It’s been a tough year for closed-end fund (CEF) investors as risk asset volatility, a slump in credit, and general unease over the Federal Reserve’s long anticipated rate increase has widened discounts.
However, many CEFs are still awarding investors with large end-of-year special distributions. In a CEF wrapper, a fund is forced to distribute any underlying portfolio earnings above and beyond its stated distribution policy to avoid paying taxes at the fund level.
This income gap is often referred to as undistributed net investment income (UNII). Furthermore, since many funds employ rather conservative board-mandated policies, they dictate that fund earnings should be well in excess of regular monthly or quarterly distributions to avoid dividend cuts.
I am often asked about whether these large distributions make for good fund management policies, and whether or not the fund is sand bagging its own performance potential. The fact of the matter is that many funds yield in the low to mid-teens when the end of year distributions are calculated back in. So why would a board intentionally maintain a lower distribution policy when additional yield thirsty investors could be lured into purchasing the fund as a result of a larger monthly cash flow?
Naturally, there are several schools of thought, but if fiduciary duty has taught me anything, it’s that board members error on the side of caution. They want to stay employed, avoid arbitration, buffer active management changes, and avoid policies that could ultimately lead to dividend cuts or discount widening.
Secondarily, there is an element of behavioral finance to special dividends, because the average Joe isn’t consistently forecasting and calculating UNII from the semi annual reports. So from that perspective alone, an announcement of a large special distribution is a welcoming sign that the fund is doing well, which might attract more capital this time of year from IRA contributions or other sources.
Furthermore, as a student of CEF investing, I never grow tired of witnessing the ramp up in trading volume following special distribution announcements. It often appears as if the distribution is emanating from some mysterious pool of capital, and not directly taken from the NAV on the ex-dividend date. As nearly every seasoned CEF investor knows by now, it makes no difference in the end whether capital is returned through distributions or capital appreciation, since total return is king.
The only time an uninformed investor could feel a sting is if a position paying a large distribution is held within a taxable account.
PDI payed a total of $2.70 in regular monthly distributions per share during 2015, which works out to a yield of roughly 9%. However, it also declared a special distribution of $2.61, which is nearly the same amount as the sum of the regular distributions. So an unsuspecting investor in a taxable account is now paying ordinary dividend tax rates on roughly 18% of income.
Anyone considering investing in CEFs should keep in mind that they are most tax efficient in a retirement account, where dividends can be reinvested or taken as income. While many unsuspecting investors view special distributions as just that, special; it’s just another day at the office for seasoned CEF aficionados.
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