund (ticker: DHY) recently held a rights offering that just expired on October 15. Existing shareholders were offered the right to buy one new share for every three shares they already owned. The new shares are being sold at a 7.5% discount to the market value determined by averaging the closing price for five days leading up to October 15.

For example, suppose you owned 3000 shares of DHY which closed on Friday at $2.93. The 3000 rights entitle you to purchase 1000 new shares of DHY at a price of approximately $2.72 (which is 0.925 times the five day average of the closing prices from Oct 11 through Oct 15). These rights were tranferrable and traded on the secondary market for several weeks. The rights generally traded for about 6 cents each. The “fair value” of the rights is about 7 cents, since three rights give you a discount of about 21 cents a share based on the current price.

These rights offerings provide good opportunities for larger, more sophisticated investors, but in some ways are unfair to small investors because:

  • They provide a way for closed-end funds to raise additional money without paying a large underwriting fee, but they are somewhat coercive, since they force shareholders to participate or face significant dilution.
  • Most small investors who exercise their rights have to pay a “corporate reorganization fee” of $30 to $50 which wipes out any advantage they may get.
  • Small investors who sell their rights pay a commission which can be a large portion of the value received.

For example, suppose a small retail investor owned only 300 shares of DHY. They would receive 300 rights that sold for about 6 cents each, so the investor would only receive about 18 bucks minus commissions on a sale. If they exercise the rights, they can buy 100 new shares at $2.72, but the corporate reorganization fee of $50 would make the total cost of the new shares $3.22 which is no bargain.

What happens to the shares from rights that are not exercised by smaller investors? There is an oversubscription option, where investors that do exercise their rights can oversubscribe for additional shares at the discounted price. This is where larger, more sophisticated investors can get an edge.

I purchased some blocks of DHY rights when they were available at discounted prices. In order to keep the commission cost down, I try to purchase rights in fairly large size- at least 9,000 share lots or more. It will be interesting to see how DHY trades next week. The NAV will drop somewhat because of the share dilution. But DHY is currently trading at a small discount to NAV, while it sold at a 10% premium a few months ago. Quite often, the premium re-establishes itself a few months after the rights offering is completed.

There was a similar rights offering earlier this year in PFN. Bill Gross purchased 49,291 shares using rights he obtained as a shareholder. He also oversubscribed for 1,000,000 shares and received 255,908 additional shares at the discounted price, or about five times as much as from his original rights. This shows that oversubscription can be quite profitable, but you need to have significant excess cash funds available in your account.

Full Disclosure: Long DHY.

H&Q Healthcare Investors (ticker:HQH)

H&Q Healthcare Investors (ticker:HQH) appears to a be a decent value now within the closed-end fund universe. It is broadly diversified, and primarily invests in biotechnology, medical devices, pharmaceuticals and medical delivery. It also invests a limited portion of the portfolio in smaller, emerging companies and some restricted securities. In their last SEC filing (as of June 30), the top five holdings were: Teva, Gilead, Celgene, Amgen and Biogen.

On August 4, the fund discontinued their managed distribution policy. HQH had been paying out 2% of NAV in capital gains distributions every quarter for many years. The purpose of this policy was to narrow the discount to NAV, but the policy was not fully successful and mainly just reduced the NAV of the fund. On August 5, the day after the press release, the discount to NAV jumped up three percent from -17.78% to -20.73%.

On September 30, the fund announced a share repurchase plan to enhance shareholder value and narrow the discount to NAV. They will purchase up to 10% of the shares in the open market. This can occur during the one year period following October 9, 2009.

Here are some recent stats on HQH:

Ticker:HQH     H&Q Healthcare Investors   no regular dividend 

  • Total Net Assets= 343 MM
  • Expense ratio= 1.51%              Discount to NAV= -20.27%
  • Portfolio Turnover rate= 65%

Disclosure: Long HQH

PIMCO Global StocksPLUS & Income Fund

There are quite a few over-priced closed-end funds trading now which pay out high distribution rates, usually produced by gimmicks. I reported on several funds that used dividend capture a few weeks ago. Another closed-end fund selling at a large premium over NAV is the PIMCO Global StocksPLUS & Income Fund (ticker:PGP).

