What happened to my distribution?

Clive Smith

Russell Investments

The recent major selloff in bond markets has highlighted the potential issues associated with managing distributions. More specifically issues can arise in fixed income portfolios when there is a disproportionately high level of realised and unrealised ‘mark to market’ losses. In such circumstances the ‘mark to market’ losses can swamp the coupon income generated by the fund. The result is that the ability of a fixed income fund to pay distributions may be significantly compromised. How an investor deals with managing the risks to distributions can become an important consideration when establishing an investment strategy.

TOFA and distributions

For many investors there is the expectations that fixed income funds will pay out regular distributions but this may not necessarily be the case. Though fixed income funds receive regular coupon payments, the issue faced with respect to variability in distributions arises from the interaction of the Taxation of Financial Arrangements Act (TOFA) with the distribution policy of the fund.

TOFA establishes the rules for defining distributable income. Fixed interest funds are on revenue account and under TOFA net income includes the following components:

a) Coupon
b) Interest
c) Net realised derivatives gains/losses
d) Net realised trading gains/losses
e) Premium or discount of purchase of securities

It is the net effect of the interaction of all these factors over the course of the tax year which determines the level of distributable income. Though many of these factors are quite stable and predictable the major source of volatility in distributions arises from components (c) and (d). Not only will the impact of these components on distributions depend on market dynamics over the tax year but also the extent to which turnover within the portfolio results in in these gains/losses being realised. From this it follows that, since all realised cash flows are classified as income, that a high level of realised losses can result in low, or indeed no, distributions in any period.   

Complicating the situation is the distribution policy of the fund itself. Distribution policies are important as a fund is required to pay out all net income by the end of the tax year. The result is that over the year the fund is required to monitor and estimate how much can be distributed in any period. 

It is for this reason that the final distribution period for the tax year is often utilised by the fund as a ‘true up’ to ensure that all net income is paid out to investors. This explains why many investors may notice that June distributions for fixed income funds often tend to be particularly volatile.

While a fund must distribute all its net income by the end of the financial year it must also take care not to overdistribute. An overdistribution is where a fund pays out more income during the tax year than it has net income for the tax year. Though, under the Attribution Managed Investment Trust regime, funds have greater flexibility to deal with overdistributions inevitably they are required to be ‘clawed back’ by one means or another. Correcting overdistributions can create complications for funds and is why one of the key aims of a distribution policy is to avoid overdistributions. It is via the potential risk of an overdistribution that unrealised losses within funds can impact on distributions as allowance needs to be made for the impact on net income from their potential crystallisation.

Though not all investors may attach the same significance to distributions, for some investors the requirement of a steady income stream is more important than simply deriving the maximum return. For these investors there are several potential means of achieving a greater stability in distribution returns.

Matching realisation of gains and losses

The initial means of managing distributions is ensuring that any realised losses are offset by realising capital gains. Where these perfectly offset the net income becomes the coupons and interest received over the tax year less expenses. Such an approach works best where positions are generating offsetting exposures such as derivatives being utilised as hedges within the fund. By their nature hedges act to offset underlying physical exposures. The matching of offsetting exposures means that both can be actively traded so that the realisation of losses on the hedge is offset by the realisation of gains on the underlying physical assets. To the extent that transaction costs are incurred by the increase in turnover there will ultimately be an adverse impact on the level of total distributions.

De-risking fixed income portfolios

The major limitation with matching realised gains and losses is that this will not necessarily assist where there are not offsetting exposures. In the absence of offsetting exposures, a structural increase in interest rates and/or credit spreads will create a net capital loss within the fund which may be realised over time. To avoid the impact from such market dynamics requires a de-risking of the fund in one form or another.

The first form of de-risking is eliminating the use of derivatives within a fund. Derivatives can create issues for distributions as the contracts utilised are normally of materially shorter terms than that of the underlying assets. Accordingly, any losses on the derivatives exposures will be realised more frequently increasing the impact on the distributable income of the fund.

The second form of de-risking involves simply recognising that a greater stability in distributions can be achieved by limiting the scope for adverse market movements to impact on net income; i.e. reduce the scope for the fund to incur ‘mark to market’ losses. To achieve this requires a reduction in the level of overall interest rate and credit risk assumed within a fund. By limiting the scope for a portfolio to incur material ‘mark to market’ losses an investor can focus on retaining the maximum amount of coupons and interest as net income.

Utilising sub funds to manage distribution risk

An alternative form of de-risking involves utilising a combination of sub funds to manage distribution risk. Such an approach is more relevant where an investor is using third party funds and therefore de-risking directly within the fund is not a feasible option. The use of sub funds to manage distribution risk leverages off ‘mark to market’ losses being netted off within funds but not being netted off between funds; i.e. the minimum distribution from a fund is zero.

As Figure 1 illustrates under such an approach the investor invests in what may be termed a Distribution Fund which in turn invests in two or more underlying sub funds. The Distribution Fund is simply a vehicle that collects the distributions from the underlying sub funds and then passes them through to the end investor. The sub funds can in turn be separated into a Risk Free Sub Fund and a Market Risk Sub Fund. The key to maximising the impact from de-risking distributions is that the Risk Free Sub Fund must be completely de-risked and is therefore guaranteed to always pay out a distribution each accounting period; e.g. a vanilla cash fund. 

The point to note is that under this structure, the risk that the Distribution Fund will not pay out a distribution in any accounting period is completely independent of the realised or unrealised ‘mark to market’ losses incurred by the Market Risk Sub Fund. 

 This is because the minimum distribution that could be paid by the Market Risk Sub Fund in any distribution period is zero. As the distribution paid out by the Distribution Fund is simply the weighted average of the two sub funds, then the risk that no distribution is paid in any accounting period is determined by the risk that the coupon/interest generated by the Risk Free Sub Fund is less than the fund cost associated with the Risk Free Sub Fund and the Distribution Fund. Though there is still a risk that no distribution will be paid this has been separated from the distribution risk associated with market movements and the resulting risk of ‘mark to market’ losses[1].

At the end of the day there is no way to guarantee that fixed income funds will pay regular distributions while a material level of market risk is being assumed by the investor. Steps can be taken to reduce the volatility in distributions but, as all returns are ultimately distributed as income, there is an inevitable trade-off between stability in distributions and the total distributions earned over the long term. It is only by understanding the trade-offs and their own sensitivity to any volatility in distributions that investors will be able to make decisions which optimise the outcomes derived from their fixed income portfolios.

[1] Note this assumes that the Distribution Fund does not trade units in the Market Risk Sub Fund. Should units in the Market Risk Sub Fund be traded then any realised losses will flow up to the Distribution Fund and will be offset against income derived from the Risk Free Sub Fund.

Clive Smith
Senior Portfolio Manager
Russell Investments

Clive Smith is a senior portfolio manager for Russell Investments and a senior member of the firm’s Alternatives research group. Based in the Sydney office, responsibilities include researching Australian and global fixed income and property...

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