Closed-end funds had a market-price return of 2.3% in the third 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 Year to date, the benchmark had a total return of 21.3% based on market price. By comparison, the S&P 500 Index2 and the Barclays Capital U.S. Aggregate Bond Index3 had total returns of 1.7% and 2.3% for the quarter, and 20.6% and 8.5% for the year to date, respectively.
The third quarter was an often volatile but generally positive period for financial markets as lower interest rates countered credit concerns. In reaction to slowing global growth, and the potential for trade tensions to weigh further on growth, Treasury yields declined as investors sought safe havens. The yield on the 10-year note fell from 2.0% to 1.7% by quarter end, after touching a three-year low of 1.5%. In Europe, yields on government bonds mostly slid further into negative territory. The European Central Bank (ECB) announced more stimulus measures, including additional bond buying at €20 billion per month with no fixed end date, as well as more deeply negative deposit rates.
Real estate funds were a positive standout in the equity category. Most sectors within equity had gains in the 1% to 3% range on market price. Real estate (11.1%) was a notable outperformer, favored for its above-average and relatively stable, lease-based income. The master limited partnership (MLP) sector was the poorest-performing sector in the benchmark, declining 3.4% along with natural gas and natural gas liquids prices, which hit multi-year lows in August before stabilizing in September.
Investors in fixed income securities showed duration sensitivity and a preference for "safe" income. Within taxable fixed income, higher-quality sectors such as investment grade (4.6% return on market price) outperformed. Preferred securities (5.7%), which rose 4.3% on NAV, benefited from a more than a percentage point lift from premium expansion. The broad multi-sector group (2.6%) also outperformed, favored for its relatively higher income. National municipal bond funds (not included in the benchmark), which are typically more interest-rate sensitive, were up 4.0% on market price and 2.6% on NAV. Conversely, credit-sensitive fixed income groups such as bank loans (–0.4%) and limited duration (1.2%) underperformed.
Closed-end fund IPOs have continued at a measured pace. The quarter saw the launch of a $710 million municipal high yield fund that traded at a single-digit premium to its NAV since its September debut through the end of the period. With a total of $4.0 billion in IPOs year to date, new supply is running at a pace not seen since 2013. A shift in the IPO structure, with investors no longer paying the up-front underwriting fees, along with buoyant asset markets and narrower than average secondary market discounts to NAV, all likely contribute to this renewed (but still relatively modest) interest in fund IPOs.
Given the likelihood of continued economic growth, we believe the Fed could disappoint markets in the scale and timing of any further "insurance" rate cuts. Lower short-end rates should help the earnings power of levered closed-end funds and raise the appeal of a relatively higher-yielding structure; however, given the time lag it takes for those effects to flow through, any cuts currently priced in are effectively neutralizing past rate hikes. An eventual return to higher short- end rates would again challenge the earnings power for closed-end funds with leverage in their capital structure.
We believe that selectivity will remain key going forward as broad measures of closed-end fund discounts have generally moved inside their historical averages this year. Valuations rarely stop once they reach historical averages, and with the current scramble for yield in full force, further discount narrowing may be the path of least resistance. With that said, we still see relative value opportunities within sectors, as specific fund mispricing remains a feature of the closed-end fund market.
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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.