This fund takes an “innovative” approach to generate artificially high dividend payouts that has attracted strong support from retail investors. They do not invest directly in equities. They invest in futures contracts (50% S&P 500, 50% MSCI EAFE) using a short-term bond portfolio as collateral for the derivatives exposure. The bond portfolio has an average duration of about two years and includes emerging market bonds. They then write call options on the US equity portion to generate additional income from option premiums. They use about 33% leverage to increase the dividends generated.

Recently PGP has generated good market performance mainly because the shares have traded from a discount to a large premium over NAV.

11/28/2008      Discount to NAV of=  -18.34%

11/11/2009      Premium over NAV= +65.14%

This is an 83% swing. Closed-end fund discounts and premiums over NAV usually revert to the mean, so PGP looks dangerously over-valued here. The shares are difficult to short, so I would not necessarily recommend a short sale, since the shares could be subject to a forced buy-in. 

Ticker:PGP     Pimco Global StocksPLUS&Inc   pays monthly 

  • Common Assets= 107 MM
  • Total Net Assets= 162 MM (uses 33.6% effective leverage)
  • Annual Distribution (Market) Rate= 12.22%    
  • Income Only Yield= 3.43%
  • Baseline Expense ratio= 1.88%             
  • Premium over NAV= +65.14%
  • Portfolio Turnover rate= 214%

 Full Disclosure: No position in PGP

Attractive Closed-End Fund (CET)

Central Securities Corporation (ticker:CET) is a closed-end fund that organized in 1929 and runs a concentrated portfolio mainly invested in US stocks. It is attractively priced and currently sells at a discount to NAV of 18.81%. Part of the reason for the large discount is that about 30% of the assets are invested in a single illiquid restricted investment with a very low tax basis, The Plymouth Rock Company. Plymouth Rock sells auto insurance and has performed very well for CET over the years.
When a fund values a portfolio, there are three kinds of “fair value” based on the observability of the market price.
• Level 1 — Quoted prices in active markets on major exchanges.
• Level 2 — Other significant observable data obtained from independent sources; for example quoted prices for similar investments or the use of models or other valuation methodologies. For CET, the Level 2 investments consist of short-term investments, carried at amortized cost.
• Level 3 — Investments in which there is little, if any, market activity. CET owns two Level 3 securities- a large position in The Plymouth Rock Company, Inc. and a small $300,000 position in Aerogroup International, Inc.
The fund purchased 70,000 shares of Plymouth Rock equity back in 1982 and 1984 for a total cost of only $2.2 million and they currently value that stock at $2,000 a share or $140 million.
But the CET valuation seems too low for Plymouth Rock. Every year, Plymouth Rock commissions an outside and independent appraisal of their stock. The last appraisal was in early 2009 and the fair market valuation was $3265 a share. After applying a 20% discount for lack of marketability, the discounted price value is $2610 which is substantially higher than the $2,000 value actually used by CET management to compute the NAV of its portfolio. The overall market has appreciated considerably since early 2009, so the current fair market price for Plymouth Rock would be even higher.

Here are some other bullet points on CET as a long term investment:

1. Low expense ratio: The annual expense ratio has traditionally been very low- around 0.60%. But in the last semi-annual report it was rose to 0.83% due to the drop in assets that occurred in 2008 and early 2009. Since June 2009, assets have grown and the next reported expense ratio should decrease again.

2. Low turnover ratio: The CET management does very little trading and the last reported turnover ratio was only 2.53%. So the “hidden” trading costs caused by the bid-asked spread and adverse market impact are very low compared to most other mutual funds and closed end funds.

3. Good long term investing performance: As of 9/30/2009, the 10 year annualized NAV return for CET was 5.42%. Morningstar places CET in the top 1% of its category for that time period.

4. The top ten stock holdings for CET as of September 30, 2009 were:

Stock Name . . . . . . . . . . . . . . . . . . % of Net Assets
Plymouth Rock . . . . . . . . . . . . . . . . . . .   29.4%
Agilent Technologies . . . . . . . . . . . . . . . . 5.4%
Brady Corp. . . . . . . . . . . . . . . . . . . . . . . . . 4.6%
Bank Of NY Mellon . . . . . . . . . . . . . . . . . . 4.1%
Coherent Inc. . . . . . . . . . . . . . . . . . . . . . .  4.1%
Murphy Oil Corp. . . . . . . . . . . . . . . . . . . .  3.6%
Convergys Corp. . . . . . . . . . . . . . . . . . . . . 3.5%
Dover Corp. . . . . . . . . . . . . . . . . . . . . . . . . 3.3%
Intel Corp. . . . . . . . . . . . . . . . . . . . . . . . . . 2.9%
Devon Energy Corp. . . . . . . . . . . . . . . . . . 2.8%

Minor Bubble Forming in High Dividend CEF’s

There appears to be a minor bubble forming in some closed end funds that specialize in creating abnormally high dividend payouts without using managed distributions.

