Trade Summary | May 2019

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Core and Mini Core Trade Summary:

  • Swap Blackstone/GSO L/S Credit (BGX) with Blackstone/GSO Strategic Opps (BGB) at 8% target weight in both the Core and Mini Core Portfolios.

Top Quality Funds

  • Blackstone/GSO Strategic Credit (BGB)

  • Nuveen Floating Rate Income (JFR)

  • JH Investors (JHI)

Top Convergence Trade Opportunities

  • Cohen & Steers Global Income Builder (INB)

  • Nuveen Floating Rate Opportunity (JRO)

  • ClearBridge Energy MLP Opps (EMO)

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Obviously, the portfolio is tilted towards high yield bonds and leveraged loans. That is the goal for the time being. Just yesterday, AllianceBernstein had a great piece talking about how high yield can help de-risk a portfolio. I know that sounds counter-intuitive but remember it has to do with from where the capital invested in high yield is derived. If it comes from munis or cash, then you just increased your risk fairly substantially. If it comes from your equities, then you did just de-risk a significant amount.

First, high yield bonds provide investors with a consistent income stream that few other assets can match. This income - distributed semiannually as coupon payments - is constant. It gets paid in bull markets and bear markets alike. It's the main reason high yield investors have historically looked at starting yield as a remarkably reliable indicator of future returns over the next five years - no matter how volatile the environment. After accounting for maturities, tenders and callable bonds, the high yield market typically returns anywhere from 18% to 22% of its value every year in cash.

Along with these payments, high yield bonds also have a known terminal value that investors can count on. As long as the issuer doesn't go bankrupt, investors get their money back when the bond matures. All this helps to offset stocks' higher level of volatility - and provide better downside protection in bear markets.

While spreads are down to 373 bps, down significantly from the levels at the start of the year, the risk-return trade off compared to stocks still makes high yield a decent place to allocate capital. The question is, how much?

We think we will be heavy into both bonds and even greater into loans for the next six months. While markets have recovered from the late 2018 lows, we don't think it is time to "go to cash" or significantly shift the target asset allocation. Reducing some risk is certainly a valid move but we would still avoid making drastic changes.

The Core is likely to be a coupon clipping portfolio for the next several months as valuations are high. Though we can expect some bouts of volatility allowing us better times to buy some funds.

In the last month, we haven't bought too much outside of the muni space. The most attractive opportunities today are:

  • Blackstone/GSO Strategic Opps (BGB)

  • JH Investors (JHI)

  • Putnam Premier Income (PPT)

  • Nuveen Floating Rate (JFR)

  • EV Senior Floating Rate (EFR)

Trades Summary

Core Portfolio:

  • Swap Blackstone/GSO L/S Credit (BGX) with Blackstone/GSO Strategic Opps (BGB) at 8% target weight.

Other More Tactical Trades To Consider:

Consider selling or swapping:

  • Guggenheim Taxable Muni Bond (GBAB): The valuation for GBAB is high, though the risk from calls is not likely to start significantly effecting the fund until early next year. This fund is about collecting safer taxable muni income so making a tactical trade is not recommended. Another option is BBN which has performed a bit better on NAV, although it's not much cheaper in terms of valuation.

  • Apollo Senior Floating Rate (AFT): Consider swapping from AFT to AIF which has a superior yield and cheaper valuation. AIF made a surprising very small distribution cut for April going from $0.107 from $0.104. AIF has 9.2 cents of UNII plus has coverage of 106%, which is why the cut was a bit of a surprise. Very small difference in holdings but they are both mostly loans with a small allocation to high yield.

JH Investors (JHI): For newer members that are waiting for better entry points into some of the Core funds, this is an optional substitute that you may want to hold until those opportunities open up. This is a decent BTZ/BIT looking fund with a multisector bent. The yield is a bit lower but it does have less junk compared to some other funds. It's about 25% investment grade/ 75% high-yield. NAV is rising nicely and there's a decent chance that on June 1, the QUARTERLY distribution is increased really bumping the price.

Mini Core:

  • Swap Blackstone/GSO L/S Credit (BGXwith Blackstone/GSO Strategic Opps (BGB) at 8% target weight.

Rationale:

The Blackstone/GSO sister funds are very similar floating rate funds from a solid sponsor. The main difference is that BGB is about 3X larger than BGX which means BGX typically trades more 'violently' than BGB. It is likely that BGX reverts back to the same discount levels of BGB, which seems more appropriate than where it trades today. Of course, there's a smaller but still decent chance BGB moves up in valuation towards that of BGX.

BGX:

BGB:

Top "Quality" Funds

These are funds with coverage ratios in excess of 98%, UNII that we deem to be strong or improving, and a z-score below -1.

(1) Blackstone/GSO Strategic Credit (BGB): The fund is a term trust that is slated to liquidate in 2027. While that 8 years is a long way away from today that we do not think a convergence trade will materialize based on it, the fund is undervalued. The current yield is 9.25% and the NII yield is actually 9.95%.

(2) Nuveen Floating Rate Income (JFR): This is one of many floating rate funds we could have selected. This may be more than a one month play but we think the opportunity here is high. The fund is trading at a -12.4% discount to NAV and pays a 7.52% current distribution yield. Coverage is right at 100% and UNII is at zero. The one-year z-score is -1.00 which is one of the few funds that have a z-score that low.

(3) JH Investors (JHI): Keeping this one on the list as we do not see anything more compelling. The next distribution will be announced about June 1. I would really like to see them institute a monthly distribution system which would likely close the valuation nicely. The fund is a lot like BTZ with a straddling of lower quality investment grade and high quality non-investment grade corporate debt. The portfolio managers have the flexibility of investing across the full spectrum of bonds going where they think there is the most value. Performance last year was not great but the fund is rebounding nicely thanks to falling spreads and solid positioning. We think the discount could close by at least two points but even if it doesn't, there is a solid NAV trend. Some of the drawbacks include a quarterly and variable payout and a relatively low yield.

Top Convergence Trade Opportunities

These are funds that have solid total return opportunities that could be realized shorter-term. The current list to select from is one of the smallest of the last couple of years which should tell you about the valuations of the CEF universe today.

(1) Cohen & Steers Global Income Builder (INB): This fund has been performing well though the price hasn't been rising as fast as the NAV. This is creating a widening gap between the two with a nearly -11% discount compared to a -8.5% average. The one-year z-scores are around -1.00 which is cheap but not crazy cheap illustrating the valuations in today's market.

(2) Nuveen Floating Rate Opportunity (JRO): Like JFR above, this fund is trading wide though doesn't quite have enough coverage to reach the "quality" list. The discount is -12.3% and the yield 7.7%. The recent price action is negative but the NAV has been trending higher nicely on the back of a strong risk market (high yield and equities). If floaters start seeing positive flows again, look for JRO to trade better than a -10% discount.

(3) ClearBridge Energy MLP Opps (EMO): One of the rare times you'll see an MLP operator on either of these lists. The 9.60% yielding MLP fund has most of the top "quality" MLP names in its top ten holdings list. The fund is now trading at a -12.2% discount which is near the 52-week lows of 13.3%. The one-year z-score is -1.40. The wider discount is due to the distribution cut to the latest quarterly payment. However, the fund is still paying $0.23 per quarter which places it near the middle of the pack for MLP funds in terms of distribution yield. And of course, given the rebound in oil we've experienced recently, it is likely that NAVs will rise and the cut to the distribution could reverse. Still, our bet is that investors bid up the price some.

Reviewing Top 'Quality' Funds from last month

Last month, our top quality picks were:

  1. JH Investors (JHI)

  2. Ares Dynamic Credit Allocation (ARDC)

  3. Blackrock 2022 Global Income (BGIO)

Reviewing Top Convergence Opportunities from last month

These are funds that look very cheap but may not have the fundamentals for us to hold it long-term.

Our picks from last month were:

  1. RiverNorth/DoubleLine Strategic (OPP)

  2. EV Tax-Managed Global (EXG)

  3. Neuberger Berman Real Estate (NRO)

Weekly Commentary | April 21, 2019

Stocks were little changed during the holiday shortened week.  The S&P 500 rose 28 bps while the Nasdaq was up 64 bps.  Small caps lagged falling 83 bps.  Bonds were slightly weaker for the week with just the high yield index up 18 bps.  Meanwhile, the VIX continues to trade in the 12s and has flirted with an 11-handle at times.  This is very supportive for risk assets and CEF discounts. 

Interest rates moved higher early in the week (hitting a one-month high) but were halted on Thursday and Friday around 2.56%.  In all likelihood, the run in rates fizzled about the same time North Korean dictator Kim Jong Un fired a couple of missiles.  

The big news on the week was the release of the Mueller Report to the public.  While the release didn't have an effect on the markets (politics usually doesn't) it removed a potential overhang of risk to them.  

Economic news continues to surprise to the upside with stronger March retail sales.  We saw some immediate upward revisions to GDP following the release.  In my mind, the economy is far too strong for a potential rate cut later this year.  I still think we will see a rate HIKE somewhere in the back half of 2019 if the 10-, and 30- year bond yields move higher.  If the 10-year sits above 3% in the fourth quarter, look for the Fed to move in December.

