The plunge in crude-oil prices is sending shock waves through closed-end funds tracking the energy sector, highlighting how the market turmoil is hitting products popular with ordinary investors seeking to boost returns during the long bull market.
Shares of the Goldman Sachs MLP and Energy Renaissance Fund have fallen 78% this month, while shares of the
have fallen 74%, respectively. Shares of the
have lost more than 80% of their value.
A closed-end fund is similar to a mutual fund, but its shares trade on an exchange. A professional manager oversees the fund’s holdings, deciding what to buy and sell. Unlike mutual funds, closed-end funds issue a fixed number of shares, after which capital rarely flows in or out of the fund. Also unlike mutual funds, they tend to use leverage to juice their payouts—borrowing at short-term interest rates and investing the proceeds in longer-term securities that pay higher returns.
That is a tactic that makes them attractive to investors when things go well, but one that can also amplify losses when markets sour. There are laws that cap the funds’ leverage, so when the value of their underlying securities falls, they often need to reduce their leverage by selling assets, as they cannot easily raise capital by issuing new shares.
That is what is happening now: As crude prices have plummeted, hurting shares of energy companies and the market value of the funds’ holdings, several have been forced to reduce their leverage by selling securities. That has cut down on the amount of money available to pay investors, which likely will lead to funds cutting their distributions, asset managers say.
“The life blood of a closed-end fund is its yield,” said Erik Herzfeld, president of Thomas J. Herzfeld Advisors, a boutique asset manager focusing on closed-end funds. “The last thing they want is to cut their dividend—that’s what keeps people invested in them.”
Last week, Fitch Ratings downgraded senior secured notes and preferred-shares ratings for several closed-end funds that invest in midstream companies, including funds managed by Kayne Anderson and Tortoise, citing “unprecedented declines” in the per-share value of the funds’ underlying securities. Even though the funds are selling securities to reduce leverage and increase cash, the forced selling has further exacerbated declines, according to Fitch.
Moody’s Investors Service this week placed a negative outlook on closed-end funds, particularly those investing in riskier areas, including the energy sector. Among other worries, the ratings firm warned that big declines in the funds’ assets placed them in danger of breaching regulations governing the amount of leverage they can employ.
U.S. crude prices have fallen 60% so far this year, as the coronavirus crisis wreaks havoc on demand for crude and a Saudi-Russia price war threatens to flood even more oil into an amply supplied market. The price drop has wreaked havoc on companies throughout the industry, forcing them to cut spending and, in some cases, their dividends. Exxon Mobil Corp. shares have declined 39% this month. Shares of
have lost about 50% of their value, while shares of
Kinder Morgan Inc.
have dropped 42% and
LP shares have fallen 49%.
Some closed-end funds have already been forced to cut their payouts. Investment firm Kayne Anderson said last week that it would be reducing the leverage of its two midstream-focused funds and that their March distributions would be delayed by a month. Moving forward, the funds will make payments on a quarterly basis instead of a monthly basis, the firm said.
Others are still undecided. The Goldman Sachs Energy & Renaissance Fund said earlier this month that it decided to eliminate its leverage entirely and will continue evaluating the fund’s distribution level in the coming quarters. Tortoise, which is also taking measures to reduce its funds’ leverage, told The Wall Street Journal that any decision on future distributions will be made at the next meeting of the funds’ board of directors.
“Leverage is lovely when things are going up, and really awful when things are going down,” said Rebecca Babin, senior energy trader at CIBC Private Wealth Management.
Shares of closed-end funds typically trade at a discount or premium to the per-share value of the funds’ holdings, depending on investor demand. The Neuberger Berman MLP and Energy Income Fund Inc., the
all were trading at least 25% below the per-share value of their securities as of Friday, according to data from the Closed-End Fund Association, a trade group that represents the closed-end-fund industry.
Some investors view that as an opportunity. If they buy fund shares at a discount and that gap narrows, they can make a profit. But if a fund’s discount to net asset value widens, then investors can lose two ways: on the decline in value of its holdings and on the fall of its own share prices.
Investors looking for bargains should proceed with caution, said Timothy Parker, a partner at Regency Wealth Management. He is advising clients against buying energy closed-end funds in an attempt to take advantage of current discounts. Demand for crude is likely to remain limited in a global economy pummeled by the virus, hitting energy companies and probably their dividends.
“It might seem like it could be a great time to buy now, but who are you going to sell it to?” he said.
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