Here are three closed end funds in this category (Data as of: October 26, 2009):

Ticker:AGD     Alpine Global Dynamic Dividend Fund   pays monthly 

  • Assets= 174.3 MM
  • Annual Distribution (Market) Rate= 17.05%    Income Only Yield= 15.30%
  • Expense ratio= 1.40%              Premium over NAV= +37.36%
  • Portfolio Turnover rate= 301%

Ticker: AOD    Alpine Total Dynamic Dividend   pays monthly

  • Assets= 1,501 MM
  • Annual Distribution (Market) Rate= 19.40       Income Only Yield= 17.06%
  • Expense ratio= 1.35%              Premium over NAV= +29.61%
  • Portfolio Turnover rate= 423%

Ticker: FAV     First Trust Active Dividend Income   pays quarterly      

  • Assets= 76.8MM
  • Annual Distribution (Market) Rate= 13.71%                 Income Only Yield= 11.34%
  • Expense ratio= 1.31%              Premium over NAV= +16.50%
  • Portfolio Turnover rate= 1722% (WOW!- they aren’t kidding when they say “active” )

These abnormally high dividends are created by using strategies that appear to be somewhat gimmicky:

-         High Yield Dividend Capture Strategy: Normally a long-term investor holds a dividend paying stock and captures four dividend payments a year. But funds that use a dividend capture strategy try to capture more dividends by rotating between two securities through the year. They typically only hold a security for a little more than 60 days so that the dividends qualify for favorable tax treatment.

-         “Special” Dividend Opportunities: These funds look for companies that are paying out extraordinarily high “special” dividends which are often one time events. Again the holding periods are as short as possible to capture the tax-advantaged dividend.

Of course these strategies explain the high portfolio turnover rates. The high turnover exposes the funds to increased trading costs such as:

  1. Brokerage commissions  (not included in expense ratio)
  2. Bid-asked spreads: Varies depending on stock traded.
  3. Market impact costs: This can be a problem especially for larger funds such as AOD when a stock moves “away” from a fund as they try to accumulate a large position.    

The brokerage commission expenses are not included in the expense ratio, and are usually not listed in the shareholder reports mailed to shareholders. But you can normally access the information in the NSAR-A and NSAR-B SEC Edgar filings on a semi-annual basis. Unfortunately, the NSAR-A and NSAR-B reports are in XFDL format which is quite cryptic. The semi-annual brokerage expense is listed on line 21 of the report. But for international stocks, brokerage commissions are often built into the price and may not be included in the line 21 value. The international stock fee is usually about 15 to 30 basis points of the transaction amount.

The bid-asked spread and market impact costs are not available in any reports and must be estimated by the investor.

Some of you may be tempted to sell short the three funds listed here. But their shares are hard to borrow and even if your broker could borrow the shares, you would most likely have to pay a high interest rate to borrow the shares which would not be worthwhile.

BEO Tender Offer- Insane Behavior?

The  Enhanced S&P 500 Covered Call Fund (ticker: BEO) recently announce the completion of a tender offer on October 14. The Fund offered to re-purchase up to 5% of its shares at a price equal to NAV (subject to a repurchase fee of up to 2% of the NAV) as of the close of regular trading on October 28, 2009.

Since BEO is currently trading at a 19% premium above NAV, you would not expect any rational person to tender their BEO shares unless they thought the NAV would appreciate at least 20% in the next two weeks.

But the Fund’s agent indicated that 15,302 shares (approx. 0.17% of the Fund’s outstanding shares) were validly tendered. In May of 2009, BEO was selling at a discount to NAV. It is possible that some investors or their financial advisors made a decision to tender their shares in May and neglected to cancel the tender  later. I would appreciate hearing from any blog readers that can explain a rationale behind the tender decision.

Another odd thing about BEO is that the fund is terminating in October 2010, so the 19% premium also seems irrationally high.