China's economic news has also been stronger as they reported Q1 GDP growth of 6.4%, higher than expected.  Growth was supported by strong industrial production, which was up by 8.5%, as well as increased consumer spending, which grew by 8.7%.  The government has been attempting to stimulate the economy by reducing taxes, spending on infrastructure, and loosening monetary policy.  It seems to be working.

Healthcare stocks continue to get pounded as Democratic Senator Bernie Sanders rises in the polling.  He has called for a Medicare-for-all solution to the healthcare problem.  That has crushed stocks like United Healthcare (UNH) which is down nearly 20% in the last four months.  

Lastly, earnings season kicked of last week with the bank stocks.  The results were largely in line, or slightly better than, expectations.  Earnings will likely be the big driver for stocks over the next month and could be the determinant for equities for most of the summer now that many of the overhangs to the market have been removed.  Trade being the last and final hurdle.  

Closed-End Fund Analysis

Distribution Increase

N/A

Distribution Decrease

N/A

Tender Offer

Blackrock Debt Strategies (DSU):  The results of the tender offer were announced for up to 5% of the outstanding shares.  The tender was oversubscribed and was pro-rated to shareholders.  The pro-ration factor is detailed below and was as expected.

EV Muni Bond (EIM):  The fund commenced their cash tender offer for up to 10% of the fund's outstanding shares or 8.97 million shares at 98% of NAV.  The tender expires on May 17, 2019 at 5pm unless extended.  

Activist Trading

PHD:  Saba is reporting a new stake in this Pioneer fund that is now 5.58% of the fund's outstanding shares.  

EVF:  Saba is reporting a new stake in this EV fund that is now 5.9% of the fund's outstanding shares.  

IVH:  Saba reducing its stake which is now 6.44% of the fund's outstanding shares, down 20% from the last filing.

Commentary

Discounts are no longer tightening on the equity side and are doing so only marginally on the bond side.  Most of that tightening on the bond side is occurring on the tax-free side.  Equity funds reached what is their long-term average (20-year) right around -6%.  Unless the market really takes off and volatility (as measured by the VIX) reaches 2017 levels, I do not expect much additional discount tightening on the equity side.

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On the fixed income side, we are slowly climbing towards par.  The current discount is -5.49%, down from -5.70% last week and 5.82% the week before.  For reference, the discount has tightened from over 9% at the start of the year and 6.6% at the start of February.  We now have 44 funds that trade at a premium, up from just 20 on January 1.

The DSU tender offer was completed last week where just over 12% of our shares were tendered.  Last week, the discount widened out a bit following the expiration, which is typical.  What happens is you have a bunch of investors who purchase solely for the tender and then sell when its completed.  

The discount today is 12.5%, which is now wider than its 52-week average of 11.45% as well as the 3-, and 5- year averages (9.9% and 10.9%).  So far, the discount has only widened by 100 bps.  

Last year when they did a 10% tender, the discount widened by 200 bps following the expiration on April 13th, 2018.  

Coverage of the fund is okay but not spectacular.  The latest data we have is from February when the fund reported just over 95% coverage and -5 cents of UNII.  March data should be out in a couple of weeks.  

The fund is up 11.8% YTD on price and 9.2% on NAV after losing 10% last year on price and 3.4% on NAV.  We still like the loan space and think it is still the most undervalued segment of the bond market today.  The surprise may come in the back half of the year if the Fed has to raise rates again.  Money will once again rush into floaters and prices will rise towards $99 (it's just under $97 today).

We are watching the trading action on DSU and will likely make a move to 'reinvest' the cash tender proceeds back into the fund if the discount widens back out to 13.25%-13.50% or greater.  

NexPoint Credit Strategies (NHF)

We sold NHF last week out of the Flexible Income Portfolio when they issued a rights offering announcement.  The discount was around 11% at the time.  It has widened another 80 bps but I do think it will continue to widen out a bit as we approach the rights offering date in mid May.  Here's my thinking.  But first, a public announcement.  

Be careful shorting this fund!  Many investors have PM'd me saying they shorted it (or were thinking about shorting it and asking my opinion about doing so) once the rights offering was announced.  If you are short going into the rights offering, you have to pay the lender the details of those rights.  But you cannot buy any rights since they are not transferable so you would have to sell the shares at the deal price. This can get kind of tricky and expensive!  

What's going on?

The fund is issuing its third rights offering of the last three years following the spin off of its real estate assets in 2015 into a separately traded entity which is traded under the ticker symbol "NXRT".  This one is similar to the last two with a non-transferable rights offering entitling the shareholder to purchase one new share of NHF for every three rights held.  For the full release, go (HERE).

If you own the fund on the record date (April 29th), shareholders who fully exercise their rights will subscribe for additional common shares of the fund.  The offering expires May 22, 2019.  We will go through the offering and recommendations below.  

First, the important dates:

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Each shareholder is given a "right" to purchase additional shares based on the shares owned as of the record date.  The ex-date will be two days prior to the record date.  

Remember that NHF has completed similar rights offerings in each of the last two years under very similar terms.  In 2017, shareholders subscribed for $269M worth of new shares.  Current NHF shareholders have through May 22nd to exercise their shares. 

In this particular rights offer, Record Date Shareholders will receive one Right for each outstanding whole common share held on the Record Date. Each Right entitles the holder to purchase one new common share for every three Rights held (1-for-3). For example, if a Shareholder owned nine shares, he/she would receive nine Rights and be entitled to purchase up to three additional shares .

So how dilutive is the offering?

Rights offerings are clearly dilutive when the new shares are issued at a discount. Shares closed this week at $21.60 with a NAV of $24.49. Ignoring offering expenses which will probably be less than one penny per share, the price received is determined by the below formula.  From the press release:

The subscription price per common share will be determined based upon a formula equal to the lesser of (1) 95% of the Fund’s reported net asset value, or (2) 95% of the average of the last reported sales price of the Fund’s common shares on the New York Stock Exchange (“NYSE”) on May 22, 2019 (the “Expiration Date”) and on each of the four trading days preceding the Expiration Date.

The fund will add about 41% more shares to its coffers following the offering when including 25% secondary subscription which is likely to be fully allocated.  The questions come down to, just how cheap it will get and what they will do with the capital.  The dilution is going to be significant.  If we think the discount will bottom out at -14%, then at a 41% increase in shares, then depending on the price, we should expect dilution on NAV to be between $1.15 and $1.30 or approximately 4.7% to 4.9%.  

In 2017, the market price of the fund rose after the rights offering was announced and then fell after it began trading ex-rights.  It then took about four months to bottom out- which is around the same amount of time we observe it takes for large distribution cutters to bottom out on average.  In each of the last two rights offerings, the best time to buy was around the time they traded ex-rights.  

The resulting performance over the last year has not been overly stellar with a NAV one-year total return of 2.58% and on price of 3.41%.  However, the 3-year number, which now incorporates TWO rights offerings, is a very strong +16.5% on price and +13.9% on NAV.  

The chart below shows the discount of the shares during the last two rights offerings.  As we noted, the best times to buy tend to be right around, or shortly after the rights go ex-.  The chart below clearly shows the dilution to the shares in anticipation of the NAV getting clipped.  In other words, the time line looks like this:  the rights go ex on April 27.  You then have until May 22, 2019 to subscribe.  At that point we will look at what the previous five trading days prices were and you get credited (if you subscribe) at about 96% of that price.  

So what do I do?

If you own the shares at this point, it may behoove you to simply hold at this point and subscribe.  This is especially true if you think NHF is a good investment and think its undervalued.  For investors in this club, you will simply increase your position by 33% - 41% and see no dilution.  

If you have no intention of subscribing, then you will get diluted fairly significantly with a NAV drop of about 4.98% (ick!) so it may be more prudent just to sell now.  But if you own and are going to subscribe, I would wait until closer to the expiration date to actually trigger the rights.  Why would i do that?  

Think of it this way.  If you have to make a decision and the decision outcome is going to be the same whether you make it on April 30th or May 22nd, then why not wait until May 22nd JUST IN CASE SOMETHING CHANGES.  I liken this to when buying shares of a CEF.  If the ex-distribution date is the first of the month, and today is the third, then I already missed the next distribution.  Why buy today when I have a full 27 or 28 days to do so in order to get the next distribution (unless I thought today was the nadir in the discount).  

The same could be said for this rights offering.  

If you want to play this but do not own the shares, wait for the shares to go ex-rights.  At that point, we are likely to see the price incorporate the discount of the diluted NAV.  Remember, the NAV is a unicorn NAV at this point because of the dilution factor.  If the NAV is going to fall by just under 5%, then the true discount is going to be almost 17%.  

As I noted earlier, the price of NHF increased following the announcement last year.  And it continued higher right up until the ex-rights date.  In fact, even after it went ex-rights (May 7), the price moved still higher before topping out on May 14th.  Then it started a long downward trend until the price bottomed on the last day of June.  

And the year before where you can see again that the price rose after the announcement and then again shortly after it went ex-rights.  However, not long later it started a longer trend lower bottoming out towards the end of June. 

Concluding Thoughts

The run-up in the shares post-announcement is the market believing there's some value in the rights and that by subscribing, some long-term value is going to be created.  I am not so sanguine on that thesis of long-term value.  The NAV is roughly the same it was two years ago when they were completing the first of these rights offerings. In addition, the distribution isn't any higher and we've seen what the performance has been in the last 18 months or so.

