CEF Outlook: Cohen&Steers, CEF Diversified Portfolio

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CEFA:

Welcome to CEF Insights, your source for closed-end fund information and education, brought to you by the Closed-End Fund Association. Joining us today is Doug Bond, Executive Vice President and Portfolio Manager of Cohen & Steers. Doug will talk about the closed-end fund market and the potential for a diversified portfolio of closed-end funds to provide solutions in a challenging market environment for income-oriented investors. Doug manages Cohen&Steers Closed-End Opportunity Fund (New York Stock Exchange:FOF).

Doug, thanks for being with us today.

Douglas Bond:

No problem. Thanks for inviting me.

CEFA:

Doug, I want to start by looking at how the current market environment has impacted the closed-end fund space. Looking first at interest rates, the Federal Reserve has raised interest rates in five consecutive meetings and is likely to do more. How have closed-end funds historically behaved when the Fed began a cycle of interest rate hikes?

Douglas Bond:

Historically, closed-end fund discounts have been widened when the Federal Reserve has raised rates. That has been the case here in 2022, and it’s a pattern we’ve seen for decades. The rationale for this is that most closed-end funds use leverage in their capital structure to improve the level of income they can pay their shareholders. When the cost of that leverage increases, funds typically have lower total earnings, and expanding discounts reflect investors’ uncertainty about future earnings and dividend levels the fund can pay.

CEFA:

The economic environment also has high inflation and slowing economic growth, while significant geopolitical tensions have added to the volatility. How has this market volatility affected closed-end funds in general? And are you seeing a bigger hit in certain asset classes?

Douglas Bond:

Until now, most asset classes have suffered from higher inflation and slower growth. Aside from energy and commodity-focused funds, most NAVs and market prices are down. Across asset classes, fixed income funds have seen a steeper discount widening, while equity discounts have on average remained below their long-term averages. Perhaps we can attribute this to the relative ability of the company to protect earnings and dividends by raising prices in an environment of higher inflation.

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CEFA:

Many closed-end fund investors are income-oriented. Does the general extension of discounts benefit an income-oriented investor looking to put new money to work in the space? How should a fund’s use of leverage affect that investor’s consideration of a potential investment?

Douglas Bond:

New money entering closed-end funds today benefits from enhanced discounts as well as higher current distribution yields. For example, today a closed-end fund index of taxable bond funds returns more than 9.5%, while this time last year the return was less than 8%. In general, buyers of closed-end funds today should expect possible dividend cuts in the future. As before, during the Fed’s tightening cycle, borrowing costs have risen for most funds and only a minority have cut the monthly dividend.

CEFA:

Doug, we mentioned FOF, the fund you manage, which focuses on investing in a diversified portfolio of closed-end funds. What is your process for evaluating potential investments? And how do you then make specific stock picks and allocate those positions as you build your portfolio?

Douglas Bond:

For FOF, we combine a top-down and bottom-up evaluation in our investment process. In making specific stock selections, we focus heavily on relative value while maintaining a focus on our overall goals of current high income and capital appreciation potential through a broadly diversified portfolio by asset class, fund sector, asset managers, assets and funds. Currently, due to uncertainty about the economy and company earnings, our stock fund’s weighting is at the low end of its historical range, and we are currently finding more bargains among closed-end, taxable bond funds than among the shares or municipal parts of the market. Having said that, many of the more recently issued 2.0 closed-end fund IPO calls offer compelling values ​​today, and we’ve been adding to those.

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CEFA:

What are the key factors that would lead you to sell a particular portfolio security?

Douglas Bond:

The main drivers of the decision to sell are relative value. If a fund is expensive due to its own history or to the competition in the same sector, it becomes a candidate for downgrade. If it’s expensive relative to its peers, adjusted for its track record as a money manager, it’s a candidate to be sold. If we believe that there is a risk of a cut in distribution, it is a candidate to reduce.

CEFA:

Are valuations in the closed-end fund space currently at attractive levels?

Douglas Bond:

Starting in 2022, stock, taxable and municipal bond funds were sold at valuations expensive at their 25-year long-term averages. Today, taxable bonds and municipal funds are cheap by those standards, while stocks remain expensive. But in all three major groups, we’re finding quality funds available at above-average discounts with high current incomes.

CEFA:

Where do you see the best opportunities?

Douglas Bond:

We would characterize today’s best opportunities as fitting one of three profiles. First, the recent initial public offerings of closed-end fund taxable stocks and bonds conducted in the so-called 2.0 framework. Based on our work, many of these sell at between one and two cheap standard deviations from a line of best fit, which explains the discount-to-dividend ratio that describes the more experienced group of 1.0 funds. Second, seasoned, broadly diversified, large-cap equity funds, selling at double-digit discounts to NAV with good long-term track records. And then, in third place, credit-sensitive taxable fixed income funds that sell at double-digit discounts and yields between 8.5% and 9.5% or more. The groups you can find them in include multi-sector high yield, prime and prime loan.

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CEFA:

What do you think are the main risks for closed-end funds in the current environment? Or are the risks more specific to a fund’s asset class?

Douglas Bond:

The two most significant risks for closed-end funds are, one, structural, the leverage in the capital structure. This leverage amplifies the NAV, market price and dividend risks associated with closed-end funds, and two, the asset class risk. In the current environment with the Fed tightening, it is difficult to disentangle structural risk, leverage, from asset class risk because a Fed policy mistake, excessive tightening, could have profound consequences for many fund sectors. different closed-end and funds with a high degree of economic sensitivity.

CEFA:

Doug, how would you see a diversified portfolio of closed-end funds being better positioned in an income-oriented investor’s portfolio?

Douglas Bond:

For most investors, I believe a diversified closed-end fund portfolio should be a high-income add-on to the equity portion of a client’s portfolio. The reason we think this is that the market prices of closed-end fund shares are often quite volatile. Regardless of the objective of the underlying asset class, market price volatility is typically fairly similar to that of equities.

CEFA:

Doug, thanks for sharing your thoughts with us.

Douglas Bond:

It has been a pleasure.

CEFA:

And we want to thank you for tuning in to another CEF Insights podcast.

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