Income and Distributions: A Range of Possibilities

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CEFs are designed with an emphasis on generating income for investors. The income they provide can come from various sources, including:

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• Interest and dividends from the underlying portfolio securities.

• Realized capital gains from selling assets for a profit.

• Return of capital (ROC), a distribution that is a portion of the original investment.

 

The distribution rate—the amount a fund pays out each year relative to its market price—can vary significantly. It's crucial to examine the source of a CEF's distributions. A fund that pays a high percentage of its distributions from destructive return of capital is essentially returning your own money to you and may be unsustainable. This happens when a fund's total return (the change in NAV plus distributions) is less than its distribution rate.

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However, not all return of capital is destructive. A fund may use ROC that comes from unrealized capital gains to maintain a consistent distribution. In this case, the fund is distributing gains that have not yet been realized by selling the underlying assets, which may be a sound strategy to provide steady cash flow.

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Tax Advantages: Making Your Income Work for You 💸

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CEFs, like other regulated investment companies, generally don't pay taxes at the fund level as long as they distribute at least 90% of their taxable income. The tax consequences are passed on to investors. The tax treatment of distributions depends on their source:

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• Net investment income is generally taxed at ordinary income rates, though certain dividends may be eligible for a lower qualified dividend tax rate.

• Realized capital gains are taxed at either short-term or long-term capital gains rates.

• Return of capital is generally not taxable and reduces your cost basis in the fund, deferring taxes until you sell your shares.

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Some CEFs are specifically structured to be tax-advantaged. For example, municipal bond funds provide income that is exempt from federal, and sometimes state and local, income taxes.

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The Reinvestment of Return of Capital

A key strategy for maintaining the integrity of an investment in a CEF that distributes ROC is to reinvest the distributions. When you reinvest a distribution, you're using the cash you receive to purchase more shares of the fund. This is particularly beneficial for ROC distributions, as you're effectively putting your own money back into the fund to buy more assets.

 

Reinvesting ROC can help mitigate the erosion of your capital. By taking the distributed portion of your investment and immediately buying more shares, you're participating in the fund's future performance and leveraging the power of compounding. If the fund is trading at a discount to its NAV, you're buying more assets for less than their underlying value.

This not only puts your money back to work but also increases your share count at a potentially advantageous price.

This strategy can be seen as a way to convert a portion of a fund's total return into a tax-deferred cash flow that is then used to grow your investment, rather than just cashing out a part of your principal.

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The Role of Leverage: Magnifying Returns (and Risks) ⚖️

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One of the key differences between CEFs and open-end mutual funds is the ability to use leverage. Leverage is the practice of borrowing money to invest in additional assets, with the goal of increasing returns. For example, a CEF might borrow at low short-term interest rates and invest the proceeds in longer-term securities that offer a higher return. The difference, or "spread," can boost the fund's income and distributions.

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While leverage can be a powerful tool for enhancing returns, it also magnifies both gains and losses. If the fund's investments perform poorly or interest rates on the borrowed capital rise, leverage can lead to greater losses and increased volatility in the fund's net asset value (NAV) and market price. Most leveraged CEFs carry a leverage ratio, typically around 33%, which indicates the amount of borrowed capital relative to the fund's assets.

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Discounts and Premiums: The Value Investor's Opportunity 🏷️

Because a CEF's shares trade on an exchange, their market price is determined by supply and demand, not by the value of the underlying assets. This often leads to a discrepancy between the fund's market price and its net asset value (NAV), which is the per-share value of its holdings.

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• A discount occurs when the market price is lower than the NAV.

• A premium occurs when the market price is higher than the NAV.

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Most CEFs trade at a discount. This creates an opportunity for investors to potentially buy a dollar's worth of assets for less than a dollar. If the discount narrows or the fund's NAV increases, the investor can benefit from both the fund's performance and the closing of the discount.

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To identify attractive investments, many investors analyze a fund's discount relative to its historical average. A fund trading at a wider-than-average discount may be a compelling buy, but there is no guarantee a discount will ever narrow. A persistent discount can also be an indication of poor fund performance or a lack of investor confidence.