If that is the result of the prior two, then the case being made for the rights offering - that there are compelling opportunities- doesn't seem to be accurate.  The proceeds from these rights offerings haven't done anything to grow NAV at a faster rate nor lead to an increase in the distribution yield of the fund.  

A poster on the Morningstar forum, Aubergine, wrote the following note:

The core problem is that when someone sells shares with a dividend attached - a reasonable estimate for the cost of equity is the the current div yield. So the issuer has to invest the newly raised monies in projects that cover at least that plus all the fees*. So even if (at NAV) the cost of equity is 10%, one likely needs to find projects yielding 13%+ or so for it to actually be accretive to anything.

This is a spot on observation that should be pondered.  NHF is the ultimate black box and without knowing what they are truly doing, the rights offerings to me are not very shareholder friendly (especially since the rights offerings are non-transferable).  As such, a position in NHF should only be opportunistic in nature and possibly only done for a trade.  

Buying shares on the last day of June seemed to work out very well on a price basis.  For example, here is the performance for the shares when buying at certain dates and going to that particular year end.  

The conclusion from the two data sets would be to wait until the end of May before purchasing shares in the fund.  

We will be watching this one closely for a potential opportunity and of course will keep you guys posted.  

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Guest Post: 6.7% Yielding BBB- Rated Preferred Stock From Energy Giant Enbridge

Guest Post: 6.7% Yielding BBB- Rated Preferred Stock From Energy Giant Enbridge

Summary

  • EBGEF is an investment grade preferred stock from energy midstream giant Enbridge that yields 6.7%. Dividends are qualified and received on a 1099.

  • Most investors are unaware that the dividend recently reset higher.

  • Enbridge has a long, successful track record which has led to 24 consecutive annual dividend increases for the common stock.

  • EBGEF should catch up to the improving environment for energy stocks and preferred stocks in general.

Weekly Commentary | April 7, 2019

The big news on the week was the strong economic data that came out- not just from the U.S. but globally.  We had the China data come out late Sunday night last week that boosted equities in the U.S. Monday morning.  We also had strong manufacturing PMI in the U.S. and then at the end of the week, a rebound in the jobs report.

With the strong stock gains on the week, the S&P 500 is now within 2% of the all-time highs set back in September.  The S&P was up 2.3% on the week, in line with mid caps and small caps.  The Nasdaq trailed a bit at +1.87%.  

Bonds were generally weaker with the Agg down 48 bps and munis down about 26 bps.  High yield did move with equities rising 60 bps on the week.  In fact, the High Yield ETF (HGY) is now back at new highs recovering from the sharp sell off it had in the fourth quarter.  When you factor in the distribution, we are now over 300 bps above that September level.  

The March jobs report showed that 196K new jobs were created.  Last month's tepid report was revised up marginally.  The three-month average is now 180K, in line with most of the last 18 months.  The unemployment rate held steady at 3.8%.  Wages slowed their rise.  

Long-term interest rates rose a bit over the last week helping the yield curve move back to positive territory.  The inversion of the 10yr note - 3-month t-bill has been a cause for investor anxiety the last 10 days or so.  

JP Morgan US Equity Macro Update – at the risk of sounding like a broken record, not much has changed for the SPX. The upcoming CQ1 earnings season should be mixed w/soft Jan-Mar numbers but positive linearity and encouraging qualitative guidance (this has been the message from preannouncements over the last few weeks) – to the extent mgmt. teams speak of improving trends, investors will forgive messy CQ1 results. The question is what happens to ’19 and ’20 consensus EPS estimates – they’ve been drifting lower for months but that process should abate given improving global growth (while the elimination of tariffs could provide a minor boost). However, even though an upward growth inflection is occurring (as was evidenced in the Mar PMI/ISM data), this may only stabilize EPS estimates (at ~$168-170 for ’19 and ~$180-181 for ’20) rather than push them higher. Fed policy is a wildcard – in order for investors to begin adding turns to the PE on account of monetary accommodation, the Fed will need to become “irrationally dovish” but right now it seems quite responsible (if global growth does inflect higher and financial conditions continue to ease w/o the Fed re-pivoting back to a neutral or hawkish policy stance, this would place upward pressure on the PE but for now it isn’t clear whether this will happen). Bottom Line: being as generous as possible on EPS (using the 2020 consensus of ~$181) and assuming a healthy PE of 16x suggests the SPX will face a ceiling around ~2900. An “irresponsibly dovish” Fed could justify ~17x in which case the SPX would surpass 3K but even under that scenario (which is pretty best-case) the upside from here is only ~3.5%.

Overall, the markets and the economy appear to be recovering from the soft patch it had in the late fourth/early first quarters of this year.  While GDP is likely to come in below 2% for the first quarter, the data suggests a re-acceleration this summer and/or back half of this year.  Even to the point where the market- and thus the Fed- may believe another interest rate hike could be in the cards.  

Closed-End Fund Analysis

Distribution Increase

EV Senior Income (EVF): +3% to $0.034 from $0.033.

EV Floating Rate Income (EFT): +2.7% to $0.076 from $0.074.

EV Sr Floating Rate (EFR): +2.7% to $0.077 from $0.075.

Delaware Div & Income (DDF):  +2.1% to $0.0905 from $0.0886

Delaware Enhanced Global Div & Income (DEX): +2.03% to $0.0904 from $0.086.

EV Floating Rate Income+ (EFF): +1.2% to $0.084 from $0.083.

Distribution Decrease

PIMCO High Income (PHK): -24% to $0.061331 from $0.080699.

PIMCO GlobalStkPLUS and Income (PGP): -23% to $0.09394 from $0.122.

Allianz Convertible and Income (NCZ): -21.7% to $0.045 from $0.0575.

PIMCO NY Muni Income (PNI): -21% to $0.040045 from $0.05069.

AllianzGlobal Convert and Income (NCV): -19.2% to $0.0525 from $0.065.

Templeton Global Income (GIM): -18.1% to 0.0336 from $0.041.

PIMCO NY Muni Income III (PYN): -16% to $0.03549 from $0.04225.

PIMCO Strategic Income (RCS): -15% to $0.0612 from $0.072.

PIMCO Muni Income III (PMX): -9% to $0.050733 from $0.05575.

PIMCO CA Muni Income III (PZC): -7% to $0.04185 from $0.045.

PIMCO NY Muni Income (NYSE:PNF): -7% to $0.05301 from $0.0703

Managed Distribution Policy

The fund adopted a managed distribution plan where they will shift the payout to a monthly payment at an annual rate of 6% (or 0.5% per month) of NAV for the remainder of this year. Starting in January of 2020, the fund is proposing to make monthly distributions at an annual rate of 6% based on the NAV on the close of business on the last business day of the previous year.

Our team wrote on this just a few weeks ago anticipating the change.

Activist Buying/Selling

SabaBuying:  MNE, EFF, VVR

KarpusBuying: EIM

SIT AssociatesBuying:  JHSSelling:  EGF, FMY

Commentary

Just a reminder, DSU's tender offer expires in a little over a week.  We recommend voting "YES".  It's a small 5% tender that we don't expect to result in too much in the way of alpha.  Still, the ability to get between 5% and 12% of your shares lifted at 98% of NAV giving you an almost 10% instantaneous gain is a good thing.  On their prior 10% tender offer last year, the proration got you 22% of your shares lifted because so many people didn't vote "yes".  

The discount at -11.26% is attractive given the portfolio.  We are still constructive on floating rate despite the negative flows and the dovish pivot of the Fed.  Yields are still at or near where high yield bonds trade and you get the upside if rates meander higher from here.  71% of the portfolio are term loans (floaters) with another 25% in high yield (fixed coupon) bonds.  

One of the best aspects of this fund is the sector breakdown with technology and consumer non-cyclicals being the top industry types.  Often we see funds that have 'communications' and 'energy' as the top industries which tends to give us pause.

Munis were the weakest CEF sector on the week while equity sectors performed well.  The top price gainer on the week was Eagle Point Credit (ECC) which gained nearly 5%.  The volatility and riskiness of this fund is not understood by the market.  It should be kept as a small allocation if held at all. 

Surprisingly, Nuveen Pref and Income 2022 Taret (JPT) gained 4.2% for inexplicable reasons.  It now sits at a 1.3% premium. 

One of the stat pieces I like looking at are the funds that lost the most premium/gained the most discount on the week.  PIMCO funds, (PGP) and (PHK) were the two largest movers last week with PGP reducing its premium by 23%.  PHK lost 18.3% and seemed to stabilize late on the week.  RCS was third at 12%.  

A quick additional note on these funds.  I have premium targets where these become attractive.  For PGP, the premium would need to fall to below 20% for us to get really interested.  At 31%, it still has a way to go.  For PHK, a fund I don't like as much as PGP, I would want to see at least the low-20% area if not high-teens as well.  

Flex Portfolio Update

Expect to see more trades in the Flexible Portfolio in the next few weeks/months as we harvest some of the gains made and rotate into other, more attractive opportunities.  Let's walk through the positions to see where we are at and our targets for each.

