Using CEFs For A 'Juiced' Bond Ladder

Bond ladders are often used to satiate the need for more defined income and capital levels at certain points in the future. It is no different than an endowment or pension fund purchasing high duration securities simply for the 'safety' of matching their assets and liabilities (ALM Matching). That may be the case even if its not the best investment at the time.

ALM matching is good way to reduce risk as you match the duration of the capital bucket with the future liability. For an individual investor, you are taking a portion of your assets and segmenting it for future use. An example would be if you need $100K from your portfolio in 2021, investing approximately $95K into a lower yielding, safe investment that matures in 2021. Thus, you've matched the $100K need tomorrow with $95K of assets today.

Since 2008, the closed-end fund market has been largely closed to new funds outside of term trusts. A term trust is a fund setup to liquidate at some point in the future. There are two types: a term trust and a target term trust. The difference being that the "target" version liquidates at a target NAV- most of the time at $9.85.

We discussed the construction of bond ladders using ETFs in a recent Weekly Commentary. It can be a good way to avoid draw-downs during bear markets and eliminating sequence of returns risk. Could a CEF replace an ETF as a bond rung and a full ladder constructed? Our conclusion is not really. As you will see below, the funds have disparate investment strategies and are not plain vanilla corporate bond portfolios.

Where these could be of use is to augment an individual bond ladder or ETF bond ladder for greater yield. Individual BBB-rated corporate bonds carry yields of approximately 4.3% with a duration of around 5 years. The corporate bond ETFs (iBonds) are yielding just over 3%- the variance being due to the shorter time to maturity.

The list of term trust funds by year to 2024:

2018:

  • Nuveen High Income Dec 2018 (JHA)
  • Blackrock NY Muni 2018 Term (BLH)
  • Blackrock CA Muni 2018 Term (BJZ)
  • Nuveen Mortgage Opp Term (JLS)

2019:

  • Nuveen High Income (JHD)

2020:

  • Nuveen Mortgage Opp Term 2 (JMT)
  • Nuveen High Income (JHY)
  • Blackrock FL Muni 2020 (BFO)
  • Blackrock Municipal 2020 (BKK)

2021:

  • Nuveen Muni 2021 Target (NHA)
  • Western Asset Muni (MTT)
  • EV High Income 2021 (EHT)
  • Nuveen High Income 2021 (JHB)

2022:

  • First Trust Senior Floating (FIV)
  • Nuveen Preferred and Income 2022 (JPT)
  • Western Asset Mortgage Def (DMO)
  • Blackstone/GSO Senior Floating Rate (BSL)
  • Nuveen Credit Opp 2022 (JCO)
  • EV Floating Rate 2022 Target (EFL)
  • Blackrock 2022 Global Income (NYSE:BGIO)
  • JP Morgan Emerging Market Debt (JEMD)

2023:

  • Nuveen Intermediate Duration Muni (NID)
  • Nuveen Intermediate Duration Quality Muni (NIQ)
  • Invesco High Income 2023 Target (IHIT)

2024:

  • Western Asset Global Corp (GDO)
  • Invesco High Income 2024 Target (IHTA)
  • AllianzGI Conv and Inc 2024 Target (CBH)
  • Nuveen Preferred and Inc (JPI)
  • Dreyfus Alcentra G Credit (DCF)
  • Western Asset IG Defined (IGI)
  • Mainstay DefTerm Muni (MMD)

How to Invest

Blindly investing in a fund (or several funds) that liquidates in the target year you require is not the best move. For funds with a target term structure (targeting a specific NAV level), if the NAV is below the targeted NAV in the 18-24 months prior to liquidation, the distribution will likely be cut even if they are over-earning the distribution. By cutting the payout, they can 'hoard' the savings and help bolster the NAV.

The risk here is if the NAV is well below the target requiring significant cuts to the distribution (perhaps to zero) in order to help the NAV recover. A good example is Blackrock NY Muni 2018 (NYSE:BLH) which has a stated liquidation target of $15. At the start of the year, the NAV was $14.86, 14 cents below the targeted liquidation. In February, they cut the distribution by 85%! That was clearly an effort to help bump the NAV back up to $15.

Investors need to compare current NAV levels versus the targeted liquidation value to analyze the glide path of the distribution up to the maturity date. Funds with the NAV above the target are likely to pay special distributions in order to 'reduce' the NAV to be on target. In other words, simply looking for funds that are trading at a discount to NAV with a short time period to liquidation could be misleading.

In Conclusion

The best way to use these types of funds is to find opportunistic investments that provide a tailwind to the yield. On SA and other boards that we visit, people spend a lot of time on the quantitative but little on the fundamental. In other words, they like to screen CEFs for a larger than normal discount and play the reversion trade. While there is some merit in that, it is a traders mentality.

Our service wants to find these opportunities, and hold them for the yield. If the underlying holdings are solid and the opportunity strong, we would hold the fund for the total return until realized. For investors who hold a safe bucket and/or a laddered strategy, adding a small piece to each ladder rung could help juice that capital.

Some Opportunities:

We prefer the term trusts, not the target terms for the very reason that the distribution often needs to get cut significantly in order to hit some bogey. When that happens, you are forced to hold (if still at a discount to NAV) in order to capture the rest of the total return. The term trust can have a varying NAV which is a risk, but investors in CEFs tend to be income-oriented. So we want to focus on what they would do in the event of a distribution cut. Those investors tend to sell out of funds with large cuts to the distribution, all else equal.

If investing in a target term, our research indicates that you want to own from approximately 6 years to 3 years. That appears to be the sweet spot where the market starts to recognize the liquidation date is approaching and tightening the discount. However, it is far enough away before the fund sponsor starts cutting the distribution- which is typically about 18-24 months out, on average.

The Best Three (as of July 31):

1. Invesco High Income 2024 (IHTA): The fund trades at nearly a 6% discount to NAV adding approximately 1% to the total return per year. The yield is just over 6% and the fund is targeting to pay out $9.83 in late 2024. The portfolio is primarily commercial mortgage backed securities with about 65% being investment grade rated.

2. Nuveen Mortgage Opp Term Fund 2 (JMT): A safer mortgage fund with a nearly 6% yield and 3.4% discount to NAV. The fund terminates in February 2020 (approx 20 months), providing you ~1.8% additional return per year. It is NOT a target term so the final distribution is wherever the fund trades at the time. The fund has a lot of non-agency MBS, similar to PCI/PDI and is approximately 55% investment grade.

3. Nuveen High Income Dec 2019 (NYSE:JHD): A target term fund that matures in 16 months. The discount is relatively tight at 1.7% (keep an eye on it for better entry opportunities) but the payout is 4.26%. The key here, as opposed to other years of this target term series (JHA- 2018, JHY- 2020, JHB- 2021) is that the NAV is comfortably above the targeted price at $10.02. Meanwhile JHY, which matures a year later, is trading at a 1.23% premium but the NAV is at $9.75, below the targeted NAV distribution at liquidation. JHD has a targeted payout of $9.86 which means that extra 16 cents will either come to you via maintaining the distribution higher or a special distribution sometime next year. It's not a monster home run but a very safe way to generate approximately 7-8% over the next 16 months.