Income Lab Ideas: Return Of Capital Isn't Always Bad

One of the recurring themes around closed-end funds is the misunderstanding of return of capital.

In general, funds that invest in fixed-income assets should ideally be covering their distributions through net investment income.

However, there are several strategies related to equity funds that can provide an investor \"constructive\" ROC.

This constructive ROC can help defer tax obligations in a taxable account, therefore creating a type of pseudo-tax-shelter for an investor on some of the cash coming in.

We recently dived into the benefits of capital gains in distributions, so it felt like an appropriate time to illustrate the often misunderstood return of capital (NYSE:ROC). This is a commonly debated topic within the closed-end fund (NYSEARCA:CEF) community and is often a source of confusion. This is especially true for newer CEF investors. That doesn't have to be so, shedding some light on the possible reasons for ROC may further help an investor grasp the concept that ROC isn't always necessarily a bad thing. It can provide a way to defer tax obligations on a portion of their incoming distributions. Some investors specifically look for this when evaluating a CEF.

Similarly to capital gains being used in a portion of distributions, ROC allows a CEF to have a managed distribution policy that allows for stable distributions. The stable distributions allow for predictable income for an investor over varying periods of time. Of course, many CEF investors know that cuts can happen at any time. When these cuts happen, the rate is usually maintained for some time. There are always exceptions and there are some funds that have a managed policy that makes the distribution a varied amount with every declaration.

One of the simplest ways to know if a fund is utilizing destructive or constructive ROC is to watch its NAV. A growing NAV over a period of time indicates that the fund is earning its distribution. An eroding NAV will indicate that they really are merely returning your investment to you. An eroding NAV isn't a sustainable long-term investment and an investor will eventually see distribution cuts.

Fixed-income investments showing ROC is generally viewed unfavorably. They may be able to justify it for very short periods, to maintain steady distributions. So, that may apply to the view that ROC can keep a distribution steady. However, I would consider it only for a short time and in small amounts. That is because unlike equity positions like common stocks, fixed-income investments won't have a chance to rebound after using significant portions of ROC.

The tax benefits from ROC being utilized in a portion of the distribution stems primarily from MLP holdings and option based CEFs. ROC reduces an investor's cost basis of the original share price purchased. This defers taxes for an investor until they sell the shares. When an investor sells the shares, it is then taxed at a capital gains rate, which is also beneficial. If a CEF is held long enough, an investor's cost basis will be reduced to $0. When this occurs any subsequent payment from ROC will be taxed at a capital gains rate.

In the case of MLP funds, there is an important distinction between how they can be set up. Generally, a CEF is structured as a registered investment company (NYSEMKT:RIC). However, a CEF can be structured as a C-corp as well. Being structured as a C-corp allows for the fund to own large amounts of MLPs. If a CEF is set up as a RIC, then the fund is limited to 25% exposure to MLPs. Bear in mind, a RIC can still be heavily invested in midstream companies that are set up as C-corps.

MLPs pay out distributions that are passed through to CEFs that hold them. Being that MLPs are also tax-advantaged due to the high amount of ROC they distribute and they are, themselves, pass-through investments. Meaning that they don't pay corporate taxes on revenue either, similar to a RIC. This is why CEFs that want to hold more than 25% of MLPs need to be registered as C-corps. Uncle Sam just couldn't fathom too many of these distributions not receiving double taxation. Similar to a company paying taxes on their revenue and then their dividends being taxed again when shareholders receive them. It is the same concept. If a RIC could hold 100% MLP exposure, then the only distributions to be taxed would be when the shareholder receives them. Since MLPs distribute out mostly ROC, the cost basis for an investor would quickly go to $0. At which time, the additional distributions would be tax-advantaged at a capital gains rate.

MLPs distribute out ROC because of all the write-offs and depreciation they enjoy. MLPs own vast amounts of real estate and equipment, so the depreciation really adds up and pushes the ROC portion of their distributions to large amounts. An image of all those beautiful physical assets and equipment is shown below - just waiting to be written off and depreciated.

For some examples, at the CEF/ETF Income Laboratory, we have two holdings that primarily focus on MLP/midstream companies. Both holdings are held in our Tactical Income- 100 portfolio. Kayne Anderson Midstream/Energy Fund (KMF), which is set up as a RIC, therefore, only 25% of its portfolio is invested in MLPs.

The other MLP/midstream focused holding is First Trust New Opportunities MLP & Energy Fund (FPL), and FPL is structured as a C-corp. As such, it isn't limited to its MLP exposure. As of their latest Semi-Annual report, the fund has about 58% exposure to MLPs.

It's worth noting FPL also utilizes an option strategy that can further create ROC opportunities.

The problem with MLP/midstream companies as a whole though, for this exercise is the fact that they have been on a downtrend since 2015. This really makes it hard to show how ROC can be a good thing. However, we can take a look at FPL's Semi-Annual report and it presents a good example.

We can see for the prior six-month period, ending April 30, the fund did receive enough NII and unrealized appreciation in the portfolio to cover their distribution. However, they are attributing the distribution to ROC even when their NAV grew in the time period reflected. Again, this isn't a great example because they also show utilized losses on their report.