Principal Real Estate Income (PGZ) has been a holding for about 16 months now and has made quite a move in the last four months.  The discount is still relatively attractive at -11.4%.  The ROC in the distribution is the result of the managed distribution policy.  We will continue to watch the NAV and the amount of ROC for signs that the distribution may be cut.  For now, we think it is safe but one of the risks of these types of funds is that you really just never know.  If you hold, I would continue to hold but I wouldn't buy here.

Pioneer Diversified High Income (HNW):  This is a classic example of why buying at an attractive discount can provide a bit of a cushion and produce alpha (superior risk-adjusted returns).  The fund continues to benefit from the recovery in high yield debt.  With a fixed coupon, if rates do rise, this fund should be effected far less.  The discount is tightening and is likely to tighten further given the well-covered distribution yield.  

Blackrock Debt Strategies (DSU) is another we've held for a long time on the basis of activist swarming the fund.  The discount just refuses to tighten despite all the stuff going on including tender offers.  At a -10.9% discount, it is still relatively cheap for the yield.  As we noted above, 22% of shares were lifted last year when they did a 10% tender.  So we expect about 11% to get taken from us this go-around.  The z-score, on a one-year basis, is just now above zero.  It would be nice for this fund to get to an ~8% discount so we could harvest the gains.  For now, we are holding and voting yes on the tender.

Ares Dynamic Credit (ARDCis similar to DSU but has more fixed-coupon debt with roughly 50% in floaters and 50% in HY (DSU is about 72% floaters).  The NAV hasn't been as upward sloping as other funds in the space.  One reason could be the higher amount of level 3 assets due to the CLO positions.   We've added to this fund recently and will likely continue to do so occasionally on weakness.  The fund is up over 11% YTD on price and nearly 7% on NAV.  

Nuveen Short Duration Strategies (JSD) has been making nice progress on closing its discount going from -16% to -7.7%.  Coverage is near 100% but UNII is slightly negative.  The last distribution move was an increase.  The NAV is mostly up nicely as the index continues to heal (overcoming fund flow headwinds).  I want this to get to a -5% discount so i can unload it from the Flex.  Stay tuned.  

NexPoint Strategic Opps (NHF):  This was an opportunistic purchase that houses mostly equity and equity-like positions.  It also has a basket of preferreds for current income and a large position in the NexPoint Re Opportunities LP REIT. Running some backtested factor testing, the fund has most prominent exposure to high yield and REITs.  The discount has tightened but the one-year z-score is still nicely negative at -0.80.   This is one we may add to tomorrow or Tuesday as the NAV jumped significantly, perhaps on a re-pricing of the LP position.  Short-term, I think this could go back to a -9% discount if the NAV is accurate and more medium-term towards 5-6%.

Neuberger Berman High Yield (NHS) was one we bought because of the massive discount and attractive yield despite not loving the sponsor (Neuberger Berman) too much.  The discount is nearing its target of -9% and we consider this position a source of cash- mainly because the yield isn't as competitive as other similar risk funds out there.  Be on the look out for a sell-alert when we his that target and/or find a suitable replacement.

Credit Suisse High Yield (DHY) was a recent opportunistic buy in a fairly liquid (low-share price value) fund.  The position is relatively small at ~3% and has not only gone to 'hold' but to a 'sell' rating at $2.53 (from $2.35).  The yield is still high at 9% but the portfolio is pretty junky.  For those wanting to de-risk, I would let this go now and wait in cash for something else to materialize.

Lazard Worldwide Dividend & Income (LOR) cut the distribution starting with the January payment by 21.7%.  It is also going through a merger with sister fund LGI.  LGI will be the surviving fund.  They also announced a tender offer for 20% of the funds outstanding shares at 98% of NAV.  That offer has not yet begun but we expect to fully participate hoping to get about 40-50% of our shares lifted at a 2% discount.  Meanwhile, the NAV is nicely moving higher on the back of the equity recovery plus the discount has been closing.  We'll continue to hold waiting for the tender offer details. 

LOR's net assets are invested with a focus on the highest yielding equity securities selected using the relative value strategy of Lazard Asset Management LLC ("LAM") and generally are a portfolio of approximately 60 to 100 US and non-US equity securities, including American Depository Receipts ("ADRs"), of companies of any size consisting primarily of securities held by other portfolios managed by LAM, including investments in emerging markets. 

PGIM High Yield (ISD) is, along with NHF and ARDC, one of the more attractive buys right now.  The fund trades at a 13.6% discount to NAV, close to the one-year average.  The yield is a "juiced" 8.4% after the fund raised its distribution by shifting to a managed distribution policy while allowing for more of the junkier credits into the portfolio through an investment policy shift.  We're still holding the shares and may add on weakness.

RiverNorth Opportunistic Muni (RMI) is the latest addition to the Flexible Portfolio.  At a 5.85% discount, the fund is still relatively attractive though we have no basis for where the discount may end up.  I'll still be picking up shares in this one over the next week or two.  

Secure Act - End of Stretch IRA?

The likelihood that congress will pass the Secure Act appears to be on the increase.  If it passes, it would effectively kill the stretch IRA which basically allows non-spouse beneficiaries of an IRA to stretch out the distributions over a 10-year period and reduce the overall tax burden.  This could be a major future tax liability for the next generation as several trillion in IRA assets sets to move down to their children.

But the bill does have some benefits including:

  • Increase RMD age from 70.5 to 72

  • Allow Traditional IRA contributions past RMD age

  • Portability of Lifetime Income Options between plans

  • Treats home healthcare workers income as earned income for purposes of IRA contributions

  • For IRAs and Defined Contribution Plans, upon death of owner, the beneficiary of the IRA must fully distribute the plan balance within 10 years, unless the beneficiary is the surviving spouse, disabled or chronically ill, not more than 10 years younger than the owner, the child of the owner/employee who has not reached the age of majority

  • Allows older workers to continue to accrue benefits for a pension after the plan has been closed

  • Expands what 529 plans can pay for, including tech schools and up to $10K towards student loans

  • Penalty free IRA withdrawals for qualified birth or adoption expenses

  • Allows long term part time employees to participate in retirement plan

  • Up to $500 tax credit for small business who auto-enroll new employees

For those with complex estate plans, this could be a potential wrench in their cogs.

Stay tuned.  This is still in the formative stages but the end result means that the Roth IRA is far more valuable and conversions should be a significant part of the planning process for those nearing and in retirement.  We will have more updates on this including some analysis and information as the bill gets closer to passage.  But once April 15th passes, it may be wise to ping your CPA about it.  

We will also be putting out a full article on this in the near future- so keep an eye out for that.

Statistics:

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A Look Under The Hood Of PCI & PDI

PIMCO Dynamic Credit and Mortgage (PCI) and PIMCO Dynamic Income (PDI) still remain at the center of our Core Portfolio- as they have for the last 3.5 years.  The "PIMCO twins" have done extremely well on a risk-adjusted basis but there are changes afoot and we thought we'd go through some of them with our members.  

The main thesis has been relatively unchanged for most of these last three years- that these vehicles housed boatloads of non-agency mortgage backed securities purchased at just the right time.  One of the things closed-end fund ("CEF") investors often fail to recognize is the initial date of new fund launches.  These can be well-timed by fund sponsors providing a competitive advantage against the rest of the sector and create a great opportunity for investors.

That thesis may be shifting- not radically- but slowly over time.  In the last year, they've been moving away from that bread and butter investment.  While it still represents the largest sector in the portfolio, the size of it is declining in terms of market value. 

We will run through why this is and what it potentially means for investors.

Despite a -2.2% decline in non-agency debt in the fourth quarter, the sub-sector finished 2018 with a +3.3% gain surpassing the broader credit markets.  New issuance continues to trend higher yoy but did fall off in the fourth quarter.  The new issuance market has been largely dormant since the Financial Crisis but has, in the last couple of years, shown signs of life. 

In the table below, you can see private label mortgages (the ingredients for non-agency MBS) constituted over one-third of the entire market in 2007.  Shortly thereafter, the space was largely gone until last year when it doubled from 4% to 8%.  

(Source:  Ginnie Mae)

The decline in the fourth quarter for non-agency MBS stems from the widening spreads realized across most credit sectors.  Recall in our previous writings that the market lumps non-agency MBS in with high yield bonds, something we highly disagree with at this point in the cycle.  Our rationale is that ten years following the Financial Crisis where subprime mortgages cratered, these borrowers continue to make their payment.  

These formerly busted MBS' that are now "re-performing loans" meaning that either the borrower started making payments again or the loan was restructured so that they could afford the payments, continue to be a main driver of PIMCOs strategy since 2010.  However, in the last several months, the percentage of the portfolio devoted to non-agency continues to fall.  

In the last quarterly update (December 31), PCI had just over 50% in non-agency debt.  That is down significantly from early last year when the fund held over 70% in the sector.  Instead, high yield and non-USD EM credit is now approximately one-third of the portfolio.  The fund has also reduced their interest rate swap exposure increasing the duration of the fund.  This not entirely surprising given PIMCOs notion that the 10-year bonds have hit their highest yields of the cycle.  They do still have several hedges on the short-end of the curve and are long "the belly".  

