EXD: Options Strategy CEF Adopts Better Strategy

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Eaton Vance Tax-Advantaged Bond and Options Strategies Fund (EXD) is an unleveraged municipal bond and equity option strategy closed-end fund, trading at a -9.0% discount, that will soon increase its distribution. The board has approvedseveral changes, summarized above.

Here we discuss why these are game changers for EXD and why we think it will become the cheapest covered call fund choice in the Eaton Vance lineup.

Out With the Old

A review of articles about EXD reveals that it gets little attention, perhaps because it’s unusual, though it will likely get more coverage going forward. In order to understand the history of EXD, before reviewing its new investment strategy, let’s first take a quick look at the old strategy.

Something to understand about EXD is in mid-2010 it launched into a post financial crisis world where many investors feared a “New Normal” and were looking for something that would perform well in that environment - something like EXD. It executed one of the most unique strategies in closed-end funds, an equity option strategy called the “iron condor.” This strategy can perform well in range bound, flat, and moderately up or down equity markets. The option positions comprised S&P 500 index put and call spreads, with the remainder of the portfolio filled out with low yielding short-term high-quality municipal bonds.

At the beginning of this decade, had the “New Normal” played out as some had forecast, EXD could have performed well. Unfortunately, the S&P 500 saw little in the way of range bound or flat markets in the years that followed. Since its launch, EXD saw a disappointing 1.1% annualized total return at NAV with the S&P 500 mostly going up instead of sideways. Throughout this period, EXD distributed destructive return of capital well in excess of its return, which ate away more than half of its NAV.

In With the New

Fortunately, this matters little to new investors. Under its new strategy, which will wholly replace the old one, EXD will soon employ a “buy-write” option strategy successfully employed by Eaton Vance covered call funds for many years.

No two Eaton Vance covered call funds are exactly alike, all having their individual differences. What they have in common is they invest in common stocks against which they write call options. This option strategy seeks to generate income derived from call option premiums, at the risk of forgoing some appreciation potential in strong up markets.

Within this group, EXD’s new strategy will most resemble that of Eaton Vance Tax-Managed Buy Write Opportunities Fund (ETV). Similar to this fund, EXD will split its portfolio into two segments, one segment seeking to outperform the S&P 500 index and the other seeking to outperform the NASDAQ 100 index. Practically speaking, this means EXD will invest broadly in the U.S. stock market, while overweighting technology stocks.

EXD will write index call options on at least 80% of the stocks in the S&P 500 and NASDAQ 100 segments. Initially, it will allocate 50%-75% to the S&P 500 segment and the remaining 25%-50% to the NASDAQ 100 segment. The advisor has discretion to shift the allocation between segments.

With these changes in place, having abandoned its municipal bond portfolio and “iron condor” option strategy, EXD should perform like other Eaton Vance covered call funds, and ETV in particular, and should be able to sustain a similar distribution level.

The fund retains its primary objective of generating high current income and its secondary objective of capital appreciation.

These changes should take effect on or about February 8th, 2019.

Increased Distribution

Beginning March 2019, the fund will switch from a quarterly distribution to a more frequent monthly distribution. The monthly distribution will be $0.0708 per share, increasing the distribution rate by 32.8%. All else equal, that would be a 9.6% distribution rate at last closing price. We anticipate that the first monthly $0.0708 distribution will be declared toward the beginning of March (at the same time as other Eaton Vance closed-end funds) and payed at the end of March.

EXD already employs a managed distribution policy and will remain a tax-managed fund. Eaton Vance tax-managed funds aim to maximize the amount of distributions treated as tax deferred return of capital rather than taxable income or capital gains.

In contrast to income and capital gains distributions, return of capital distributions are not subject to current tax. Instead, each shareholder's tax cost basis is reduced by the amount of the distribution, which increases the amount of capital gains (or decreases the capital loss) they will recognize on sale. See here for more information.

We expect a substantial component of the distribution will continue to be return of capital (the good kind).

Decreased Expenses

As part of these changes, the management fee will decrease from 1.25% to 1%, in line with other Eaton Vance covered call funds.

Covered Call Funds Ranked

Next we compare EXD to 7 peers: Eaton Vance Tax-Managed Global Diversified Equity Income Fund (EXG), Eaton Vance Tax-Managed Diversified Equity Income Fund (ETY), Eaton Vance Tax-Managed Buy-Write Opportunities Fund (ETV), Eaton Vance Tax-Managed Global Buy-Write Opportunities Fund (ETW), Eaton Vance Tax-Managed Buy-Write Income Fund (ETB), Eaton Vance Enhanced Equity Income Fund (EOI) and Eaton Vance Enhanced Equity Income Fund II (EOS).

These funds all pursue similar strategies, differing in which stocks they invest in, the extent of their covered call writing, whether they write single stock call options or index options, etc. None of these funds employ leverage. They all have managed distribution policies, with a portion of their distribution being return of capital.

The table shows that EXD will lead on distribution rate when its distribution is increased in March. Since EXD trades at a discount to NAV and we do not expect the distribution will be cut any time soon, we see this as a positive.

Of these funds, EXD also leads on discount, trading at a -9.0% discount, which is larger than any of the other funds. For comparison, ETV trades at a 6.8% premium.

The distributable earnings column may be of interest to tax sensitive investors, e.g. those investing in taxable accounts. It shows the sum of capital gains plus UNII as a percentage of net assets, taken from the most recent annual or semi-annual report. The lower this number, the more readily a fund can distribute return of capital or find capital losses to offset capital gains and the less likely it will be forced to distribute taxable income. On this metric, EXD leads at -13% (the reason it’s negative is because it inherited an accumulated loss from its prior strategy).

Over the past 5 years, Eaton Vance covered call funds have each returned somewhere between 5% and 11% annualized at NAV, depending on the particular fund. EXD had a negative return over this period because of its old investment strategy. While EXD performed worse on this metric, it’s replacing its strategy with one most similar to ETV. ETV returned about 8.9% at NAV, putting it among the top performers.

Conclusion

Because EXD will soon employ a different investment strategy, we think investors should look beyond the fund’s poor past performance.

We think the market could come to value EXD as an equal among Eaton Vance covered call funds. Whether or not that happens going forward, we think EXD offers the best value, being the cheapest option among Eaton Vance covered call funds, particularly for those who want to overweight technology or for higher cash distributions.

We also think that EXD has the best potential among Eaton Vance covered call funds to continue to distribute tax deferred return of capital for many years to come, more so than others and particularly ETV and ETB, which have accumulated considerable taxable earnings that have the potential to be distributed to shareholders in the future.