ZTR: Discount Remains Attractive As Better Performance Takes Hold (NYSE:ZTR)

Written by Nick Ackerman, co-produced by Stanford Chemist

The Virtus Total Return Fund (NYSE:ZTR) is a closed-end fund that invests in a portfolio of utilities and fixed-income securities. The fund is continuing to trade at a wide discount, as it had been since our prior update, though it has narrowed a bit since then. Besides the discount being relatively attractive, the fund is positioned to perform well in a lower-rate environment, with the Fed on the verge of cutting its target rates.

In fact, the fund has performed quite well since our prior update. The reduction in the discount since that time also helped to push it to outperform the S&P 500 Index during this time. However, the underlying portfolio itself had been performing quite strongly, too. The S&P 500 Index isn’t an appropriate benchmark, but it can help provide some overall context to general equity performance.

ZTR Basics

• 1-Year Z-score: 0.56
• Discount/Premium: -12.70%
• Distribution Yield: 10.15%
• Expense Ratio: 1.56%
• Leverage: estimated 29.34%
• Managed Assets: $573.56 million
• Structure: Perpetual

ZTR’s investment objective is quite simple: “capital appreciation, with current income as a secondary objective.” They intend to accomplish this through a combination of equity and fixed-income investments.

They will focus the equity portion on “owners/operators of infrastructure in the communications, utility, energy, and transportation industries.” The fixed-income sleeve is designed:

“to generate high current income and total return through the application of active sector rotation, extensive credit research, and disciplined risk management designed to capitalize on opportunities across undervalued areas of the fixed income markets.”

The fund employs leverage in an attempt to increase potential returns. Of course, that also comes with the greater risk of potential losses. It also comes with a higher expense ratio. When including leverage expenses, the fund’s total expense ratio came in at 4.32%.

Discount Means Tender Offer Potential Opportunities

Since our last update, the fund concluded a tender offer for 10% of shares at 98% of NAV. Stanford Chemist discussed that tender offer in more detail, both prior to and the final results. The tender offer was conducted in an effort to reduce the fund’s discount—and at this point, it would have had fairly mixed results as the discount remains at a double-digit level. That said, there are another two potential “conditional” tender offers moving forward.

Is the fund management offering these tender offers due to the kindness and best interest of shareholders in their fund? Absolutely not. This was the result of activist pressure from Bulldog Investors, SIT Investment Associates and RiverNorth Capital Management. SIT Investment Association has seen its once ~8% stake reduced to around 3.5% more recently. RiverNorth still holds around an 8.5% stake in the fund.

With these conditional offers in place, it isn’t necessarily guaranteed that these will be triggered.

The two additional conditional tender offers:

1. A first conditional tender offer for up to 10% of the Fund’s then outstanding shares at a price equal to 98% of the Fund’s NAV if the Average Trading Discount¹ of the shares is equal to or greater than 12% during the consecutive 180 calendar day period beginning 30 days after the expiration of the Tender Offer.
2. A second conditional tender offer for up to 10% of the Fund’s then outstanding shares at a price equal to 98% of the Fund’s NAV if the Average Trading Discount of the shares is equal to or greater than 10% during the consecutive 180 calendar day period beginning April 1, 2025.

The first tender offer concluded on May 1, 2024. So, we are already well into the second conditional tender offer period, where the fund’s discount needs to average over a 12% discount. At 180 calendar days, that’s roughly a six-month or half-year measurement period. At this point, it is looking like the next offer will trigger, but we still have some time to go.

That said, it means that investors should be on the lookout for these potential offerings to take advantage of these moves. In the first offering, while it was for 10%, as usual, not all investors participated. Investors who participated with 100% of their position had around 29.18% accepted—nearly triple the 10% offer.

Historically speaking, ZTR had actually traded much closer to its NAV per share. The caveat here is that this fund has gone through several changes, including mergers with another fund. The long-term history then becomes less important due to that merger in 2019.

Distribution Looks Enticing, But Watch Coverage

A couple of points could see the fund’s discount narrow moving forward aside from the conditional tender offers alone. The relatively high distribution rate the fund pays could still entice some investors. With a more optimistic outlook in a lower-rate environment for this type of fund, it could also garner more interest if it can continue to perform well.

Along with several changes in the fund’s history and its merger, the distribution history of the fund is also one that has seen changes quite regularly. Though they’ve been sticking mostly with a monthly distribution for a while now.