This does lead to why option based CEFs can generate ROC though, primarily it is through realizing losses. That's because when a fund writes an option, they collect a premium that would usually be considered a capital gain and be taxed as such (generally a short-term holding period). However, if the fund writes a call and collects a premium, they can offset this with an unrealized loss in the portfolio and turning it into a realized loss. Essentially, when a covered call "profits" it is because the underlying asset does not appreciate and the premium is considered a capital gain. If the underlying position declines in value it can then be turned into a realized loss that was offset from the premium received. Option funds work best in flat and slightly down markets. They can lag during strong bull markets because they are having to "give away" their winners at lower than prevailing market prices. In a slightly downmarket these premiums can add up to shave off the losses of the underlying portfolio.

Eaton Vance has several popular option writing funds, one of them being Eaton Vance Tax-Managed Buy-Write Opportunities Fund (ETV). The fund has a long history of utilizing ROC in its distribution. All the while keeping their NAV per share pretty flat since the financial crisis of 2008/09. Meaning that the ROC being utilized by the fund is not truly destructive.

Data by YCharts

For the years of 2017 and 2018, ETV has paid out considerable amounts of ROC shown below.

The NAV per share for ETV is currently $14.23, on January 3, 2017, the fund had a NAV per share of $14.16. Since that period of time, the fund has paid out 33 distributions at a rate of $0.1108. This equals out to $3.66 per share in payments for that duration. We can clearly see that the ROC utilized by ETV is not destructive. Based on the NAV per share amount growing or basically flat over the last 2.75 years while contributing much of its total distribution to ROC.

Another benefit of ROC is that the fund can maintain its distribution if it believes they can turn things around. Of course, some do this for too long and it doesn't eventually end well. However, there are perfect examples of how it can be beneficial using some examples from an article I published summarizing CEFs that never cut their distribution with an inception pre-2008.

In that prior piece, I highlighted 5 funds - 3 of which took full advantage of utilizing ROC to maintain their distributions. I went through all 5 funds and pulled their distribution characterizations through the brutal period of 2008/09. To better understand what they had to do to maintain their distribution. I will review the charts again quickly on the 3 that did rely on ROC payments.

BlackRock Health Sciences Trust (BME)

DNP Select Income Fund Inc. (DNP)

PIMCO Income Opportunity Fund (PKO)

These three funds relied on ROC through the years to be able to maintain their distribution. Of course, 2008 was an exceptionally bad year. That doesn't take away from the fact that the funds were still able to maintain their distributions and eventually get back on track. It's also worth noting that DNP does have exposure to MLP investments and that contributes to the ROC portion as well.

PKO is an example of primarily being a fixed-income fund that was able to use ROC for a short period of time to maintain the payout.

This would have been viewed as destructive ROC though, at the time. That's because every subsequent payment that came from ROC was definitely taking away from the fund's NAV. Since they were able to get back on track though, I think it was a fair use of destructive ROC. It allowed for their continued payment of distributions and helped defer tax obligations for an investor.

The tax-benefit of utilizing ROC in one's portfolio is deferring tax obligations until an investor sells the shares. If held long enough, the cost basis will be adjusted all the way to $0. At that time any further distributions that are appropriated as ROC will end up being taxed in the year received at a capital gains rate. Generally, this will take many years to get to this point so should be safe to say that it should be considered long-term. The majority of investors fall into the 15% tax bracket, which is much more favorable than ordinary income rates.

Some funds can utilize ROC to maintain steady distributions, even during times of some volatility. Of course, there are those funds that also just simply over distribute without a chance to recover. I think a good example of this is PIMCO's Global StocksPLUS & Income Fund (PGP) that continually pays out ROC and held off a distribution cut for a long period of time. Now, over the last several years they had to begin to cut quite severally. The current distribution is about half of what it was in 2015. Although, the fund has shown quite healthy total returns on a NAV basis and isn't necessarily a bad fund. However, total market returns would show a different story as the fund was bid up to stratospheric level premiums.

However, when used appropriately it can be a great thing for investors to enjoy the same level of income month after month. Three funds that we used above are a great example of this, during the 2008/09 financial crisis they were able to maintain their distribution and subsequently recover.

CEFs with option-based strategies can use a kind of "lose = win, win = win" strategy. By harvesting unrealized losses in the underlying portfolio they can pay out distributions as ROC - while receiving premium income. And vice versa, if their options strategy begins losing money these losses can offset gains in the portfolio.

A downfall of trying to invest with ROC as a focus is knowing exactly how the characterization will be at the end of the year. That is because the official breakdown is not known until year-end when the funds calculate the exact breakdown. Therefore, when we receive a section 19(A) notice, that is only an estimate. The estimate can change vastly by year-end. It's worth noting too that any fund with distributions estimated to include sources other than NII is required to release a section 19(A). This would include ROC and capital gains, which can be confusing to an investor when they see this press release. I'll admit, I use to pay attention to these press releases but they just aren't reliable enough to utilize in most funds is what I've found. However, we can still assume that MLP and option strategy funds will include a good portion of ROC. It is just that the exact makeup is unknown for tax purposes until the end of the year.

The simple rule is if a NAV is flat or growing, then the ROC is constructive. If the NAV is trending down, then the ROC is destructive. This doesn't help address the issue of declining investments more broadly, like in the energy space, where the underlying assets have been in a downtrend for many years. However, it is still a good gauge for most CEFs, just be aware of the issues behind using this as a sole metric.

Overall, ROC should not be immediately characterized as a bad thing. It can serve a couple of different purposes that can indeed help an investor. I hope this helps clear up some of the misunderstandings surrounding ROC in distributions.

I am/we are long BME, ETV, KMF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.