Last week, Barack Obama became the first U.S. president to visit Cuba in nearly nine decades.
As you may recall, President Obama announced that the United States would re-establish diplomatic relations with Cuba in December of 2014.
Of course, investors immediately began searching for ways to profit from the re-opening of trade and travel with Cuba.
Some investors thought they had uncovered a gem called The Herzfeld Caribbean Basin Fund (CUBA), a closed-end fund (CEF). After all, the ticker seemingly told you all you had to know.
From December 16, 2014 to December 23, 2014, CUBA rose 107%. The fund went from a discount of over 10% of its underlying net asset value (NAV) to a massive 70% premium.
Except there was one big problem: CUBA had little direct exposure to Cuba.
Close, but no cigar.
By mid-January 2016, the fund had lost over 60% of its value and was once again trading at a discount to its NAV.
CEFs, like CUBA, have a set number of shares outstanding. Therefore, supply and demand forces determine whether the shares trade at a premium or discount to NAV.
CEFs tend to be relatively small and illiquid, so their holders are predominantly individual investors. As a result, CEF share prices are heavily influenced by the herding of retail investors – perfectly illustrated by the CUBA episode.
However, CUBA is an especially small CEF. Such pricing anomalies would never occur with the larger funds run by prominent financial institutions, right?
In June of 2014, near the height of the “reach for yield” mania, I recommended selling two high-yielding PIMCO closed-end funds.
Over the next 15 months, PHK and PGP both lost roughly 40% of their values (distributions included but not reinvested).
The premium for PHK evaporated and the premium for PGP hit a more reasonable but still elevated 18%.
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The premiums have since re-inflated for both funds. In fact, the premium on PGP recently reached an unprecedented 103%.
It seems as though many folks are using the snapback rally in the credit market as an excuse to bid up several closed-end funds with impunity.
The following table is a list of several CEFs trading at high premiums:
The Babson Capital Corporate Investors (MCI) is rated five stars by Morningstar and has a great track record, but no fund is worth a 20%-plus premium.
The PIMCO Municipal Income Fund (PMF), PIMCO California Municipal Income Fund II (PCK), PIMCO New York Municipal Income Fund II (PNI), and PIMCO California Municipal Income Fund III (PZC) are all trading at very high premiums. No matter how bullish you are on muni-bonds, there’s no reason to pay up this much for exposure.
The financial markets may not make sense all of the time, but, as you can tell, craziness is the norm in CEF land.
When a CEF you own trades at a small premium to its NAV, you should at least consider selling it. When that premium exceeds 15%… hit the bid and get out as if you’re fleeing a communist dictatorship.
Safe (and high-yield) investing,
Alan Gula, CFA