The current distribution rate works out to 10.15%, with the fund’s discount being quite sizeable; the actual NAV rate comes to 8.86%. The fund has historically struggled to cover its distribution as it has performed poorly. That is especially true in the last several years but 2024 has seen that turnaround.

Like many funds with a sizeable sleeve of equity positions, the fund will require capital gains to fund its distribution. A higher rate environment put significant pressure on the fund—which is likely one of the main reasons why the fund decided to cut its distribution. We had noted that the distribution was going to be an “uphill battle” late in 2022. It took about 5 months, but they did ultimately cut their distribution in 2023.

The pressure of higher rates came in the form of the fund seeing a reduction in net investment income. As borrowing costs increased, the fund saw a hit to NII. The latest semi-annual report had the total expense ratio at 4.32%, which was up from fiscal 2023’s 3.87% and fiscal 2022’s 2.26%.

During this period, we also saw realized/unrealized losses within its portfolio. As the underlying portfolio of fixed-income and utilities are also interest rate sensitive due to their own borrowings and having to compete with risk-free rates rising.

While the fund could cut its distribution, I think, given the current conditions of the market, they will likely choose to continue to pay out the current rate.

For tax purposes, the fund has seen a large portion classified as return of capital. During a period where the fund has struggled to perform and cover its distribution, this is quite expected.

However, return of capital distributions could continue even if the fund continues to perform as well as it has in 2024. This is because the fund is currently carrying long-term capital loss carryforwards of nearly $12.5 million. The fund had paid out $20.23 million in its last semi-annual report, so they could be used up quickly but the fund is a bit smaller now after the tender offer.

Additionally, a fund can have ROC distributions if they don’t realize capital gains and instead looks to continue to harvest losses. In the end, watching NAV is the more important factor in determining coverage of the distribution. The fund has seen its NAV erode over the long term, but it has looked more promising in 2024, given the expectation for lower rates. A more optimistic outlook and manageable distribution could see the NAV continue to trend higher or relatively flat.

ZTR’s Portfolio

While they are split between taking an equity and fixed-income approach to their investing, they have focused their portfolio largely on the common stock side of the sleeve. That accounts for nearly 75% of the fund, with the fixed-income sleeve spread amongst a rather diversified basket of various fixed-income instruments.

The above was as of the end of May 31, 2024. In looking at the equity sleeve sector allocation today, they continue to place a heavier emphasis on utilities. That said, industrial companies still comprise a fairly significant sleeve of the fund.

The above breakdown represents allocations of the entire fund in terms of percentages, the below breakdown from the fund’s site represents 100% allocations based on the equity sleeve of the portfolio. That’s why the percentage allocations are quite a bit different, it isn’t just some natural portfolio changes that the fund might have seen.

In terms of the sector allocations for the fixed-income sleeve, they slightly emphasize those holdings with investment-grade credit ratings. AAA accounts for nearly 18% of the sleeve on its own. “Ba” and lower represents below-investment grade exposure based on Moody’s credit rating scale that they are using. For ZTR, the exposure that comes with that designation comes to less than 38%.

Again, the chart provided below represents allocations based just on the fixed-income sleeve, not the entire portfolio. So, what we are seeing is the credit quality breakdown of roughly ~25% of the entire fund.

In looking at the top holdings of the fund, we have a few of the usual suspects in the utility/infrastructure space. That includes names such as NextEra Energy (NEE) and American Tower Corp (AMT)—which seem to be pretty regular staples in these types of funds. Then, there are Sempra (SRE) and The Southern Co (SO) as utility names that are also pretty common in these types of funds.

However, we also have some other quite interesting global names that aren’t often seen in other funds in this space. National Grid (NGG) tends to show up elsewhere somewhat regularly.

Still, Aena SME SA (OTCPK:ANYYY), Transurban Group (OTCPK:TRAUF) and Flughafen Zurich AG (OTCPK:FLGZY) are all names that don’t show up frequently. These are also all traded on the pink sheets in the U.S. That could help provide more diversified exposure for some investors who may be lacking in the global investment department.

Conclusion

ZTR has seen that “potentially brighter future” we thought could happen come to light. With the discount still remaining wide and the better environment for the fund near, it remains an interesting fund to consider for income investors.

The fund delivers a ~10% distribution rate to investors, and thanks to the sizeable discount, the NAV rate is more manageable. That said, the fund will need to continue to perform well going forward in order to achieve coverage for that distribution. This is because, like most funds with sizeable equity holdings, it will take capital gains to fund a large portion.

Additionally, with the conditional tender offers in place, that’s another angle to consider and take advantage of for investors who are holding this fund.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.