Closed-end fund commentary 2Q 2022

4 minute read

July 2022

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Closed-end funds declined in the second quarter as investors dialed down their risk level on concern over inflation and rising interest rates.

Closed-end funds had a market-price return of –13.5% in the second quarter, as measured by the S-Network All Taxable ex-Foreign plus Capped Muni CEF Index,1 bringing the year- to-date return to –18.5%. By comparison, the S&P 500 Index2 and the Bloomberg U.S. Aggregate Bond Index3 had total returns of –16.1% and –4.7%, respectively, for the quarter, and –20.0% and –10.4% for the year to date.

Investment Review

Closed-end funds declined in the second quarter as investors dialed down their risk level on concern over inflation and rising interest rates. The quarter featured inflation readings at 40-year highs as Russia’s invasion of Ukraine led to a pronounced increase in prices for energy and other commodities. In response, most major central banks began to aggressively raise interest rates to slow demand. The Federal Reserve increased its key interest rate by 50 basis points in early May followed by a 75 basis-point hike in June, the sharpest individual hikes in decades. The Fed’s actions raised fears that the economy, already showing signs of slowing, would tip into recession, helping to send prices of stocks and bonds lower. Volatility was high throughout the period as bond yields rose sharply before backing off slightly by the end of the quarter.

Discounts to net asset value expanded during the quarter but ended the period down from their widest levels. Taxable fixed- income funds traded at an average 3.3% discount to NAV at quarter end, up from 2.3% at the start of the period; in June, the discount for the group topped 7% before backing off. Their long-term average discount is 3.3%. National municipal funds’ average discount widened to 5.7% from 5.1%, compared with their long-term average discount of 3.9%. The average discount on equity funds reached 3.6%, up from 1.4% at the start of the quarter but below their long-term average of 5.3%.

Returns based on market price and NAV were down for fixed income and equity closed-end funds, with market price returns mostly worse than NAV returns. With most sectors suffering double-digit declines over the quarter, taxable fixed income funds fell slightly less than equity funds. Overall, taxable fixed income funds lost 12% in market price and 11.2% on a net asset value (NAV) basis. Within taxable fixed income, U.S. sector bond funds outperformed the group, dropping 6.3% in market price and 4.3% on an NAV basis. Equity funds, on average, declined 14.9% in market price and 13.3% in NAV. U.S. equity funds (–18.3% in market price and –15% in NAV) led decliners, while MLP funds (–8.6% in market price and –10.7% in NAV), declined but outperformed the group.

The IPO window for closed-end funds appears to be closed for the time being. Two planned closed-end fund initial public offering were canceled during the quarter. An increase in equity market volatility, combined with uncertainty around inflation, rates, economic growth and the Russia-Ukraine war has kept investor appetite subdued.

Investment Outlook

The Fed is on track to continue raising interest rates through the rest of this year as inflation remains stubbornly high. Investors will be watching inflation and economic growth, as both more persistent inflation and slow economic growth will filter down to closed-end funds as higher short-term borrowing costs impact funds’ earings power. Volatility—driven by the Fed’s rate hikes, monthly inflation readings and geopolitical turmoil—is likely to remain a feature in the closed-end fund market. We expect that as the Fed tightens, discounts will continue to expand and move to or through their long-term averages in many funds and sectors—retreating from the historically full valuation levels reached in 2021.

Following two years of a booming primary market for closed- end funds with large IPOs, it appears that investor sentiment toward closed-end funds has cooled. We will continue to seek opportunities created by any market volatility in reaction to developments related to Russia-Ukraine and evolving macroeconomic conditions.

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