Play The Odds With Term Funds: Annualized Gains Up To 15%

In the world of closed-end funds, (“CEFs”) there are three types of fund structures.

• Perpetual: As it sounds, the fund has a perpetual mandate and continues to operate ‘forever’
• Term: This fund has a specified date in the future when it will self-liquidate at NAV.
• Target Term: This type of fund not only has a specific date in the future where it will liquidate, but it also has a target price it will liquidate at.

The goal of the two term fund types is to minimize the discount at which the fund trades versus its share price. We like to use the tether analogy where the price is tethered to the NAV since the shareholder will receive back the NAV, not the price, upon liquidation.

This is a significant benefit, as it means any discount to the NAV is captured between the purchase date and the liquidation date. For instance, if the fund is trading at a -5% discount to NAV, and it liquidates at the end of the year, well in addition to the yield you are collecting between now and then you will also capture the NAV since that is what is paid out to shareholders.

The risk is, in some cases, the fund sponsor changes their mind and says, “our fund is so good it should go on forever.” They then put it up for a vote to shareholders – and most of the time, shareholders potentially not knowing what they are doing, they vote with management. Despite the fact it likely goes against their own interests.

Today we have four funds that are nearing their completion dates. We’ll go through them one-by-one.

1. Nuveen Preferred and Income Term (JPI)

This is, as the name suggests, a preferred stock fund. By mandate, at least 50% of the fund has to be in investment grade preferreds. Here is the key, the fund trades at a -3.3% discount and will liquidate on August 31, 2024.

So between now and that date, you are going to receive, in addition to the monthly distributions, an extra 3.3% return. Not a bad deal.

One of the key considerations when buying term funds is you have to be comfortable with the underlying asset. Preferred bank stocks, while not risk free, aren’t commercial real estate or bitcoin. The NAV is unlikely to jump around a ton.

Now, here is the rub. Nuveen is trying to convert the fund to a perpetual fund. If you go to the fund’s website, you’ll see a popup with a ‘proxy season’ notification asking you to vote “FOR” the proposal.

The vast majority of the time, you would want to vote AGAINST management and the conversion to a perpetual fund. This is Nuveen wanting to retain these assets and the fee revenue they produce. However, the proposal is one that is becoming quite commonplace today in these conversions.

They are giving shareholders who vote for the proposal to still get out at NAV via a tender offer. See below:

If you vote ‘yes’ or ‘for’, the fund will convert to a perpetual fund, but you also have to tender ALL of your shares at NAV. In the flyer below, you want option 2 where you ‘exit’ and tender all your shares at NAV. That is the only way you capture the 3.3%.

So what’s the risk? Really, there is none other than the risk in the NAV, which is fairly minimal. Or that you fill out the card incorrectly. I guess you could vote note and the vote passes, and you’ve failed to tender your shares.

If the vote fails, then the fund goes on to liquidate as scheduled on August 31st. If the vote passes, and you fill out the card correctly, then you tender your shares at NAV. The question then becomes when that tender occurs.

Even if it’s after the Aug 31st date set forth in the original governing docs, you’ll still capture the discount.

This is a great opportunity to capture very low risk returns. We figure the IRR to be about 5.5% and annualized to be about 13.6%. That’s an S&P 500 type of return with about one-third less risk.

2. Virtus Convertible and Income 2024 Target Term (CBH)

As the name suggests, it is a convertible securities fund. As compared to JPI above, there will be more NAV risk in this one since convertibles can move around a lot more than preferreds.

This is a target term fund, so the prospectus states that they will attempt to return $9.83 upon expiration of the fund’s term on September 1st. With a NAV of $9.15, it will be hard for the fund to achieve that level, although it is not out of the question. They would need a strong market tailwind between now and then.

The average maturity in the portfolio is only 1.9 years, so between now and expiration of the fund in September. The greatest driver of the NAV though will be technology stock prices and consumer discretionary performance. Over 16% of the account is driven by Block Inc. (SQ), Wayfair (W), and Chinese electric carmaker, NIO.

We calculate that the total gain/loss on the thesis is about 5.75%, slightly more than JPI above for about the same time period. However, the NAV volatility is slightly higher as well.

What I like is recently the NAV has been on a nice and steady climb while the price has been fairly flat. Investors are capturing a ‘free’ 3.6% for the next 4 months and 20+ days. That’s not bad.

BNY Mellon Alcentra Global Credit 2024 Target Term (DCF)

Again, as the name implies, this is a target term so it’s meant to liquidate at a certain date and price. The liquidation date is December 1, 2024 or just under 8 months from today.

DCF is mostly a high yield bond fund with 438 holdings and a weighted average coupon of 7.86%. The effective maturity is about 5 years. What that tells me is that the portfolio maturity dates are NOT aligned with the fund’s liquidation date. So you will have some interest rate risk between now and the liquidation date of the fund.

This is a global fund with about 52% of the holdings in the US and the rest in Europe. Below is the credit quality and asset mix breakdowns.

As opposed to the first two, you have a bit more credit risk here compared to JPI and even CBH. That said, there is *only* 6% in CCC rated debt, the lowest rung of the investment quality ladder.

The asset breakdown is a mix between bonds, structured credit, and loans.

The fund is trading just over a -3% discount, which is lower relative to the other two funds that liquidated earlier. So between now and then you capture 3% plus 8 distributions of $0.035 per share per month for a total gain of 6.6%.

While that is higher than the first two, you have to consider two things. 1) There is more risk here (still less than stock risks), and 2) there is longer time to maturity, meaning you get to collect more distributions. The annualized return is much less at 10.2%. That is nearly 4% less than JPI and CBH.

However, this is one to keep on the radar and see if you can get some shares below $8.55 (about a -4% discount) because at that level, your annualized return looks more compelling.

Invesco High Income 2024 Target Term (IHTA)

This is one of the more risky one’s, but one you can also earn higher returns because of that risk. You just have to be patient.

It’s a target term that is slated to liquidate on December 1, 2024 at a certain price. Like most target terms, it won’t reach that target price of $9.83 as the current NAV is $7.92. The yield is 5.30%.

Between now and December 1st, you capture the current discount of -5.7% plus earn 8 distributions of $0.033 per share per month. The IRR is approximately 9.56%. Annualized gain is near 15%.

However, with this fund, you are invested in a more volatile asset – commercial real estate mortgages. Most of the mortgages are investment grade, with 34% being BBB-. That said, they are still commercial mortgages, which is an area in significant flux.

The NAV fell sharply last year when commercial mortgages got hit on the potential “crisis” in the space. Since November, we’ve seen a nice recovery. However, in the last month, it appears we’ve resumed that downward trend again.

That is the risk for this fund. We just don’t know what the NAV will do between now and then.

Concluding Thoughts

Term funds are similar to buying a discounted bond that is nearing its maturity. There are a few other risks that are involved here. For example, your maturity or par value is going to fluctuate, whereas with a bond, you get back 100c on the dollar. However, investors are more handsomely compensated for this risk with close to equity-like returns, lower than equity risk, and much greater visibility.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.