PCI and PDI are not outperforming the multisector space like they normally do.  The main drivers of that are the lack of a significant rally in non-agency MBS compared to other sectors of the market and the relative differences of funds in that sector.  For instance, PGP, despite the significant drop it has taken recently, continues to be the top performer mainly because it is really an equity index.  Franklin Universal Trust (FT) is a fund that has over one-third of the portfolio in stocks.  So you do have to be careful comparing funds in this particular sector. 

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The total return on PRICE has been a far different story and speaks volumes on the need to be ready to pounce on great opportunities.  We pounded the table in December about the deal of the year being offered up by the markets in these names, particularly PCI.  A confluence of factors came together to create this opportunity.  Those included:

  • Tax loss harvesting

  • Special distribution capture selling

  • A large drop in the NAV due to distribution payments

  • Massive negative sentiment in the CEF space

  • Fast widening credit spreads

In the chart below, you can see the darker line completely collapse in mid-to-late December because of those factors.  Of course the NAV was also down (partially) due to those same factors listed above.  In our Flexible Portfolio, we essentially used up all cash to go massively overweight the position.  

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And thus, the YTD price returns are up low-to-mid teens easily besting the S&P 500.  That is fantastic performance for a bond fund.  Since then, we have taken off the overweight and moved back to our target weight in the Core Portfolio.  

Valuation

With PCI at a +2.7% premium and PDI at a +15.3% premium, the funds are very close to fully valued.  We have not added to either of the funds in the last three months and continue to hold at levels slightly above their target weights.  We are happy to continue to collect the 8.5% income stream and wait for the next market hiccup to re-add the overweight position.  

Many investors think the shares are overvalued but we would disagree.  One of the reasons would be that they are still a couple of points off the 52-week highs in terms of premium.  In addition, z-scores are positive but no where near the +2 levels that would initiate a cause for caution.  Lastly, the new Federal Reserve's dovish tilts means that interest rates will remain lower, leverage costs are no longer the severe factor they were, and CEF structures earnings 8%-9% are now more attractive warranting a higher valuation.

Distributions

One of the most common questions we receive from members is whether we think PCI or PDI will cut their distributions in the near-term.  Right now, we see nothing that would cause us concern about the sustainability of the payment.  PCI and PDIs distribution payment have been the same since October 2015.  In the interim, they have paid significant cash payments in the form of year-end special distributions.

Coverage levels for both funds fell off in the last few months, albeit from very high levels.  PCI was at 192% in December but it declined to 89.2% in February.  PDI was at 85% in December and is now sitting at 76% as of February.  We will be getting March figures in about two weeks time which should shed some significant light on trends. 

UNII levels are still nicely positive with PCI at +22 cents and PDI at 10 cents.  PHK, PGP, and RCS, all of which cut their distributions on April 1st, all have negative UNII values of -12 cents, -12 cents, and -21 cents*.  In addition, and this is the key, all three of these funds have issued 19a notices for most of the last two years.  If PCI and PDI were likely to cut, we would likely have to see many months of 19a notices come out.  We think the distributions are safe for several more months at the least.  

Concluding Thoughts

The reduction in the level of non-agency MBS is not a large concern for us.  PIMCO is known for putting the best ideas into these vehicles that they can find because they get the most bang for their buck.  Sticking a small position into PIMCO Income, their large open-end mutual fund, won't have any effect simply because of its massive size.  

One thing to consider is that most banks and hedge funds have been unloading these securities as they've closed the gap to par.   With the selloff in high yield securities and only the small decline in non-agency MBS debt during the same period, perhaps they took some of that position off to re-allocate towards high yield.  

In any event, with these funds there's a lot of trust in PIMCO management.  You're largely investing in a black box.  Well maybe not completely black but definitely obscured.  When you do that, you just have to study the NAV, assess the valuation, and compare to what else is in the market today.  

Most bond CEFs have recovered mightily since the start of the year so there aren't many other cheap options where you can earn 7.5%-plus yields with some upside optionality to boot.  For now, we are holding on to our position and collecting the income stream- though as we noted earlier, we did take off the significant overweight we had on PCI.  

Another market hiccup will surely come.  Until then, we have some dry powder sitting in open-end funds and even some cash that is on the sidelines ready to be deployed.  One of the hardest things an investor can do is buy when the market and these funds are selling off strongly.  Our marketplace service helps guide (hand hold) members who do get scared and don't know what to do during those times.  

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Weekly Commentary | March 31, 2019

Not too much happened this week and markets were nicely positive reversing prior week's losses.  Stocks had their best quarter in a decade with industrials leading the way in the S&P 500.  Utilities were the worst performing sector with telecom the next worst.  Google, which is a large portion of the sector, was fairly weak on regulatory pressures.  

First quarter earnings will start in a couple of weeks and thus, investors were largely in a holding pattern as volumes were extremely low.  Volatility, which jumped earlier in the week, moderated as we progressed through it.  The largest IPO of the year helped stocks when Lyft began trading.  

Global growth continues to look sluggish with data in housing starts declining by 9% in February.  Pending home sales also had a weak month dropping yoy.  The news counters the bump in refinancing activity with the lowest mortgage rates in a year.

Muni demand continues to be strong as new supply was well received by the market.  As tax bills come due, demand for and interest in munis is likely to only increase.

The yield curve remains inverted between the 10-yr and the 3-month t-bill (by about 3 bps, 2.41% to 2.43% and just above the Fed Funds target rate of 2.40%).  Historically, the inversion has preceded a recession by 12 to 24 months.  However, between the inversion and the actual start of the recession, risk assets tend to rally (in some cases dramatically).  

Dallas Fed president Robert Kaplan suggested that an inversion would need to be deeper and last for months to be a significant worry.  Some suggest that it takes several quarters for rate hikes to filter through the economy (libor-based borrowing tends to take a quarter or more to reset).  There could be multiple hikes still working through the economy.  

JPM Commentary:

How worried should investors be about earnings? The CQ1 preannouncement season has been busier than normal and a number of high-profile companies have cut guidance this week, including ADM, ALB, BECN, DWDP, Infineon, LUV, Osram Licht, and Samsung Electronics (ALB and DWDP were out overnight). Many of these companies are citing temporary/exogenous headwinds that ostensibly should abate in CQ2 and beyond (ADM, ALB, and DWDP all suggested this and Infineon said CQ1 would mark the trough of the semi cycle). Investors may come to see a silver lining in the growing pile of warnings as they will knock CQ1 expectations low, creating a low bar for companies to “surprise” once the reporting period actually gets underway. Meanwhile, there have been some encouraging earnings developments this week as a bunch of Feb-end firms (like ACN, LULU, PVH, and others) put up solid prints and the two builders (KBH and LEN) both made sanguine remarks on domestic housing trends (although the Feb-end season has been far from perfect – RH slashed its guidance overnight and recall FDX underwhelmed too). In the near-term, all the recent earnings updates are probably a positive as expectations are very subdued at the moment – TSYs have surged and people are overly nervous about the state of growth. The CQ1:19 SPX EPS estimate has declined from ~$42 back in Jan to ~$38.80 at this point but CQ1 did contain a number of one-time headwinds that won’t repeat going forward (the gov’t shutdown, extreme weather conditions, etc.).

For those that keep saying that "this time is different" when it comes to the yield curve inversion, do not believe them.  I can recall the same things being said in 2006-2007.  The most common refrain back then was that China was buying up loads of our debt depressing the long-end of the curve.  

The key for the next three months will be first quarter earnings and guidance for the next quarter/ rest of the year.  Expectations have been reduced significantly since early December so if results come in further below those already reduced levels, expect a weaker market.  But the greater probability is that the economy was decelerating back to the prior level of growth.  We do not think it will decelerate further than that and growth will be in the 2% range again.  

As such, expectations look to be a little low for the year.  In addition, a second re-acceleration is also possible given the lower rate environment.  The risk is to the upside as we move through the second quarter.  

Closed-End Fund Analysis

Distribution Increase

Voya Prime Rate Trust (PPR):  Monthly distribution increased by 7.8% to $0.0275 from $0.0255.  

Distribution Decrease

N/A

Merger

EV Muni Bond II (EIV) completed the merger into EV Muni Bond (EIM) on March 22, 2019.  The exchange ratio was 0.982064.  

Initial Public Offering

Tortoise Essential Assets Income (TEAF):  Tortoise launched a new fund, raising $296M in assets with the overallotment.  The fund will trade on the NYSE with the following investment strategy:

  • The fund is intended to provide investors with exposure to essential assets sectors across all levels of an issuer’s capital structure, including access to direct investments that may not otherwise be widely available to many investors. The fund will emphasize income-generating investments in social infrastructure, sustainable infrastructure and energy infrastructure. It will provide investors with access to the skill and experience of the Tortoise platform with deep expertise in essential assets and income investing.

Tender Offer

EV Muni Bond (EIM):  The fund announced a cash tender offer for up to 10% of its outstanding shares at a price of 98% of NAV.  The tender begins on April 18th and expires May 17th of this year, unless extended.  

  • The Board also authorized the Fund to conduct two conditional cash tender offers to follow the Firm Tender Offer, provided certain conditions are met. Specifically, as soon as reasonably practicable after the Firm Tender Offer closes, the Fund will announce via press release the commencement of a 120-day period. If, during such period, the Fund's common shares trade at an average discount to NAV of more than 6%, the Fund will conduct an additional tender offer beginning within 30 days of the end of the month in which the First Trigger Event occurs.

