We would like to share with you our review and outlook for the closed-end-fund market as of June 30, 2017. For the quarter, the market-price total return of the Morningstar U.S. All Taxable ex-Foreign Equity Closed-End Fund Index1 was 3.5%, while its return on a net asset value (NAV) basis was 1.7%. Year to date, the index had a total return of 10.3% based on market price and 6.5% based on NAV. By comparison, the S&P 500 Index2 and the Barclays Capital U.S. Aggregate Bond Index3 had total returns of 3.1% and 1.4% for the quarter, and 9.3% and 2.3% for the year to date, respectively.
Closed-end funds advanced in the second quarter amid a supportive macro backdrop that was broadly favorable for financial assets. Stocks climbed to record highs on an improving earnings outlook as global economic growth continued at a modest pace. Bonds advanced and yields declined as inflation remained subdued.
Fixed income funds outperformed equity funds in the second quarter on both a market price and NAV basis, in contrast to the first quarter, when equity funds outperformed. Fund discounts to NAV continued to narrow, despite the U.S. Federal Reserve raising its benchmark short-term interest rate by a quarter point, the third such increase since December 2016. The Fed also signaled its intention to continue to raise short-term interest rates, which would increase borrowing costs for closed-end funds employing leverage. At the margin, rising borrowing costs pressured the earnings power of most closed-end funds, but investors remained focused on seeking out attractive yields and were willing to pay greater prices for closed-end funds.
Positive investor sentiment could be seen in equity fund discounts to NAV narrowing in the quarter from 5.8% to 3.7%, and down from 8.2% at the start of the year. The recent move brings equity funds discounts below their long-term average discount of 5.2%.
Broad-based equity funds advanced along with the major U.S. and global stock market averages, adding to the funds' healthy year-to-date gains. Global growth & income (7.4% return on market price) and equity tax-advantaged (7.2%) were among the top-performing diversified funds.
The performance of more specialized equity funds was largely a function of changes in interest rates and energy prices. Utilities funds (8.6%) benefited from the decline in long-term interest rates as low rates were seen as a positive for companies that rely on borrowing for their capital-intensive businesses. For real estate funds (6.2%), faster growth and the decline in rates were a positive as well, although gains were tempered by weakness in retail-related sectors in light of recent bankruptcies and store closing announcements and the potential impact on landlords' cash flows.
MLP (–6.9%) and energy resources funds (–2.9%) were among the few equity sectors to experience negative returns in the quarter. The two groups were hurt by a decline in crude oil prices, which fell on concerns that the oil market would take longer to reach balanced conditions as rising U.S. supply threatened to offset production cuts from the Organization of Petroleum Exporting Countries (OPEC) and participating non-OPEC producers. For MLPs, those concerns were largely misplaced as rising oil volumes are beneficial to midstream energy companies, translating into improving cash flows that could be used to strengthen balance sheets and increase cash distributions. Commodities funds (–3.5%) declined as precious metals prices edged lower as the market reacted negatively to the unanticipated hawkish tone of the Fed's June policy statement after the recent run of soft inflation data.
Most fixed income closed-end funds enjoyed healthy gains in the quarter thanks to the decline in long-term interest rates and strong investor demand. Taxable fixed income and municipal bond funds saw discounts to NAV come down. The average discount for taxable fixed income funds ended the quarter at 2.6%, which is slightly narrower than their long-term average. Municipal fund discounts narrowed to 3.5%, compared to a long-term average of 3.8%.
Preferred securities funds (7.8%) were the top-performing fixed income segment on both a market price and NAV basis. The funds continued to benefit in the declining interest rate environment from the long duration and high quality of their underlying holdings. Investor demand for the funds pushed prices to a premium to NAV.
Mortgage bonds (6.7%), which tend to hold high-quality, long duration securities, and multi-sector funds (6.1%), which have the flexibility to shift assets among fixed income categories and currently offer the highest yields among closed-end funds, likewise enjoyed strong gains. Here as well the two categories trade at premiums to their NAVs.
Convertibles funds (5.2%), the most equity-like fixed income category, benefited from positive stock market sentiment as well as the decline in interest rates. High yield funds (2.9%) lagged most other fixed income categories as investors favored higher-quality bonds in what was both an interest rate and credit rally. The group was one of the few sectors to not benefit from an improvement in valuations and they continue to trade at a 6.7% discount to NAV.
Senior loan funds (0.7%) trailed more interest-rate-levered funds. The funds invest in bundles of adjustable rate loans that banks extend to corporations and therefore don't particularly benefit from declining interest rates. Government funds (0.0%), which predominantly invest in U.S. Treasury inflation-protected securities, also lagged as softer economic data eased the inflation outlook.
Taxable municipal bond funds (3.4%) and national municipal bond funds (3.9%) posted strong returns due to the high credit quality and long duration of the securities in their portfolios. Against a backdrop of rising leverage costs and yields being pressured due to bonds being called, investor sentiment for municipals continued to improve with fund market prices rising faster than NAVs Positive sentiment could also be seen in the strong inflows into open-end mutual funds in the quarter.
New Issues Market
There were no closed-end fund initial public offerings in the quarter, continuing the recent trend of light issuance. The few fund offerings that have occurred this year have been limited to fixed income strategy funds with finite terms.
Interest rates may rise gradually in response to continued growth and a modest increase in inflation. Additional Fed rate hikes could increase borrowing costs for levered closed-end funds and modestly impact their income potential. But with borrowing costs not rising at a rapid pace, the spread income that levered funds can earn remains an attractive proposition.We expect positive global economic growth conditions to persist through the second half of the year, with improving employment and rising personal incomes likely to spur consumer spending and business investment alike. Growth in the U.S. has the potential to accelerate further if Congress is successful in passing regulatory reforms and infrastructure spending.
Valuations on equity funds may continue to improve, but with discounts now below their long-term average, we believe there is only modest room for additional valuation compression. Similarly, fixed income funds trade at discounts to NAV that are below historical norms, which is likely to limit total returns going forward. However, we continue to find attractive values across various closed-end fund categories.
We believe selectivity will be the key to success for the remainder of the year, with the best long-term returns likely to be found in closed-end fund categories where discounts to net asset values are wider than their historical averages. Among equity funds, we see good opportunities particularly in equity tax-advantaged funds and covered call funds, as well as sector opportunities in financial and health care funds. Within taxable fixed income, we like the relative earnings and dividend advantage associated with multi-sector funds. Opportunistically, senior loan funds offer attractive relative valuations. Continued strong fund investor inflows and little new bond issuance should prove favorable for municipal funds, although total returns between now and year-end may consist entirely of tax-exempt income streams.
With respect to new issuance, 2017 remains on pace to be the fourth-consecutive year of relatively light activity by total volume. More new issues may come to market, but the proceeds raised are likely to remain modest, keeping most investors' focus on opportunities available in the secondary closed-end-fund market.
(1) Returns are based on market price per Bloomberg L.P. Sector constituents are determined as per the Morningstar U.S. All Taxable ex-Foreign Equity Closed-End Fund Index. The Morningstar All Taxable ex-Foreign Equity Index measures the market-capitalization-weighted total return of taxable equity and fixed income closed-end funds; it excludes international, regional and country closed-end funds. Index returns update frequently and are subject to change.
(2) The S&P 500 Index is an unmanaged index of 500 large capitalization, publicly traded stocks that is frequently used as a general measure of stock market performance.
(3) The Barclays Capital U.S. Aggregate Bond Index includes U.S. government, corporate and mortgage-backed securities with maturities of at least one year. Benchmark returns are shown for comparative purposes only and may not necessarily be representative of the Fund's portfolio.