The 1929 Closed End Fund Mania

In 1929, there was a closed end fund mania that rivalled the internet dot-com mania of the late 1990’s. Most closed-end funds in 1929 sold at large premiums over NAV. Most “experts” at the time thought this was justified – the fund managers’ superior ability to pick stocks was thought to multiply the value of the fund by 1.5 or more. (Hmm, sounds like the justification used for paying high fees for hedge funds today). Here is an excerpt from the “Magazine of Wall Street”with recommended guidelines for selecting closed end funds (published September 21, 1929):

“Shares of an investment company capitalized with common stock only and earning 10 percent net on invested capital might be fairly priced at 40 to 50 percent in excess of liquidating value. If the past record of management indicates that it can average 20 percent or more on its funds, a price of 150 percent to 200 percent above liquidating value might be reasonable… To evaluate an investment trust common stock, preceded by bonds or preferred stock, a simple rule is to add 30 percent to 100 percent, or more, depending upon one’s estimate of the management’s worth, to the liquidating value of the investment company’s total assets.”

Here are some amazing statistics about closed end funds during the 1928-1930 time period:

1) The median closed-end fund premium in the 3rd quarter of 1929 was 47 percent. By the summer of 1930, the median closed-end fund sold at a 25 percent discount. This negative 72 percent swing added to the 12 percent negative return in NAV resulted in a near wipeout in the market value of these funds.

2) There was a huge issuance of closed end funds in the 3rd quarter of 1929- about 1 billion in the two months of August and September alone. This is equivalent to about 10 billion in purchasing power today, and about 60 billion relative to the size of the US economy.

3) Closed end funds completely dominated new stock issuance in the summer and early fall of 1929. In June and July, ALL new equity issues were closed end funds. The over-pricing of closed end fund crowded out individual stock issues during this period.

4) During the early 1920’s, closed end fund promoters rarely disclosed their holdings. They argued that a closed-end fund has tangible assets (it’s portfolio) plus intangible assets (the skills of its managers). They argued that if a fund revealed its portfolio, other investors could “free-load” and copy the fund’s portfolio and avoid paying the management fee. They looked at a fund’s portfolio as a trade secret. (Again, note the similarity to today’s hedge funds). This attitude changed after the 1929 crash, when closed end funds did start to disclose their holdings to make it clear that their fund was still solvent and their holdings were selling at a discount to NAV. The discounts to NAV that developed in 1930 were considered extremely abnormal and was very puzzling to the pundits of the time.

5) Here is some data on some individual closed end fund premiums taken from a research paper by De Long and Shleifer:
-Investor’s Equity Co. +166% premium (late 1928)
-General American Investors +233% premium (early 1929)
-Capital Administration Co. +1235% premium (early 1929)
-US & Intl Secur. Corp. +212% premium (June 1929)
-Investor’s Equity Co. +276% premium (July 1929)

The Goldman Sachs Trading Company deserves special mention. Goldman Sachs was the largest promoter of closed end funds during the 1928-1929 time period. Goldman Sachs partner Sydney Weinberg, when asked why his company had formed so many closed end funds, replied- “Well, the people want them”.

In December1928, Goldman Sachs formed the Goldman Sachs Trading Company but retained enough common stock to keep control. In the summer of 1929, it launched the Shenandoah Corporation. Goldman Sachs held most of the common stock in Shenandoah and sold common/preferred stock to the public. This established a fund of funds with leverage.

The Shenandoah Corporation then set up the Blue Ridge Corporation, holding most of the common stock itself and selling common/preferred stock to the public. This established a fund of fund of funds with leverage at two levels. Any gain in Blue Ridge would be passed on to Shenandoah with leverage, and these gains would be further magnified as they flowed back to Goldman Sachs Trading.

The Blue Ridge Corp sold at a 46% premium in August 1929, but fell to a discount of 24.5% by 1930. The Shenandoah Corp sold at a 103% premium when it first came out as a new issue in 1929. Goldman Sachs discovered that leverage is a two way street and the Goldman Sachs Trading Corporation stock collapsed from its high point of $280 a share in 1929 to $1.25 in 1932.
If anyone is interested, you can purchase a beautiful engraved cerificate of the Blue Ridge Corporation from scripophily.com. It was issued in 1930 and costs $69.95. I wonder if any Goldman Sachs employees have this certificate hanging on their office walls.

Closed end fund resources

Here are some good resources for closed end fund investing:

Nuveen Closed end fund site

Closed-End Funds from Capital Link 

Herzfeld Closed end Funds: Their newsletter contains good information but it is a little pricey for most individual investors.

Closed-End Fund Association