CEF Report May 2021: The Tight Get Tighter
Summary
In the first quarter, closed-end fund discounts tightened by 261 bps from -6.3% to -3.7%. But in the month of April, we saw another 80 bps of closure.
We think the muni CEF space looks relatively attractive compared to the taxable bond CEF categories.
As such, we've been trimming many of our taxable bond CEF positions while increasing the exposure to munis. It's my contention that muni CEFs will eventually hit a premium.
Look at funds that have wider discounts and higher yields as those securities are attracting the most amount of capital.
RSF, ARDC, VCIF, NCZ and BWG fit that mold. We also like preferreds of CEFs for long-term income streams. NHF-A, OPP-A, XFLT-A, ACP-P, and OXLCP.
(This report was published to members of Yield Hunting on May 7. All data herein is from that date.)
This is our monthly report giving an overview of the current status of the CEF market along with the trends and themes we are seeing. Given the richness of the market today we need to be careful allocating capital. We've spent a lot of time discussing trimming back overall exposure to leveraged CEFs in order to reduce risk as future returns from here will be lower. We do spend some time on a few securities that look a bit interesting here for those needing to allocate capital. Please note, these are shorter term trades.
Those securities include:
RiverNorth Specialty Finance (RSF)
Ares Dynamic Credit Allocation (ARDC) *Core Fund
Vertical Capital Income (NYSE:VCIF)
AllianzGI Convert & Inc II (NCZ)
BrandywineGLOBAL Income Opp (BWG)
And for more long-term investors, I think you can buy many of these preferreds of CEFs for yields of 5% or more.
Aberdeen Credit Opps P (ACP-P)(ACPPV)
RiverNorth/DoubleLine Strategic Opp A (OPP-A)
NexPoint Strategic Advisors (NHF-A)
Oxford Lane Capital (OXLCP)
But again, be very choosy with what you buy, if you don't have to buy anything.
Current State of the CEF Market
In the first quarter, closed-end fund discounts tightened by 261 bps from -6.3% to -3.7%. But in the month of April, we saw another 80 bps of closure to -2.9%.
Today, taxable bond CEFs are rich relative to equity and especially muni CEFs. In more than 76% observations, muni CEF discounts have been tighter than taxable bond CEFs. The taxable bond CEF space sits at a small premium to NAV compared to -3.8% on Jan. 1. But muni CEFs sit at a -2.1% discount compared to -4.4% on Jan. 1.
The scare of higher rates is clearly affecting the muni space. Our contention is that later this year rates will stop rising as the second derivative growth trade rolls over and the stimulus-induced spending slows down. Year-over-year comparisons will not look as strong and earnings growth will have a much harder time.
At the same time, we have "tax talk" in Washington and the prospect of much higher capital gains taxes in the high net worth space. That tends to induce more demand for munis in general even if nothing comes of the talk. The technical setup (supply vs. demand) in muni bonds is still skewed heavily toward demand.
Thus, we think the muni CEF space looks relatively attractive compared to the taxable bond CEF categories. As such, we've been trimming many of our taxable bond CEF positions while increasing the exposure to munis. It's my contention that muni CEFs will eventually hit a premium to NAV where they've spent just over 10% of the time since 1997.
So what do you do if you don't need muni exposure (your tax rate is too low) but need yield which you get primarily from taxable bond CEFs?
You have to either ignore the valuations (buy-and-hold) and not be phased when the premiums go away in favor of wider discounts. If you can handle that type of volatility in your market values (not income) then that is good and do so.
However, if your approach is more of a total return strategy, then you have to do something different. We would be focusing on NAV momentum and what I call the Siren Song: the combination of the last vestiges of wide discounts and higher yields.
NAV Momentum
One of my top screening tools today is to look for funds that are experiencing NAV growth near term. I like looking at the five-day, 10-day and 20-day NAV returns for those seeing some inflection higher, and outperforming the sector as a whole. Funds that see faster NAV growth are likely to eventually experience faster share price growth. Sometimes the lag between the two can be significant and many days/weeks.
