Assessing the Risks and Rewards of Return of Capital Distributions in Closed-End Funds

The Virtus Dividend, Interest & Premium Strategy Fund (NFJ) has long been a case study in the complexities of closed-end fund (CEF) distributions. Its latest quarterly distribution of $0.305 per share, announced for September 2025, is entirely sourced from return of capital (ROC), a structure that has defined 81.9% of its year-to-date payouts [1]. While ROC distributions can offer tax advantages, their prevalence in NFJ’s strategy raises critical questions about sustainability, investor risk, and the broader implications for CEF investors.

The Mechanics of ROC in CEFs

Return of capital is a unique distribution type where a fund returns part of an investor’s original investment or unrealized gains. Unlike dividends or capital gains, ROC is not taxed in the year received but instead reduces the investor’s cost basis, potentially increasing future capital gains taxes when shares are sold [2]. For CEFs like NFJ, ROC can serve as a tool to maintain stable distributions when net investment income (NII) and realized gains fall short. However, this approach carries risks. If a fund consistently distributes ROC without generating sufficient returns, it risks eroding its net asset value (NAV) and long-term earnings potential—a phenomenon termed “destructive return of capital” [3].

NFJ’s reliance on ROC underscores this tension. Its Managed Distribution Plan aims to deliver consistent payouts, but the fund’s recent structure—where 100% of the September 2025 distribution came from ROC—suggests that its NII and gains may be insufficient to sustain its target rate [1]. This raises concerns about whether the fund is prioritizing distribution stability over capital preservation, a trade-off that could penalize investors in the long run.

Tax Implications and Investor Considerations

The tax deferral benefit of ROC is a double-edged sword. While investors avoid immediate tax liability, the reduced cost basis means that future gains will be taxed at a higher rate. For example, if an investor sells NFJ shares at a price higher than their adjusted basis (original cost minus ROC), the taxable gain increases proportionally [3]. This dynamic is particularly relevant for funds trading at a discount to NAV, as is often the case with CEFs. If NFJ’s share price rebounds, investors could face unexpectedly large capital gains taxes, even if the fund’s underlying assets have not appreciably increased in value.

Moreover, ROC distributions can mask a fund’s true performance. A fund that frequently returns capital may appear to deliver consistent income, but this could be a sign of poor asset management or an overreliance on distribution strategies rather than organic growth. For NFJ, the fact that 81.9% of its YTD distributions are ROC indicates that its income-generating strategies may be underperforming relative to its payout obligations [1].

Balancing Risk and Reward

The key to evaluating ROC distributions lies in understanding the fund’s financial health and distribution sustainability. CEFs with strong NII and capital gains can use ROC strategically to smooth payouts during market downturns. However, when ROC becomes the primary source of distributions, as in NFJ’s case, it signals a potential misalignment between the fund’s income generation and its payout commitments.

Investors should also consider the broader market context. CEFs like NFJ often trade at discounts to NAV, which can amplify the impact of ROC. If the fund’s share price is volatile, the tax implications of ROC could become a significant liability. Conversely, in a stable market, ROC might provide a tax-efficient way to maintain income without immediate tax drag.

Conclusion

NFJ’s distribution structure exemplifies the duality of ROC in CEFs: a tool for tax efficiency and distribution stability, but also a potential indicator of unsustainable practices. While the fund’s Managed Distribution Plan aims to deliver consistent returns, its heavy reliance on ROC highlights the need for investors to scrutinize the sources of their income. For CEF investors, the lesson is clear: ROC distributions should be evaluated not in isolation but as part of a fund’s broader financial strategy. A fund that prioritizes payout consistency over capital preservation may offer short-term benefits but could erode long-term value—a risk that NFJ’s recent disclosures make difficult to ignore.

Source:
[1] Virtus Dividend, Interest & Premium Strategy Fund Announces Distribution and Discloses Sources of Distribution Section 19a Notice [https://www.barchart.com/story/news/34433343/virtus-dividend-interest-premium-strategy-fund-announces-distribution-and-discloses-sources-of-distribution-section-19a-notice]
[2] Understanding Return of Capital | Closed-End Funds [https://www.nuveen.com/en-us/insights/closed-end-funds/understanding-return-of-capital]
[3] Return of Capital and CEFs: Part 3 [https://www.fidelity.com/learning-center/investment-products/closed-end-funds/return-of-capital-part-three]