  • The Initial Conditional Tender Offer will be for up to 5% of the Fund's then-outstanding common shares at 98% of NAV per share as of the close of regular trading on the NYSE on the date the tender offer expires. If the Initial Conditional Tender Offer occurs, the Fund will announce via press release the commencement of a second 120-day period. If, during such period, the Fund's common shares trade at an average discount to NAV of more than 6%, the Fund will conduct an additional tender offer beginning within 30 days of the end of the month in which the Second Trigger Event occurs.

  • The Second Conditional Tender Offer will be for up to 5% of the Fund's then-outstanding common shares at 98% of NAV per share as of the close of regular trading on the NYSE on the date the tender offer expires. The Second Conditional Tender Offer will not commence and the Fund will not announce a second 120-day period unless the Initial Conditional Tender Offer occurs.

Commentary

CEFs continue to see discounts tighten across the board.  Some valuations look excessive but areas of the taxable bond market remain a bit cheaper than the rest.  

Some funds that look expensive include:

(I don't trust that 1-year z-score for CET as cefdata.com has +0.7)

Here are what some national muni CEFs have done, sorted by YTD:

BTA is now up 15.7% YTD and nearly 14% in the last year.  The discount has tightened and is now less than 1.5% away from par.  The yield is just under 5% so from that perspective it is still relatively attractive but as we wrote in the muni update for this month, we think there are better choices.  If you still hold, think about swapping to BKN or MQT.  

For those that own Reavers Utility Income (UTG) they issued a 19a for March with 36.9% being long-term capital gain and 63.1% net investment income.   Fiscal year to date, 47.7% has been net investment income and 51.9% being long-term capital gain.  Utilities continue to look attractive as money flows into defensive stocks.  While rates look like they've bottomed- at least in the near-term but likely for the interim- investors still appear to be on edge about putting capital to work in high beta stocks.  

Some Nuveen funds also issued 19a notices.  Primarily their covered call / buy-write strategies. 

Lastly, we saw some significant preferred stock rebalancing last week with dozens of issues seeing over 3x their average daily volume.  There were seven issues that saw more than 10x their average daily volume.  

  1. AllianzGI Convertible and Income (NCV-A):  34x volume

  2. AllianzGI Convertible and Income II (NCZ-A):  25x volume

  3. Gabelli Conv and Income (GCV-B):  15x volume

  4. UMH Properties (UMH-C):  11.5x volume

  5. Rexford Industrial Realty (REXR-B):  11x volume

  6. First Bancorp (OTCPK:FBPRP):  11x volume

  7. Southern CA Gas (OTCQB:SOCGM):  10x volume

  8. Cedar Realty Trust (CDR_B):  9.5x volume

  9. Public Storage (PSA-W):  8.6x volume

We will have some ideas for those looking for individual preferred ideas in our update coming out next week.

Statistics

Here is CEF sub-sector info for the last week. Please be advised that these are CEFConnect's sectors and don't always reflect the actual investment exposures in the fund.

Here we look at our universe of Core funds- primarily in the taxable and municipal sectors.

Lastly, we do a top 10 expanded to ALL CEFs.

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YH Convergence Trade Report | April 2019

YH Convergence Trade Report - April 2019

A convergence trade is a closed-end fund that is trading at a wider-than-usual discount and is likely to close that discount. On some occasions, the discount is warranted- most likely because they cut the distribution. Other times they are trading wide because of the sector being out of favor or general market weakness.

We look at our table to see those funds that are trading well below their 52-week average. We further inspect how far off the fund is from its 52-week high. Given the favorable Fed backdrop - basically a green light for CEFs- in general we think it is highly possible that they re-reach those 52-week highs in premiums.

Please note, this is not a blanket buy recommendation of these funds but a starting point for further analysis.

There is a lot of data below- do not be intimidated! The keys here are the two grey columns on the right side of the table.

The "convergence opp" column (third from the right) shows the amount of potential discount closing if the fund were to get back to their 1-year discount (recall that we said we thought discounts could exceed their 1-year levels and approach 52-week highs). The second to last column (green labeled "52W Disc High %") on the right shows the 52-week high in discount/premium. The last column (52 wk High Opp) shows the amount of discount tightening that would be needed in order for it to reach those 52-week highs again.

Remember, sometimes discounts exist for a reason - most likely because the distribution has been cut. I'd love to start a discussion and get a conversation going on some of these opportunities. Please leave comments below or join us on the chat during the market hours.


It is interesting to see the differences month-to-month in the chart. The list continues to shrink as the discounts tighten up.

For those that are looking for a quick and reduced universe of funds to investigate, check out these funds. Watch for those that have recently reduced their distribution.

Again, if you think you've found a gem in the rough, comment below or send me a quick personal message and we dig deeper.

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Weekly Commentary | March 24, 2019

Stocks suffered their largest one-day loss of the year as global growth fears accelerated after manufacturing data was released on Friday.  We had two main events this week:  the FOMC meeting on Wednesday and the preliminary (also called "flash") PMIs Friday morning.  In addition, to those we had some bad earnings releases from Nike, Fedex, and Micron helping drive down the narrative.

On the week, the S&P 500 fell just over 1% while small caps fared the worst losing over 3%.  Bond indices did well thanks to those falling rates.  The Agg was up 0.87%, while high yield was up 26 bps.  Munis did well rising 67 bps. REITs and utilities did the best on the week.  

The 10-yr ended the week at 2.44%, the lowest level this year and down significantly from last Friday's 2.58%.  Oil did not move much on the week ending around $59 a barrel.  But the VIX spiked on Friday to 16.8 from a 12-handle on Wednesday.

The Fed meeting on Wednesday had Chairman Jay Powell dialing back the rate hike outlook to zero for 2019.  This was down from two hikes expected in the December release.  The committee now sees only one hike over the next three years while the market is now pricing in a small cut next year.  More below on the Fed's dovish stance.

Europe continues to look sickly.  The German manufacturing sector ("PMI") sparked the sell-off as their initial reading hit a 6-year low of 44.7 (anything below 50 is a contraction).  The Eurozone as a whole is still above 50 at 51.3, but that reading was below forecast.  

Lastly, we had some terrible earnings releases from Fedex, Nike, and Micron which exacerbated the negative sentiment.  Fedex, an economic bellwether, fell far short of expectations and cut guidance (again).  Micron also issued light guidance but the shares rose on the news.  Nike's report was not bad but spoke to some larger global weakness.  

In reaction to the news, global bond yields plummeted with the 10-yr German bund reaching negative territory for the first time in nearly 3 years.  The terms "recession" and "yield curve" saw some of the largest searched trends on Google on Friday as a recession indicator was triggered.   

The 10s-3m curve (10yr yield minus the 3-month t-bill yield) went negative on Friday thanks to global growth concerns and falling yields globally.  This likely exacerbated the decline in the markets.  When it inverts, investors believe there is a recession coming relatively soon.  The last time the curve inverted was in 2007, near the peak of the market prior to the global financial crisis.

Typically, a recession comes 12-18 months following an inversion.  What is important and often failed to be mentioned in the media is that the curve needs to stay inverted for a full quarter- not just hit for a day or few days.  So technically, we are not there yet.  We will keep watching.  

As of yet, there were no signs of panic in the credit market.  This is a good thing as it could be more algo/sentiment driven market movement in the equity indices.  

As we've been saying, this is late cycle but it is unlikely that the bull market ended on Friday.  We were just a few points from all-time highs going into last week.  It is likely we make another run for them soon.  The key factor is not what is happening here (in the U.S.) but in China and Europe.  Chinese growth is an important domino that could either propel us to new highs or drag down US (and European) growth further.  

Closed-End Fund Analysis

Distribution Increase

FT Sr Floating Rate (FCT):  Monthly distribution increased 4.2% to $0.0625 from $0.06.

Distribution Decrease

N/A

Special Distribution

Insight Select Income (INSI):  Distribution amount of $0.14.  Ex-div date of 04.04.19 and payable on 05.08.19

Name and Investment Policy Change

Highland Floating Rate Opp (HFRO) is changing its name to Highland Income Fund (HFRO).  The cusip and ticker will remain the same.  The policy change simply removes the old requirement of having 80% of net assets invested in floating rate loans.  

  • The Fund will pursue its investment objective by investing primarily in the following categories of securities and instruments:

  • (I) floating-rate loans and other securities deemed to be floating-rate investments;

    1. (II) investments in securities or other instruments directly or indirectly secured by real estate (including real estate investment trusts ("REITs"), preferred equity, securities convertible into equity securities and mezzanine debt); and

    2. (III) other instruments, including but not limited to secured and unsecured fixed-rate loans and corporate bonds, distressed securities, mezzanine securities, structured products (including but not limited to mortgage-backed securities, collateralized loan obligations and asset-backed securities), convertible and preferred securities, equities (public and private), and futures and options.

  • Once effective, the Fund will no longer be required to invest at least 80% of its assets in floating-rate loans and other securities deemed to be floating-rate investments. Highland Capital Management Fund Advisors, L.P., the Fund's investment adviser (the "Adviser"), believes the change will expand the Fund's universe of opportunistic investments and provide additional flexibility when investing outside of floating-rate instruments.

