Weekly CEF Market Report - April 4, 2021

Macro Picture

The S&P 500 crossed the 4,000 mark for the first time ever on the holiday-shortened week. The S&P 400 Midcap Index also hit a new high on Thursday. Early in the week we saw volatility rise because of the Archegos blowup but contagion worries from a few stocks being liquidated were put to rest by Wednesday. The news flow quickly shifted to Biden's infrastructure plans and markets calmed.

The infrastructure plan is $2.25T, which was actually at the lower end of expectations. Although later in the week Biden said a second package would be revealed later in April that focused on health care, education, and child-care spending. Biden’s plan did not include tax increases on upper income individuals, as some had speculated, but it did include raising the top corporate tax rate back to 28% to cover the cost of the bill.

Economic data came in strong this week with consumer confidence recording the largest gain in 18 years for March. Consumer expectations also showed a large jump. Payrolls came out on the holiday showing over 900K jobs were created and the unemployment rate fell to 6%. A lot of the job gains came from leisure and hospitality as well as government.

Bond yields ended the week at 1.72%, which were near the upper end of the range and about 5 bps from the post-Covid highs. The VIX is down to 17.3 which we discuss below.

Commentary

Like a broken record, discounts tightened further in the last week reaching -1.73% for taxable bonds from 2.06% the week before. In the last four weeks, taxable bond CEF discounts have tightened by nearly 1 point. We are now just 40 bps from the lows set just before Covid hit (again, this was a one off, one week event).

Muni bond discounts have been fairly stagnant the last three weeks as investors are hesitant (read: fearful) of rising rates. As opposed to taxable bond CEFs, there remains more value in the space with the potential for greater discount tightening. For one, the average long-term discount for muni CEFs is tighter than taxables by nearly 2.5 points. Said another way, over long periods of time muni CEFs tend to trade tighter than taxable bond CEFs. So mean reversion theory would state that either muni CEFs should get tighter discounts or taxables should start trading wider.

The VIX is now around 17, the lowest levels since the pandemic started over a year ago. The fact that the VIX is finally falling down is supportive of CEF discounts.

In this Weekly Commentary article we discuss potential blowouts for discounts in the future. The problem is that most of the time the catalyst that blows out discounts is an unknown unknown. Meaning it could not be foreseen ahead of time. This was the case slightly more than a year ago. How many in January 2020 could accurately say they saw a virus causing a massive sell off in the markets?

The largest threat to CEF discounts that is known would be rising rates and inflation. The current environment is actually fairly rare in that we have ("fast") rising inflation expectations and rising long-term interest rates with CEF discounts tightening.

It can be argued that CEF discounts are more of a function of the leverage they employ and thus, the spread or steepness of the yield curve, is what matters most. I.e. the ability to borrow at zero and put that capital to work at ever higher rates as long-term interest rates rise.

However, that belies the fact that the overall effective yield of the High Yield Master Index is near record lows. So even though the yield curve is steepening, yields are nearing records lows because the other factor is spreads. Remember there are two factors that drive the yields of bond assets: interest rates and spreads. Spreads being the additional yield over and above the risk free treasury bond.

Spreads are tight and there is no juice left there. So upside from a rising NAV from price appreciation is likely over. A portfolio manager can still select a discounted bond that they believe is mispriced and produce "alpha" but as a broad assessment, cap gains will be harder to come by.

From a CEF perspective, discounts are also tight. The high yield CEF sector, one of the more popular and better performers long-term, is trading at one of the tightest levels of the last five years. Even going back ten years there are only 11% of observations that were tighter. What could drive those wider?

As noted, spreads are tight. Tighter spread mean capital gains will slow or even reverse. That could cause some investors to sell and widen out discounts.

Leverage costs seem to be the largest driver of CEF discounts in the last decade. As leverage costs have dropped, CEF discounts have tightened. When leverage costs have risen (like 2015 and 2018), discounts have widened materially. The Fed is on hold until at least the end of next year if not longer so leverage costs should not be a 'fear variable' for discounts.

Then there's the macro of course. Something that causes high yield spreads to blow out. In 2014-2016, it was the collapse of oil prices. In 2018, it was market volatility in relation to higher rates. In 2008 it was the Financial Crisis. In general, high yield spreads do not blow out often. In fact, it is a fairly rare occurrence and typically only occurs when the S&P 500 is in or nearing a bear market.

The chart below shows those occurrences since 2007. They are not often. And we can go years without much movement (2012-2015).

Given the last event happened just a year ago, the scarring and fear that that caused is still fresh in our minds. This could cause some investors to "sell out" too quickly and forgo many months or even years of higher coupon payments when rotating out of CEFs and into mutual funds/ETFs or other lower yielding securities.

So the question, what is the solution?

Unfortunately, there is no hard and fast rule. Each investor needs to assess how much of their portfolio will be devoted to CEFs. Risk budgets need to be analyzed and investors should remember how they felt a year ago when discounts widened so fast. That obviously could happen again at any time for reasons completely unknown to us.

In my mind, risk averse buy-and-rent investors should be taking down there CEF exposure in favor of mutual funds, ETFs, and senior securities like baby bonds and preferred stocks. They can also use some term CEFs as a discount mitigant but those will not be perfect since they are also currently trading rich.

Income-only focused investors can simply do what they do best: focus on the distribution stability of their holdings and ignore valuations. Nothing wrong with that. Distributions should be ok for the next several quarters. Eventually, if the HY Master Effective Yield remains this low or lower, distributions will become more precarious. Additionally, if leverage costs go up, it will definitely mean distributions will come down.

Buy-and-hold investors I think can stay put for now. As I noted above, spreads can remain tight for a long period of time. Add in the fact that leverage costs remain low and shouldn't rise for at least a year and a half, I think the known variables are not a risk. It is the unknown unknown that is the only risk on the table today. That is likely why CEF discounts could remain tight for some time.

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