Weekly Commentary | December 30, 2018

Stocks turned out some decent sized gains for the week but not without some fairly remarkable volatility.  The week started off poorly with the worst Christmas eve going back to the 1930s pushing the S&P into bear market territory.  Following the closed markets on Tuesday, Wednesday saw one of the largest point gains ever with the Dow jumping over 1,000 points on the day.  

The VIX hit a 10-month high of 36 before dropping back to 28 by the end of the week.  

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Interest rates ended the week lower as money continued to flow out of equities and into safe haven areas of the bond market.  The 10-year yield is down to the lowest level since March at 2.716%.  The 2-year yield is down to 2.518% implying a far move dovish expectation from the Fed.  On November 8th, the yield was over 2.96%.  

JPM Market update – stocks finished modestly lower following the last few days of gains, with the SPX down 3.1pts at the close. It was another volatile session in which the index spent the majority of the day in the red before a late-afternoon buying surge pushed it up as much as 1%, only to then come back for sale in the last hour of trade to finish in the red. Once again there wasn’t a whole lot of news our over the last 24 hours, and the price action was largely a function of broader market forces and investor positioning (pension fund rebalancing has been cited as a key driver for the market rally on Wednesday and the late-day rally on Thursday). The US government remains partially shut-down and there’s been no real progress towards a deal. The WSJ reported this morning that it’s increasingly likely for the shut-down to extend into January, and while this normally isn’t something that markets care too much about, it comes at a time when investor anxieties are high owing to a list of other growing concerns (i.e. the state of global growth, Fed policy, trade, and a White House in chaos). Looking into next week there are a few important items on the calendar that will provide additional clarity into the state of growth, including China’s NBS PMI’s for December on Monday morning, the US manufacturing ISM for December on Thursday morning, US auto sales for December on Wednesday morning, and the US jobs report on Friday morning.

Economic data was mostly mixed with a very strong Chicago PMI but a plunge in the Richmond Fed Index.  Consumer confidence dropped to 128.1 but still remains quite high.  Lastly, holiday spending was strong topping last years record sales.  

The next couple of weeks should be interesting as we have a lot of economic data for December out plus people returning to work from the holidays.  We'll be keeping on eye on everything.

Closed-End Fund Analysis

Distribution Increase

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Distribution Decrease

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Liquidating Distribution

Blackrock Muni 2018 Target Term (BPK), Blackrock CA Muni 2018 Target Term (BJZ), and Blackrock NY Muni 2018 Target Term (BLH):  The funds met their target objective of returning the original $15 IPO price to shareholders.  The BPK fund started its liquidation process back in October with the $0.2855 special distribution.  It paid another $0.205 in November as a special distribution, and finally, its liquidating distribution announced today will be $14.6555 for a total distribution of $15.146.  Since inception, the annualized total return on NAV was 5.13%.  From the release:

BlackRock Municipal 2018 Term Trust (BPK)

  • Special Distribution Declared October 1, 2018 (payable December 27, 2018): $0.2855

  • Special Distribution Declared November 1, 2018 (payable December 27, 2018): $0.2050:

  • Final Liquidating Distribution Announced Today (payable December 28, 2018): $14.6555.

  • Total Distribution: $15.1460

  • Since BPK’s inception, the fund’s annualized total return on net asset value was 5.13% and the market price total return was 4.83%.

BlackRock California Municipal 2018 Term Trust (BJZ)

  • Special Distribution Declared October 1, 2018 (payable December 27, 2018): $0.3363

  • Special Distribution Declared November 1, 2018 (payable December 27, 2018): $0.1950

  • Final Liquidating Distribution Announced Today (payable December 28, 2018): $14.4870

  • Total Distribution: $15.0183

  • Since BJZ’s inception, the fund’s annualized total return on net asset value was 4.54% and the market price total return was 4.25%.

BlackRock New York Municipal 2018 Term Trust (BLH)

  • Special Distribution Declared October 1, 2018 (payable December 27, 2018): $0.2534

  • Special Distribution Declared November 1, 2018: (payable December 27, 2018) $0.1750

  • Final Liquidating Distribution Announced Today (payable December 28, 2018): $14.5895

  • Total Distribution: $15.0179

  • Since BLH’s inception, the fund’s annualized total return on net asset value was 4.47% and the market price total return was 4.17%.

Commentary

Discounts tightened a bit during the week thanks to some relatively calmer markets and likely a dearth of sellers.  Some good signs are emerging as the PIMCO funds have seen some more significant discount tightening from being massively oversold.  For example, PCI, which started the week at a 10.3% discount, ended the week at just 6.04%.  Anytime you see 4% of discount tightening without any catalyst to do so, that is a major snap back.  