  • Until the effective date, the Fund will continue to invest in accordance with the 80% Policy. Once the changes take place, the Adviser still expects to invest a significant portion of the Fund's portfolio in floating-rate securities.

Commentary

The Fed announced that they are essentially done in this cycle- for the time being- both in raising rates and in reducing the balance sheet.  The Fed Funds curve is now flat and even assumes a very slight cut through 2020.  That means it's better for the market that the Fed will not act for the next two years.  

Any CEF investor must incorporate the current and anticipated interest rate environment when assessing where to allocate capital.  One thing we looked at this week is the possibility of raising 'sell threshold' figures on the Google Sheet to incorporate the new benign rate environment.  It is clear that the previously established thresholds were built under a different paradigm.  

Other things we will be looking at is the allocation to floating rate.  While it has helped us the last few months given how oversold it was in December/January, I do think it is time to consider reducing that allocation.  If you want to maintain exposure to securities with a lower duration, then look at hedged fixed income strategies and high yield alternatives instead.  Some that come to mind at PPT, ISD, and PIMCO twins. 

Muni CEFs and non-agencies in the mortgage sector continue to be the best positioned in this current environment given the falling rates and inverted curve.  Munis especially are attractive and continue to provide a natural hedge to the market moves.  While we do not see a substantial leg lower in the near-term, the inverted curve and the slowing global economy does increase the likelihood.  

Below are some one-day changes in NAVs for different funds.  You can see why we focus on the MBS funds.  While PCI and PDI saw NAVs decline a bit, largely because of the exposure to high yield, the heavier MBS open-end mutual funds were either flat or up on the day.

The last two securities on the list (HYG and MBB) show the differing performance of the sectors on Friday.  High yield, which has been performing well, lost 36 bps on the day while MBB, a mortgage focused ETF, was up 33 bps.  That helps drive the NAVs of the open end funds like PTIAX (+31 bps), IOFIX (+8 bps), and CLMFX (+40 bps).  

This continues to be an area we like.  Unfortunately in the CEF space, there aren't many cheaper options so we've been using open-end funds.  Watch JMT/JLS for a better opportunity to get in.  Remember, these funds are merging and becoming perpetual trusts with a 100% tender offer.  Any discount greater than 1% is a buy for me.

PIMCO UNII Report

PIMCO released their monthly UNII and earnings report on Thursday after the close.  The big news from it was the revision to the four prior months for both PCI and PDI.  This was not a huge deal as it looks like PIMCO essentially, starting in October, reversed the data points for (PCI) and (PDI).  In other words, the PDI data was placed in the PCI field starting in October and vice versa.  The table below lays it all out.  

The $1.06 net investment income number for PCI prior to the revision was the PDI number for October.  PCI's NII should have been $0.87.  The same mistake was made for both coverage ratio and UNII.  This appears to be more of a data entry error rather than an accounting error.  

PIMCO muni CEFs continue to shed valuable UNII.  PCQ (CA Muni) lost another two cents of UNII in February for the second straight month.  At this rate, it will exhaust its UNII balance in 18 months.  PML, the other high UNII fund, lost 1 cent.  PNF and PYN, both NY muni CEFs, each lost a penny too.  Average UNII across all funds fell by one cent to 8 cents.  

Overall, coverages were down a bit with the average muni CEF ratio at 91.1% compared to 93.2% in January.  Still, the 3-month stacks (February 3-month coverage ratio versus November's 3-month coverage ratio) are nicely positive, in many cases double-digits.  

The coverage ratios and UNII levels for the taxables aren't very valuable given the unrealized gains are not incorporated into net investment income until realized.  For the muni CEFs, they are more valuable.  

For the taxables, as I've said a hundred times, I like to look at NAV changes for indications into distribution health.  

Valuation is clearly another story.  The premium on PDI seems more warranted today than it was a month or two ago given the Fed's pivot.  Still, the NAVs have struggled as of late. I like to look at trailing 30 day periods for clues as to NAV performance.  For example, for PDI the NAV was $27.76, about $0.10 cents above where it stands today.  This during a time of mostly improving credit spreads.  But during the prior 30-day period, the NAV increased by $0.22.  And the 30-day period before that, by $0.30.  So clearly the rate of change (second derivative) is slowing.

A key indicator for us would be it going negative for several 30-day periods.  

Some of the other taxable CEFs look weak on the tax UNII report including PKO.  But the NAV is still positive over the last 30 day period and is comfortably positive over the YTD period with $0.59 of growth.  

Roughly the same dynamic is occurring with PFN and PFL, which both still have nice cushions on NAV YTD growth.  

Still, I probably wouldn't be adding to any PIMCO CEF here.  And I looked back and haven't purchased any shares in almost three months.  There's still a possibility that the market will see this report and sell on it providing another entry opportunity.  But that is looking less and less likely as time passes.  The PIMCOs taxables do tend to sell off around ex-distribution dates (around the 8th-12th of each month).  

In terms of the 'buy under' and 'sell over' figures for the PIMCOs, we will likely do some minor adjusting to incorporate the new interest rate environment.  

Muni Market Update | March 2019

Muni Market Update | March 2019

Executive Summary:

  • Discounts are much tighter than 3 months ago so we've gone from looking for shorter-term trading opportunities to longer-term "holds"

  • Fundamental research is again key as we hunt for those funds that are likely to sustain their distribution for the rest of the year.  

  • We want to avoid distributions cuts as the rest of this year appears to be a coupon +- return environment.

Safe Bucket - Update 2019

Cash Substitutes:

  1. PIMCO Active Enhanced Bond (MINT):  See recent write-up (HERE)

    • Forward yield:  2.72%

  2. Lord Abbett Short Duration Income (LUBAX) (LUBYX):  A moderate fee, very short duration bond fund that is very safe.  

    • Forward yield: 2.73%

  3. iShares Short Maturity Bond (NEAR):  Another highly liquid actively managed (key point) bond ETF with low duration and high quality.

    • Forward yield:  2.84%

  4. Invesco Short Term Bond ETF (GSY): Another liquid, actively managed bond fund with mostly high quality stuff.  

    • Forward yield:  2.53%

  5. SPDR Bloomberg Barclays 1-3 Month T-Bill (BIL):  A liquid treasury ETF that invests in the short-end of the yield curve.  

    • Forward yield: 2.23%

I'm really agnostic about the first four above.  I do tend to favor MINT simply because of the brand name.  NEAR actually has slightly better liquidity though but MINT has more than enough shares traded each day.   

UltraShort Bonds:

These have slightly more risk than a traditional money market fund but are still classified as a 1-rating.  The addition of a few of these options along with PONAX (5.25% yield) can increase the overall yield of your Safe Bucket to over 3%.  

PGIM Absolute Return Bond (MUTF:PADAX):  A higher quality multisector fund that does contain some (<30%) in high yield securities.  

  • Forward yield:  3.44%

Semper MBS Total Return (SEMMX):  An MBS-focused fund with a concentration in non-agency rMBS.  We've highlighted this one several times for its strong risk-adjusted returns.

  • Forward yield:  4.44%

Metropolitan West Unconstrained Bond (MUTF:MWCRX):  This one costs a fee at Fidelity, but it's a decent fund.  The fund has about 20% in HY securities with a mix across sub-sectors to the bond market.    

  • Forward yield:  4.25%

MainStay MacKay Unconstrained Bond (MASAX):  Another low duration blended fund.  About half of the fund is corporate bonds with the rest in government-related securities.  About 27% of the fund is in HY securities with most being in the BB (highest) rated segment.  

  • Forward yield:  3.30%

TCW Strategic Income (TSI):  Our only closed-end fund for the bucket.  This is a low-risk largely corporate bond fund run by a premier manager.  The PMs of the fund toggle back the risk as the economy progresses through the cycle.  TSI yields 5.3% and trades at a 4.8% discount to NAV.  Anytime this fund gets to a -6% discount, we tend to add a few shares if we have excess cash.  Just beware of liquidity as it could take several days to get out of large positions and if you're trying to take advantage of opportunistic selloffs elsewhere in the market, you may miss the boat.  

Some Considerations:

We have been primarily focused on short-duration funds for the last 3-4 years given the low rate environment.  As we approach the end of the cycle, it may be necessary to add some duration to the bucket in order to capitalize on rates falling as we move into a slower (or even negative) growth environment.  

For larger balances where liquidity is not a factor, you could use a TreasuryDirect account and purchase directly from the U.S. treasury-treasury bills and notes.  

We get asked a lot about certificates of deposits (CDs).  1-year CDs, according to bankrate, now average around 2.70%.  Going out any farther than a year does not make sense given the flatness of the curve.  For example, a 2-year CD pays 2.80%, only 10 bps more to have your money locked up another year.  

For those looking to build a ladder portfolio, we still like BulletShares from Invesco (Invesco website here).  The iBonds from Blackrock are also good.  Just be mindful of liquidity. 

Below is the table from Invesco on their BulletShares.  The starting yield-to-worst for the current year fund is approximately 2.64%.  Taxes should be considered here as nearly all of the distribution is considered ordinary income.  For non-qualified account, think about using the iBonds Municipal Target ETFs.

