Closed-end funds had a market-price return of –25.40% in the quarter, as measured by a linked benchmark consisting of the Morningstar U.S. All Taxable ex-Foreign Equity Closed- End Fund Index and the S-Network All Taxable ex-Foreign plus Capped Muni CEF Index.1 By comparison, the S&P 500 Index2 and the Barclays Capital U.S. Aggregate Bond Index3 had total returns of –19.60% and 3.15%, respectively.
The economic shock from COVID-19 and rising credit spreads led to unprecedented losses for closed-end funds in the quarter. Equities and credit-sensitive fixed income assets broadly declined as virus containment efforts resulted in a global recession and exerted significant strain on credit markets. Policymakers acted decisively, with the Federal Reserve and other central banks cutting interest rates and employing additional policies to support functioning credit markets. Governments globally introduced massive fiscal relief packages to aid affected businesses and households. The sweeping policy responses (monetary, regulatory and fiscal) have been much swifter than in 2008 and, in the main, more forceful. While we expect a sharp contraction in growth in the second quarter, we believe these measures should prevent this from becoming a prolonged recession.
Closed-end fund discounts to net asset value (NAV) widened in all categories and briefly reached levels not seen since the global financial crisis. For equity funds, the average discount to NAV widened from 2.7% at the start of the year to 6.0%, wider than the category's long-term average of 5.3%. The average discount for taxable fixed income funds widened from 0.9% to 6.0%, compared with a long-term average of 3.1%. Tax-exempt municipal funds saw their average discount widen from 4.2% to 7.9%, wider than the long-term average of 3.8%. We believe the sharp drop in net asset values, when coupled with wider discounts, significantly improves most funds' and sectors' one-year-forward total return/value proposition.
Price declines in a wide variety of equity and fixed income asset categories created concerns of forced closed-end fund deleveraging and potential distribution cuts. Closed-end funds have mandates to keep asset coverage ratios above a certain level. We believe the recent sharp selloff in a variety of equity and fixed income categories led to "forced" deleveraging—and that a number of recent distribution cuts were the direct result of market action compelling managers to deleverage. While only a handful of managers have commented on this phenomenon, we believe that a wider array of funds will reduce distributions across both equity and fixed income groups over the next several months.
Sharply wider credit spreads resulted in losses for all fixed income segments. Credit spreads relative to U.S. Treasuries widened materially and yields for a wide range of security types rose to multi-year highs. Other than U.S. government bond funds (–14.2% total return), which invest in inflation- protected securities and therefore declined in the deflationary environment, there was relatively little dispersion divergence in taxable fixed income fund returns: short-duration bonds (–19.3%), U.S. investment-grade bonds (–21.7%), high-yield bonds (–23.6%) and preferred stock funds (–25.7%). This suggested that investors made relatively little distinction in terms of credit quality, duration or issuer fundamentals. We believe the current dislocations in the fixed income market are only temporary and are not an indication of enduring problems in the financial system.
Municipal bonds were the top-performing fixed income category, but they experienced extraordinary volatility on concerns that the loss of tax revenues could result in credit rating downgrades. Diversified municipal bond funds (–7.2%) were likewise pressured by investors' desire for liquidity, as seen in a sharp spike in mutual fund outflows in March. Although issuer fundamentals have deteriorated with the economic disruption, we believe the credit profiles of municipals remain among the most attractive in the closed- end fixed income market. Furthermore, municipalities would likely be among the first to see relief from federal assistance packages.
Equity funds also saw relatively little variation in returns. General equity (–27.5%), global equity (–26.3%) and option income fund (–23.1%) returns were roughly commensurate with broad equity market benchmarks' performance. Utility funds (–24.4%) and real estate funds (–35.0%)—capital- intensive sectors that are typically more defensive in down markets—came under unusual pressure due to recession fears as well as, perhaps, concerns about their ability to access the capital markets to meet their funding needs.
Weak energy prices and contract counterparty risk weighed heavily on master limited partnerships (MLPs) and MLP funds (–70.9%). COVID-19's detrimental impact on global oil demand and a dramatic shift in policy from Russia and Saudi Arabia towards recovering market share caused a record selloff in crude oil to 18-year lows. This led to concerns of reduced throughput volumes and producers' potential inability to meet their obligations to midstream companies. Exacerbating the decline in MLP share prices was MLP closed-end funds' need to deleverage. A number of MLP funds have already announced distribution cuts of 70 to 80 percent, and we expect more funds in this category to announce sharp distribution cuts in the next few months. We view the sharp decline in energy prices as a medium-term shock to the system, not a long-term change in global energy dynamics. Also, we believe midstream energy companies are better positioned for this downturn than they were in 2015, thanks to the adoption of more sustainable business models.
Despite uncertainties surrounding the ultimate economic impact from the coronavirus, our outlook for closed-end funds remains generally positive. Our expectation is that economic growth will resume in most developed markets late in the third quarter, assuming COVID-19 containment efforts are largely successful. In the meantime, central banks and governments are likely to take further monetary policy and fiscal actions to stem the decline in growth, if needed.
All three major categories of closed-end funds (equity, taxable fixed income and municipals) reached valuation levels in mid- March that historically have led to above-average returns in the following 12-month periods. Broad measures of closed- end fund discounts are once again wide of their historical averages. Such extreme valuations, coupled with significant monetary and fiscal stimulus, suggest that investors who take advantage of the volatility from COVID-19 are likely to be well rewarded.
Lower short-term interest rates should help the earnings power of levered closed-end funds and raise the appeal of the relatively higher-yielding structure. We believe that once the virus is contained—evidenced by a slowdown in new cases and a slowdown in spread to new countries—the scramble for yield will resume and closed-end fund valuations will once again begin to narrow.
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(1) Returns are based on market price. Prior to 7/31/19, the benchmark was the Morningstar US All Taxable Ex-Foreign Equity Index. Thereafter, it is the S-Network All Taxable ex-Foreign plus Capped Muni CEF Index. The S-Network All Taxable ex-Foreign plus Capped Muni CEF Index is a market capitalization-weighted index comprising all taxable closed-end funds and Diversified Municipal Bond Funds, except for single-country funds and region-specific equity funds The Morningstar US 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. All closed-end fund sector returns are based on Cohen & Steers calculations and classifications of the current U.S. listed closed end fund universe.
(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.