PDI also saw the same significant snap back, and then some.  It started the week at a 0.77% discount, the lowest valuation that fund has traded in the last year.  By the end of the week, it was back to a 7.17% premium.  

One Heck Of A Round Trip For PDI

It was only 10 trading days but it felt like forever.  That is often how bear markets and sharp declines work. 

The market is highly inefficient.  Check out some of these valuations and moves in the last few days.  (and potential swap ideas).

The inefficiency is especially acute in the Nuveen target term high income series.  Yesterday, Nuveen High Income 2023 Target (JHAA), which recently IPO'd at $70M, rose 5.74%.  This is a bond fund that has no business rising that much in a day.  At one point, the fund was up nearly 20% and halted by the exchange.  I highly doubt any members own this but if you did, please sell at a nearly 11% premium to NAV.

The Nuveen High Income 2020 Target (JHY) is also now extremely overvalued.  The shares are over a 6% premium for a fund that will liquidate in less than two years now (3% per year headwind to your return).  The one-year z-score is +4.90.  (SELL!  SELL!  SELL!).  Conversely, you could go out one year to the Nuveen High Income 2021 Target (JHB) which trades at a 5.50% discount.  It's one-year z-score is -2.0.  This would be a GREAT pair trade if you could find borrow to short the JHY fund.

Another swap idea is in the Invesco terms.  Invesco High Income 2023 (IHIT)trades at a 1.6% premium with a one-year z-score of +3.0.  Conversely, the Invesco High Income 2024 (IHTA) trades near a 6% discount and has a one-year z-score of -0.60.  The NAV of IHTA has performed fantastic during this market swoon too- it's down only 5 cents during December.  The fund was recently at $9.03 which is a bargain.  There isn't a ton of liquidity so limit orders are a must- along with patience.  

Another fund to look out for would be PIMCO Strategic Income (RCS) which has bucked broader CEF trends and seen its premium increase over the last month.  Holders of the fund may want to swap out into something like First Trust Mortgage Opp (FMY), at least until the valuation comes down.  The exposures are not quite the same as RCS is 64% Agency MBS and 14% non-agency MBS, while FMY is almost exactly the reverse.  RCS is currently attempting to change their tax reporting structure which may cause a cut to the distribution as well.  

We are finally seeing some things move our way.  The Core model was up 3.55% during the week, a nice snap back though we need another week like that to get back to even on the month.  Considering there's only one trading day left, it's probably not going to happen.  

Blackrock Updates

Blackrock released their monthly EPS and UNII report for November.  On the taxable side, we saw coverages generally slide a bit during the month.  Nine of the twelve of the taxable Blackrock funds saw coverage decline in the month while UNII was more mixed.

Some observations:

  • Blackrock Debt Strategies (DSU) saw coverage decline back below 97% for the first time since July.  UNII is now at -2.42 cents, down from -1.8 cents in July.  While the degradation is apparent, it is extremely slow at this point.  Unless we saw a dramatic fall off in December given the volatility, it is unlikely that Blackrock will cut on Wednesday.  

  • Blackrock Limited Duration (BLW): A Core Portfolio fund, remains above 100% coverage for the fifth month in a row.  UNII fell to 4.48 cents, from 4.65 cents.  

  • Blackrock Multi-Sector (BIT):  This fund has been a bit of a conundrum and all over the place which could be due to the junkier/foreign assets held in it. BIT has 20% outside of the U.S. and now 10% below CCC, another 9% in CCC, and 17.3% in single B.  This fund is far junkier then it was not long ago.  Coverage is down to 85%, down 9.1% in the last two months alone with UNII down to -10.6 cents.  We wouldn't be surprised to see a cut on Wednesday.

  • Blackrock Credit Allocation IV (BTZ):  This is the mirror of BIT with 70% in investment grade.  This is another fund that has become "junkier" over time with now 11% in BB and even 3+% in CCC or below.  While the coverage remains above 100% and has been flat, along with UNII, just understand that leverage is up a bit and junk up a lot over the last year.  

On the muni side, things held up will in December with the average national muni fund coverage at 109.81%, virtually unchanged from the month before.  However, over a 3-month period, coverage is down about 3.5% from 115.8%.  UNII figures were down slightly to +5.2 cents from +5.6 cents last month.  This breaks the string of 3 straight months of UNII improvement.  Looking at the aggregate figures for all funds tends to give a good idea of the health of the funds and sector in general.  Most muni funds across the same sponsor tend to look similar- with similar holdings.  

We will have a full muni update in the next ten days following distribution announcements next week.

Nuveen Updates

Nuveen also released their monthly numbers for November. 