The problem here is that NAV growth is stalling. We are nearing the end of that game simply because high-yield spreads are so tight. The chart below shows that spread in the last year and how we've been meandering on the bottom around 3.25%. This is the tights of the last 10 years. So one shouldn't expect much more reduction in spreads which has the effect of increasing taxable bond CEF NAVs.
(Source: Fred Database)
The only funds that we expect to see NAV growth would be those that are under distributing. That simply means the fund is not paying out all the underlying bond's interest income to the shareholders. When it isn't paid out it pushes up the NAV of the fund. So you offset a lower yield with NAV growth. In the end, it usually means similar total returns as a fund that's paying out all of its investment income and thus realizing less NAV growth.
With spreads tight, we're already seeing NAVs flatten out. That could retard any further gains in valuation (i.e. discounts tightening and premiums rising). Over time, with no further gains from NAVs, borrowing will have to stagnate. That's because as a NAV rises, if the fund doesn't add to total borrowing the effective leverage declines. So a rising NAV is almost self fulfilling in that it adds to borrowing which adds to investment income which supports the distribution. Without NAV gains, that virtuous cycle is ending.
On top of that, you have bonds maturing or getting called and being replaced with lower coupon securities. You can think of that like a snowball that builds as it rolls down the hill. Over time, the fund is replacing more and more positions from high yields to lower yields reducing investment income leading to an over-distributing situation. That will eventually weaken the fund's fundamentals and put the distribution in a precarious situation. Eventually, it would need to be cut if nothing else changes.
We are already seeing that with Ivy High Income Opps (IVH). The fund has cut the distribution four times in the last year. Most of the cuts were small but in aggregate, it amounts to a 20% drop in your income. But the NAV is up 5% in the last three months so you are still doing fairly well from a total return investment. This is what we are looking for... NAV growth despite what is going on with the distribution.
This may not be a long-term sustainable trade but it's a result of the current environment and having to adapt.
Novice Investors Are Entering En Masse
When you see the largest discounted funds substantially outperform all CEF discount tightening, you're likely seeing the novice CEF investor enter the space. Those investors tend to buy the highest yielding or the most discounted funds because those are the two metric they know. In the first quarter, the highest discounted funds (bottom quintile) saw discounts tighten by nearly 150 bps more than the entirety of the CEF space.
When the funds with the highest yields and widest discounts are getting all the attention, you know there's new investors entering the CEF market that have possibly never owned a CEF before.
In the last two months, I've received countless emails and messages from non-subscribers to our Marketplace service asking very basic questions on closed-end funds. This is not something new but the magnitude of the number of questions has increased substantially. That tells me investors are "discovering the space" and, not knowing any better, looking at the two most basic variables.
This is one reason why fund sponsors have been moving toward managed distribution policies ("MDP"). A MDP is a distribution system that pays out more than the net investment income of the fund. In other words, the fund is over-distributing on purpose. If the fund earns $10mm in bond income from the underlying portfolio but pays distributions totaling $15mm, then the $5mm has to come from somewhere. It comes out of the NAV which is similar to a dividend on a stock. All else equal, that reduces the NAV and the investor gets back some of their own capital back (called "return of capital").
We're seeing a number of fund sponsors do this so the fund looks more appealing to these new investors. That is helping to reduce the discount of the fund and increase the demand for their shares. In some cases, this is allowing them to conduct "rights offerings" to increase the share count of the fund and raise more assets (and thus revenue).
So where does this leave us?
We are forced to feast on the breadcrumbs at this point. We are forced to adapt and be more tactical in order to generate alpha and decent returns.
Often, that means more trading, something many of our members are loathe to do. For those who do not want to trade more, making a few wholesale changes may be in order (if you do not want to buy-and-hold and ride the bumps). That may involve rotating from CEFs into OEFs (open-end mutual funds and exchange traded funds) in order to reduce risk and "place hold" your capital until we see more volatility.
But for those who want to be more tactical, we think rotational trades, dividend capture strategies, and NAV momentum is what to focus on here.
