RiverNorth Capital’s Patrick Galley: Closed-end fund space on a roll

The closed-end fund market has continued on a tear in the first quarter of 2010.

The closed-end fund market has continued on a tear in the first quarter of 2010. All sixteen asset classes in the RiverNorth Closed-End Fund Index experienced positive net asset value (NAV) total returns. Market price returns did even better as discounts narrowed for thirteen of the categories.

The RiverNorth Closed-End Fund Index posted a NAV total return of 4.76% and a market price return of 6.57% for the quarter. The average discount of the index narrowed from 3.24% at December 31, 2009 to 1.45% at March 31, 2010. This is the narrowest month-end discount since December 2006. All categories except for Government & Agency Bonds, Non-U.S. Equity and U.S. Equity saw their average discounts narrow in the quarter.

The Bank Loan asset class experienced the largest discount narrowing of all categories – the average discount narrowed 1,004 basis points, to a premium of 3.89% from a discount of 6.15% as of year-end. The significant discount narrowing is most likely related to the general consensus among investors that short-term rates will rise in the near future.

Because corporate bank loans are generally floating rate securities pegged to LIBOR, they provide investors with attractive floating rate yields relative to alternative fixed income securities bearing interest rate risk and short-term maturities with very low rates. The current average yield is approximately 5.9%. Investors should not lose sight of the fact that this category invests in below investment grade securities and therefore investors are taking on credit risk, something that many seem to have quickly forgotten given current premium levels.

First quarter 2010 witnessed four closed-end fund initial public offerings, raising approximately $858 million in new closed-end fund assets and is on pace to surpass 2009’s $2.3 billion aggregate raise. The largest of the four IPOs was the $370 million ING Infrastructure, Industrials and Materials Fund (IDE). I believe this is a positive development as it relates to investor sentiment toward risk assets outside of the fixed income asset class.

Fund sponsors have been busy raising new assets at existing funds through secondary offerings and rights offerings. Specifically the Master Limited Partnership asset class has been taking advantage of their premiums to net asset value and issued four secondary offerings in the first quarter of 2010. The SEC requires funds to trade at a premium to net asset value in order to issue new shares through a secondary offering.

For those funds not trading at premiums or at risk of trading to a discount, fund sponsors can issue new shares through rights offerings, whereas only existing shareholders have the right to purchase new shares at a discount to the prevailing average market price. Three rights offerings commenced in the first quarter and I expect to see additional offerings throughout the year as funds look to increase assets and take advantage of closed-end fund demand. Approximately 37% of all closed-end funds are trading at premiums to their net asset value.

Investors looking to gain equity exposure at an attractive discount should consider Royce Value Trust (Ticker: RVT). The current discount of approximately 15% makes this small-cap value equity strategy attractive compared to the fund’s three-year average discount of 5%. In addition, unbeknownst to most current shareholders, Royce waives the management fee on RVT if the fund’s rolling 36-month total return on net assets is negative, which is currently the case. Therefore the manager will not charge the fund a management fee until either short-term performance improves or negative performance in the fourth quarter of 2008 is rolled off. This is a very unique structure among closed-end funds that should warrant consideration.

Patrick W. Galley is the Chief Investment Officer of RiverNorth Capital Management, LLC, an investment management firm based in Chicago, Ill. The firm specializes in quantitative and qualitative closed-end fund trading strategies and is the investment adviser to the RiverNorth Funds.