CEFs (Closed-End Funds) are having a very strong year. Many of our CEF investments at High Dividend Opportunities have achieved significant upside in 2024. Notably, John Hancock Financial Opportunities Fund (BTO) has seen returns of over 30% year-to-date.
We've also seen some significant distribution increases among several CEFs. Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP) has opted for several small increases, while peer Nuveen Preferred & Income Opportunities Fund (JPC) has opted for a large 40% increase in the dividend earlier this year.
There are questions about why CEFs are experiencing such strong returns and whether we expect the performance to continue into 2025. Let us discuss this in more detail.
Declining Interest Rates
The most significant catalyst for CEFs in 2024 has been dropping interest rates. There are two reasons why this is beneficial for CEFs:
CEFs are leveraged instruments: Most CEFs use a variable interest rate that is linked to SOFR. It is this leverage that helps them outperform the indices and allows them to pay out higher distributions, and the management contracts are usually based on gross assets, providing a financial incentive for the manager to use leverage. Higher interest rates have increased interest expense and, therefore, reduced the benefits of using leverage. Lower interest rates do the opposite.
CEFs typically invest in rate-sensitive asset classes: CEF investors are those who seek higher levels of income. These funds are required to distribute substantially all of their taxable income, which includes both interest/dividends received as well as any capital gains. CEFs that invest in REITs, preferred equity, bonds, and other types of debt tend to struggle with rate hikes but are experiencing strong recovery with rate cuts.
The Factors That Will Drive Further Upside
Looking ahead into 2025, there are a lot of questions about how many more rate cuts we will experience. With inflation declining and the labor market being much softer than it was, the near-term interest rate policy is either going to be dovish or without change. Rate hikes are not a serious consideration for the foreseeable future, meaning CEFs will either experience flat or shrinking interest expenses.
We expect this to drive distribution raises in many CEFs. So, how do we predict which CEF is likely to raise its distribution in the near term?
Predicting CEF Distribution Increases
CEFs are required to pay out substantially all of their taxable gains. However, it is often possible for management to delay realizing gains and causing a taxable event. As a result, managers often have quite a bit of discretion in determining whether to increase the distribution or retain unrealized gains and grow the fund’s NAV. However, as gains accumulate, it becomes more likely the CEF will increase the distribution. Observing how much the NAV is going up is a good way to estimate which CEFs might be likely to increase their distribution in the future, even if the exact timing might not be predictable.
Here are two CEFs that are well-positioned to deliver distribution hikes.
Pick 1: BTO – Yield 6.7%
John Hancock Financial Opportunities Fund (BTO) is a CEF focused on the financial services sector, with 85% of its assets invested in U.S.-based banks, capital markets, and insurance firms.
BTO Fact Card
On its semi-annual report dated June 30, 2024, BTO reported ~$39 million in unrealized gains on investments, adequate to support over three quarterly distributions. The CEF’s NAV is up 35% over the past year and is close to post-GFC highs.
Born in 1994, BTO has a long history of delivering for shareholders. In 2022, BTO raised its distribution after NAV crossed $40, and with NAV knocking on that door again, another increase could be on the cards.
Pick 2: UTG – Yield 7%
Utility-focused Reaves Utility Income Trust (UTG) is having a great year, with its underlying companies being tangible beneficiaries of the AI revolution. Most of the CEF’s top holdings are utility companies establishing long-term multi-billion dollar power purchase agreements with Big Tech firms.
UTG Fact Card
On its semi-annual report dated April 31, 2024, UTG reported $121 million in unrealized gains, adequate to cover 8 months of distributions.
UTG has maintained steady monthly distributions for shareholders since its inception in 2004. The CEF’s NAV is up over 24% in the past year and is back in the mid-$30s.
On several occasions when its NAV was at similar levels in the 2010s, the CEF has delivered distribution increases.
Conclusion
2024 has been a great year for CEFs. NAVs have risen, distributions have been raised, and discounts to NAVs have continued to shrink. We expect this momentum to continue in 2025, fueled by more rate cuts and improving valuations of rate-sensitive assets like REITs, utilities, banks, preferred equity, and debt.
YTD, we have experienced 24 dividend/distribution hikes, but there are several CEFs in our portfolio that are well-positioned to deliver raises in 2025 based on demonstrated NAV growth, unrealized gains, and a positive outlook for their underlying holdings.
CEFs have crushed it in 2024, and we expect that momentum to continue in the foreseeable future. Valuations and distribution levels are still attractive; you haven’t missed out (yet).
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