Paying a Premium to Take on More Risk

Would you willingly pay $1.25 for something worth $1.00? This is not a trick question. The data showing the current price and the actual value is clearly stated and easily accessible. Knowing this, would you pay $1.25 for something worth $1.00?

In a world operating in accordance with the efficient market hypothesis (EMH), such price discrepancies could not exist. If they did appear, they would quickly be corrected. Potential buyers would walk away from the overpriced asset rather than opening their wallets. Potential sellers would lower their asking price until they could find someone to trade with.

In reality, the markets are not fully efficient and some investors do willingly pay a significant premium. We see examples of this occurring in the closed-end fund space. As of Wednesday’s close, the PIMCO Strategic Income Fund (RCS), PIMCO Global StocksPLUS & Income Fund (PGP), PIMCO Corporate & Income Opportunity Fund  (PTY) and the PIMCO High Income Fund (PHK) were trading at premiums of approximately 25% or more relative to their net asset value (NAV). Put another way, buyers of these funds are paying $1.25 or more for each $1 worth of assets.

What’s the attraction? Beyond familiarity with the PIMCO name are the high yields these funds trade with. The Closed-End Fund Association (CEFA) calculates their yields as ranging between 8.68% (PTY) and 11.09% (PGP). The distribution yield—which can include capital gains and the return of capital—ranges between 9.22% (PTY) and 12.77% (PHK).

These high yields are possible because of the use of leverage. Global StocksPLUS & Income’s portfolio, for example, has 23.8% of its assets leveraged. The high ratio reflects the use of derivatives such as reverse purchase agreements and credit default swaps. Investors who do not understand what these instruments are should not buy shares in funds that invest in them.

Leverage is often used by closed-end funds to boost returns and distributions. When it works, shareholders are happy. When it backfires, shareholders take a big hit. Leverage is akin to playing with fire: you’re fine until you are burned, and sometimes those burns are severe.

Paying a high premium to own a closed-end fund that makes use of leverage means making two bets beyond the bets that shareholders of mutual funds and non-leveraged exchange-traded funds (ETFs) make in regard to fund-specific return. First, shareholders of these closed-end funds are counting on others to also be willing to pay a high premium to own the fund. Second, these shareholders are hoping to get out of the fund before the use of leverage backfires and the underlying value of the fund’s assets incur a massive drop. It’s risk on top of risk.

Astute and patient investors can find bargains in closed-end funds. The key is to look for situations where you can pay less than a dollar—preferably much less—for a dollar’s worth of assets. The CEFA’s free screener can identify such funds. I like to look at the premium/discount history chart and table on a fund’s quote page to see how the current discount compares with the historical averages. (Some closed-end funds have histories of trading at discounts to their NAVs; I want the current discount to be bigger than average.) I also take into account the fund’s expense ratio, its historical returns, whether not it uses leverage (I personally prefer non-leveraged funds) and the fund’s investment strategy. I will go to the fund’s website—which can be found by doing an online search on the fund’s name—to see what the fund is investing in and to get more information about the strategy.