This article was first published to Systematic Income subscribers and free trials on July 9th.
Welcome to another installment of our weekly CEF Market Review where we discuss CEF market activity from both the bottom up – highlighting individual fund news and events – as well as top-down – providing an overview of the wider market. We also try to provide historical context as well as relevant themes that seem to be driving the markets or that investors should be aware of.
This update covers the period up to the first full week of July. Be sure to check out our other weekly updates covering the BDC as well as the preferred/baby bond markets for insights across the entire income space.
It was a good week for the CEF sector as markets continued to recover from their June slump. Most CEF sectors are up in July on higher inventories and tighter credit spreads. Only higher quality sectors that are more sensitive to rising Treasury yields are down on the month.
CEF rebates tightened sharply, erasing their previous decline. We now view fixed income discounts as fairly valued rather than cheap, while CEF equity sector discounts remain expensive in our view.
Overall, the valuation picture in the CEF market is less rosy than it was in June, as haircuts and credit spreads have tightened over the past few weeks. The CEF market is now back to its level of around two months after a trading range of around 13%. It has not yet broken out of its lower lows/lower highs trend.
One of the themes we’ve discussed over the past few months is that the higher yields of the underlying assets allow the discounts to act as a yield lever, amplifying the additional return that each percentage widening of the discount can bring to investors.
One way to look at this dynamic is to offset the generally high CEF management fees. In short, when the returns of the underlying assets are high and the discounts are significant, the active management fees are, indeed, often greatly reduced, or even eliminated in some cases.
For example, let’s take a look at the disaggregation of returns for the Limited Time Preference and Income Fund (LDP) shown below. What we see is that the management fee on net assets is around 1.06%, while the additional increase in yield due to the discount is around 0.49%. So, one way to think about the current environment is that investors are getting a 50% discount on the fund’s active management fee.
Two additional things are worth considering. First, it clearly works best when the management fee is not excessive and the discount is reasonably large. Funds that trade at a premium incur additional active management fees.
And second, investors clearly need to avoid value traps. We don’t want to pay low effective management fees if the value added by management is negative. And vice versa, it sometimes makes sense to pay an additional management fee (i.e. buy a premium fund) if this is warranted. In our experience, the first situation (i.e. value traps) is much more common than the second.
The start of the month brought news from the CEF cast. As already pointed out in a separate article, the PIMCO Dynamic Income Opportunities Fund (PDO) has risen. Our view here is perhaps unusual in that we would have preferred there not to have been a regular distribution increase with the trickle down in the form of special distributions (the fund would not be able to avoid a special distribution given the tax rules, i.e. a CEF must pass through 90% of its net investment income to maintain its corporate tax exempt status).
Indeed, the fund’s discount has now tightened from a double-digit level to around 5%, leading to reinvestments at a higher price. Investors who follow the bottom-up return profile of the fund or the hedging/UNII profile of the fund need not be aware that the fund was internally generating returns in excess of its distribution.
Invesco has cut a number of Muni CEF distributions, as have MFS and Nuveen. Nuveen also cut two of the preferred CEFs (JPS and JPT), likely due to previous deleveraging which we have already highlighted and which is what it did during the volatile period of 2020. This trend of CEF distribution cuts municipal is something we highlighted earlier and is a trend that will continue for some time.
Interestingly, Nuveen has increased distributions for all of its lending funds, which makes sense in the context of Libor rising well above the typical 0.5-1.25% range of lending Libor floors. .
The Tax-Advantaged Preferred Securities & Income Fund (PTA) has released its semi-annual report. Net profit increased 4% from the prior six months, which was a pleasant surprise given higher debt costs and the absence of floating rate preferred securities in the portfolio (apart from PNC.PP which has just been launched).
Even though PTA fixed 85% of its floating rate hedging cost, it is interesting to see that the rise in short-term rates had no impact on its NII. Perhaps it has turned into higher coupon favorites over the past 6 months. Borrowing hasn’t changed significantly – which will allow it to maintain income, unlike the FPF or Nuveen funds (which just cut).
There was a comment on a recent article that – the fund continues to distribute ROC (per monthly article 19 statements) – isn’t that bad? In our opinion – not really. Section 19 ROC is a long-standing and unusual characteristic of Cohen funds in the industry. There are no obvious reasons for this. Compared to the preferred CEF sector, the Cohen funds have a similar sub-sector profile, similar rating profile, similar expenses, similar leverage, similar coupon profile, similar return profile and rate of return. net asset value distribution that is actually below the industry average.
In short, there is no obvious reason why Cohen funds should have a lower level of revenue generation in the industry. If they really had a much lower level of revenue generation in the industry, they shouldn’t have been able to generate an industry-in-line return while carrying the largest duration hedges in the industry. So it’s weird – it could be an accounting issue or a different treatment of swaps. It is also important to point out that often the monthly ROC figures disappear when the final annual report comes out. This is the kind of thing that can trip people up – sometimes an over-reliance on imprecise coverage or neat estimates of investment income can send the wrong signal.
Position and takeaways
As highlighted above, the CEF market staged a small rally, supported by tighter discounts and credit spreads as well as higher inventories. In absolute terms, CEF’s valuations are reasonably attractive; however, they are no more attractive than during the period when we increased CEF holdings in our income portfolios. For this reason, we are not continuing this rally and instead waiting to see how the macro situation develops over the next few months. The recent payrolls report suggests that the Fed will have to do more to halt still fairly robust economic activity, which could easily turn into renewed volatility in the markets.