This is the Safe Bucket list of funds from the Google Sheet:

PTIAX, SEMPX/SEMMX, PONAX, and PIGIX should be classified as short-term bond funds with the commensurate risks that come from that space.  We get many questions on why wouldn't we just put most of my safe bucket into a fund like SEMMX which yields much higher than GSY or MINT?  That is because the risk profile is highly different though they can both be rated "1".  SEMMX isn't diversified as it is completely invested into the non-agency MBS space.  

PIGIX, could be substituted with iShares iBoxx Corporate Bond (LQD) for more liquidity.  These two funds have nearly half of their allocation in BBB-rated debt which is the lowest on the quality spectrum.  

Liquidity is also important.  LDUR, while similar to MINT but with slightly more duration and more yield, has much less liquidity.  

Concluding Thoughts

Spreading your bets around is key along with focusing on credit quality and liquidity.  Having all of your safe money in CDs or money-markets makes little sense to me given the lack of flexibility.  But aligning your 'need' with short-term liquid assets while keeping your tactical money- the capital sitting on the sidelines in highly liquid and safe stuff (like MINT).

I think you could easily target a 3%-3.25% overall safe bucket yield and not be reaching very far out on the risk spectrum.  

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Weekly Commentary | March 17, 2019

Tech has regained the broader market leadership once again with Apple doing well this past week.  The news on the stock is the expectation of a video streaming service.  Boeing was the big laggard as all of their 737 Max 800 planes were grounded following a second accident.  

Indices for the week were up nicely with the S&P up nearly 3%, Nasdaq up 3.78%, but Dow lagging at +1.64% thanks to Boeing.  Bonds also did well thanks to falling yields with the AGG up 23 bps, high yield up 80 bps, and munis up 17 bps.

Other than the Brexit deal again being delayed, the largest news flow on the week probably came from the retail sales data.  January sales rebounded slightly from that horrible number we saw for December.  However, December's numbers were revised down to -1.6%.  Hard to imagine that people are going to save that much more as wage gains hit the largest figures since 2007.  More likely there's something faulty in the data.  Some suggest the absence of Toys R Us in December could be the culprit.

Bond yields were the other big story.  With consumer prices coming out mid-week showing a 1.5% increase in February, below January's 1.6% pace and slower than expected, inflation is not a concern.  The lower CPI supports the Fed's view for pausing here.

All in all, the reasons for the resumption of the rally are the same as they were two months ago:  an accommodative Fed, restrained inflation, signs of improvement in China, a China trade deal negotiations progressing, and a strong earnings season.

It appeared more that the markets needed a period of consolidation before advancing again.  And while Brexit produced a ton of media attention, it really has little bearing on our markets.  Europe is still a basket case (as it has been for most of the last decade) which is helping to boost the dollar.  Until that reverses, it is hard to imagine international developed stocks outperforming the U.S.  In fact, the US dollar is probably the largest risk to the market as EPS growth for the S&P is already a bit shaky and a higher dollar would reduce that further.

Interest rates continue to inch lower and broke the psychological 2.6% level on Thursday, hitting the lowest level since the start of the year.  

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The two-year yield, which is a good barometer for Fed actions, also continues to sink lower.  It has made an incredible move since mid-November when it nearly hit 3%.  

Clearly the lower interest rates along aid our closed-end fund strategy.  The more important figure is the 2-year number, which can be used as a benchmark for borrowing costs for the leverage within the funds.  The lower the 2-year yield, the lower the interest costs, and the greater the earnings power of the fund.  

Closed-End Fund Analysis

Distribution Increase

Blackstone/GSO Sr Floating Rate (BSL):  Monthly distribution was increased by 3.7% to $0.111 from $0.107.

Clough Global Equity (GLQ):  Monthly distribution increased by 6.5% to $0.1123 from $0.1055.

Clough Global Opp (GLO):  Monthly distribution increased by 5.6% to $0.0882 from $0.0835.

Clough Global Div & Inc (GLV):  Monthly distribution increased by 3.4% to $0.1032 from $0.0998.

Distribution Decrease

India Fund (IFN):  Quarterly distribution decreased by 4.8% to $0.59 from $0.62.  

Blackstone/GSO L/S Credit Income (BGX):  Monthly distribution decreased by 1.7% to $0.115 from $0.117.

Blackstone/GSO Strategic Credit (BGB):  Monthly distribution decreased by 0.91% to $0.109 from $0.11.

Tender Offer

Blackrock Debt Strategies (DSU):  The fund announced the start of a 5% tender offer at 98% of NAV.  The tender offer expires on April 15, 2019, 5pm EST.

Activist Trading

Karpus

Buying:  EIM

Selling:  EIV

SIT Investment Associates

Buying:  FMY

Bulldog

Buying: CUBA

Selling:  LOR

Saba

Buying:  RGT, NKG, EHI, HIO, HIX, NBO

N-2/IPO

Blackrock Science and Technology II-  The fund filed a N-2 form for an initial public offering on February 28th.  Further details will be released soon.  The fund looks to be similar to BST.  

Commentary

Discounts continue tighten albeit much more slowly than we saw in January and February.  Over the last 3 weeks, the discounts on bond CEFs have tightened about 22 bps overall ending the week at -4.95%.  This compares to 5.17% at the start of the month and 6.25% in mid-February, the last time CEFA issued their weekly update (and inexplicably stopped issuing the report).  

Munis again did well last week with taxable muni NAVs up nearly 1% and tax-free national munis up 52 bps before falling back Friday ending at the bottom of the list.  Single-state muni NAVs were right behind them near the bottom.  These sectors have moved significantly since the start of the year (and we will have a muni update out next week).  The one-year z-scores for the tax free income single state sector is now +1.3, the richest of any sector.  National munis are second at +1.07. The average discount is down to just over 5%, well in from the 10-15% level we saw in December.


For those with larger (and more tactical portfolios) of muni CEFs, you may want to slowly and lightly begin to trim some positions.  Those z-scores are not anything to worry about and do not indicate a massive overvaluation by any stretch, although some due diligence is needed to decipher which individual funds are expensive and which are not.  

Surprisingly, high yield CEFs are now the next most expensive sector with a +1.26 z-score.  Remember, these z-scores have not yet risen to the egregiously overpriced levels that are typically reflected with a z-score above +2.0. 

If you look at what has a negative value, Real Estate (Global), MLPs, covered calls, and some equity categories are there.  But the level for those z-scores are not very low.  Clearly discounts are not anywhere near where they were two or three months ago and compared to the last year are more on the expensive side.  

This is not a call to go to cash by any means.  But the only purchase I have made in the last 10-12 days was some small allocation to Nuveen Senior Floating Rate (EFR).  Floating rate itself has done what we expected it to do with discounts that are now far tighter than they were in early January when we wrote "Why Floaters Look Attractive Despite Lowered Rate Expectations."

So here we sit, in no man's land, neither significantly overvalued nor significantly undervalued.  Some specific funds remain on the cheaper side:  ARDC, DBL, TSLF, and AFT.  Others remain on the more expensive side:  ECC, PGP, JHB, BGH, PDI, GBAB.  Boring tends to be a good thing in CEF land.  Without any obvious buy candidates and only marginal sell one's, we collect our income stream.  

Multisector Review:

The price performance of the group has been strong and perhaps has masked a bit of the NAV struggles.  And when I say struggles I'm referring to some of the funds that have lagged others.  For the most part, the entirety of the sector has done very well with all funds up YTD.  

Below is the premium/discount of the space.  You can clearly see we are back to where we were prior to the fourth quarter swoon.  That pricing performance is responsible for the strong YTD returns realized in accounts.  


But the NAVs (below) tell a different story.  For example, you can see that PIMCO mortgage funds (PDI)(PCI) are nearer to the bottom of the list.  But the category has a wide range of different types of funds.  FT (Franklin Universal Trust) has a large allocation to equities - mainly energy stocks.  To compare that to PDI which is predominantly mortgages is not an apples-to-apples comparison.  PGP and RA also have large amounts of equity exposure.  

The stand out is BTZ, which is doing very well so far this year.  The combination of steady rates and falling corporate bond spreads have aided the NAV of the fund. 

Mortgage-focused funds like many of those circled haven't zoomed out of the gate at the start of this year like their peers.  However, they also didn't get clobbered like many of the funds that have large allocations to high yield bonds, floating rate, and other higher risk areas of the bond market. 

TSI is a lower risk fund without any leverage so it stands to reason it would lag a bit.  GOF and GGM have significant positions in floating rate securities (mostly outside of the mortgage market) and rates have been stagnant to falling this year.  

We wouldn't draw any conclusions from the data and do not see anything that is a screaming buy.  We tend to keep broad exposure to the space given the diversified sub-sectors of focus.  For instance, PDI, PCI, and DBL give us exposure to the non-agency MBS space we like so much.  BIT and BTZ give us the full spectrum of exposure to the corporate bond market- both investment grade and non-investment grade.  And lastly, TSI is a great safe bucket holding that gives us a fairly low-risk 5.3% yield.  

Statistics

First, sector performance for the week. 

Here are the stats on the Core funds showing the top and bottom 5 price movers, NAV movers, highest premiums, largest discounts, highest and lowest yields, and z-scores.

We extend that to all CEFs showing the top and bottom 10.

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