What I've Been Watching And Some Possible Places To Allocate Capital
There are so few good options for taxable bond CEF space (we hope to do a full review of the muni space in coming weeks). Right now I would focus on funds that are experiencing strong NAV momentum, have higher yields, or wider discounts. These are the funds attracting the newbie CEF investors and seeing strong returns in relatively short periods of time.
In this space I like (some are repeats):
RiverNorth Specialty Finance (NYSE:RSF)
We're seeing more new issuance of preferred securities. While I like the term preferreds best (given their defined maturity date), some perpetual preferreds are too juicy to pass up- especially when you consider the risk vs the return.
(1) Aberdeen Credit Strategies 5.25% (ACP.P): This is a $25 par perpetual preferred stock issue that came out on May 3rd of this year. The coupon is $1.3125 per year paid quarterly (3,6,9,12). Surprisingly, the issue was rated A2 which is a strong investment grade rating. I feel that the issue was a bit mispriced - even though the fund is higher risk and could increase overall leverage. More likely, we will see the fund do a rights offering or ATM offering (N-2 already filed) to increase the size of the fund. This preferred issue then augments their existing leverage if the fund's size expands. Asset coverage is above 300% so the NAV would have to fall very sharply for the preferreds to be in any risk of trouble. We would be ok buying this one well over par at $26 or less.
(2) RiverNorth/DoubleLine Opportunistic 4.375% (OPP-A): This is another preferred stock issue of a closed-end fund. A CEF issues preferred stock to finance their leverage instead of going for a bank loan or issuing other securities. This is a lower coupon issue at $1.09375 and a current yield just under 4.50%. The dividend is paid quarterly (2,5,8,11) but is not callable until 11/15/2025 unless they open-end the underlying CEF, OPP. In the next couple of months, shareholders of OPP will vote to convert the CEF into an OEF, a regular mutual fund. If that happens, the preferred stock will be called early at par ($25). With the shares currently trading below par, that would be about 70 cents of upside should that occur. Asset coverage is extremely strong. This is a strong investment grade issue with an A1 rating from Moody's. We would be a buyer under par so anywhere under $25 but just note we just passed a dividend date.
(3) Oxford Lane Capital 6.25% (OXLCP): This is a term preferred of a CEF (seeing a theme here)? The 6.25% issue is set to mature on 2/28/2027 and becomes callable on 2/28/2023. The annual coupon is $1.5625 but most uniquely is that this preferred issue pays monthly, not quarterly, on the last day of the month. This is not an investment grade issue- hence the higher coupon. However, I do think this one is relatively safe and like most preferreds of CEFs this one also has to maintain 200% or greater asset coverage. The underlying common shares (OXLC) would have to fall substantially (greater than 70%) for the CEFs to get into any trouble. In March 2020, it fell by 53%. We would be a buyer of this one too (in lesser amounts than the above two options) below $25.
(4) NexPoint Strategic Opps 5.50% (NHF-A): This is another preferred of a CEF that's unrated by the two larger ratings agencies but is rated by Egan Jones at BBB- (the lowest investment grade rating). It's callable in 2.5 years at $25 per share but currently trades at $22.62. The underlying, NHF, is in the process of converting to a REIT (shareholders approved the conversion in August of last year). Asset coverage is strong although you have more risk here than I believe the other three options given the underlying is going to be more volatile securities. This is a great option for a small slice of the preferred portfolio.
Concluding Thoughts
We would look to add several of the above preferred positions to your portfolio to augment sold off taxable bond CEFs and maintain portfolio yield. In other words, instead of going from CEFs to mutual funds and sacrificing income, you could add some of these funds at 0.5%- 1.5% positions (max 2,500 shares each) to help reduce that income drag.
In terms of CEFs, we will continue to highlight those funds that are experiencing recent strong NAV growth, have higher yields, and wider discounts. Those are the funds that investors are pouring money into. These are quicker trades to consider as once the NAV gains slow and roll over, you may see selling pressure.
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