  • On the taxable side, the story is the floating rates which continue to show increased coverage ratios.  JSD increased to 105.7%, JRO to 109.5%, and JFR to 109.6%.  JQC, which recently instituted a capital return plan (mentioned in last week's weekly) has coverage over 111%.  UNII on the funds also improved though four of the five are still below zero.  

The preferred funds also saw coverage improvement as interest rates declined and current yields in the preferred space look compelling.  Coverage remains near 100% and UNII is improving overall.  

  • A fund that may be at risk for a cut is the taxable muni fund, Nuveen Build America Bond (NBB).  The fund was recently merged with NBD, a similar strategy fund. UNII on the fund is now -7.8 cents. If any fund on the taxable side were to cut next week, we think it could be NBB or JGH.

  • Nuveen Global High Income (JGH) saw coverage fall to just 96%, from 100% the month before and 102.2% in September.  UNII has been improving, however, but that may stop soon.  

  • All in all, we do not see a ton of risk of cuts on the Nuveen taxables unless trends have continued in December and management sees a reasonable expectation of that trend continuing for some time.

On the Nuveen Muni side, coverage remains strong with the average national fund at 104.2%, up slightly over October.  On the UNII side, the average national fund is on the verge of breaking below -1 cent for the first time since May 2017.  This would be a great step forward for these funds as they've struggled over the course of the last year.  

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Again, we will have a full update on the muni side coming out shortly. 

MFM Annual Report (MFS Funds)

This past week, MFS Municipal Trust (MFM) released their annual report through October 31.  The reason this is important is that their "high yield" muni funds are all relatively similar but MFMs fiscal year end date is a month prior to MFS High Yield Municipal (CMU) and MFS High Income Municipal (CXE).  This is similar to Pioneer which has two similar municipal funds that have a one-month offset in fiscal year -end.  We reported on that (MHI) vs. (MAV) last month.  

While we plan to update the entire muni space in about a week, we wanted to focus on these funds in particular because they look especially compelling.  Below is the updated portfolio breakdown for MFM based on credit quality.  While it is a high income fund, it does have 78% of the total assets in investment grade, plus another 60% in either non-investment grade or not-rated.  

*A quick sidebar here, in the muni space, unlike the taxable bond space, just because an issue is unrated doesn't necessarily mean that the bonds are "junk".  But often small municipalities do not want to pay to have their bonds rated (it is not economical) and they know they will not have a problem selling them at an appropriate interest rate.  

The duration of the portfolio is identical to the other high yield funds (CXE and CMU) around 9 years with similar average coupons.  

Below is the breakdown of the top 5 sectors of each of their muni funds.  You can see that CXE, CMU, and MFM all have hospitals as the top exposure industry.  

The fund outperformed the muni index (Bloomberg Barclays Municipal Bond Index) with a total return on NAV of 1.5% vs. -0.51%.  Despite rising leverage costs, the fund did benefit from the use of leverage which is derived from variable rate muni term preferred shares.  

The fund does have a partial hedge on to reduce the duration of the portfolio through the use of futures contracts on the 30-year treasury bond.  The notional value amounts to just $7.3 million and the contracts expire this month- it remains to be seen if they roll them.  

Net investment income in the period ending October 31 was $15,337,740 versus $16,175,979 last year.  Net realized gains were also down this year to $118K from $2.4M.  The fund earned 37 cents per share in net investment income and paid out 37 cents in distributions to shareholders (100% coverage).  While realized and unrealized gains were lower again this year resulting in the lower NAV overall, ($7.10 vs. $7.36 on Jan 2).  Net investment income, while trending slightly lower over the last five years, hasn't moved all that much [$0.41 in 2014, $0.42 in 2015, $0.41 in 2016, $0.39 in 2017, and $0.37 in 2018].  

Concluding Thoughts:

The financials of MFM look solid without the same amount of degradation that we've seen across other muni funds this past year.  This bodes well for the other two "sister" funds CXE and CMU.  For example, CXE today yields a hefty 5.86% distribution yield which, if in the top bracket, is equivalent to a 9.90% yield on the taxable side.

Remember, the distribution is more variable- a trait of MFS closed-end funds.  In other words, MFS adjusts the distribution more often to equate it to actual net investment income.  This avoids the massive distribution cut that some CEF sponsors have had to do in order to right their ships.  

The current discount is exceptionally wide at 11.4%.  We believe this is due to the fact that after not adjusting the distribution for 8 months, they have reduced the distribution two months out of the last three.   The total of the two cuts has been 6.25% and for the year has been 10%.  Over the prior twelve months, the fund has earned 3.1 cents per month compared to the current payout rate of 2.25.  UNII is now over 4 cents.

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