Weekly Commentary | January 13, 2018

The markets continued to repair themselves although by weeks end, appeared a bit tired.  The strong start to 2019 of course only has materialized after a very weak fourth quarter in 2018- including a rare non-recessionary bear market.  

Stocks were up for the third consecutive week with small caps outperforming finally allowing the Russell 2000 Index to emerge from bear market territory.  The S&P was up 64 points or 2.47%.  Volatility also continues to moderate with the VIX hitting the lowest levels in a month and ending the week near 18.  We are now more than half way from the pre-October levels.  

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Much of the healing has been due to hopes that China and the U.S. will come to an agreement or at least make significant progress towards one.  Talks began on Monday and were expected to last for 3 days.  

Meanwhile, the partial government shutdown rolls on but hasn't seemed to impact the market.  Now in its third week, there is still only small hope that a resolution is near.  The impact on the economy and the markets remains marginal although that may change. President Trump is likely to use his emergency powers to get the border wall built and re-open the government before any real damage is done.

The Fed speakers this week reiterated the dovish tone signaling that they are on hold until further notice.  Chicago Fed Chief Charles Evans was probably the most influential and important.  He has been an avowed hawk (favoring higher rates).  This week he came out and stated the FOMC would be watching the data for the next six months before deciding again on rates.  This seems to indicate that the March hike is being 'skipped' and that June is the likely next move.  He also stated that it was "noteworthy" how much focus the market has placed on the balance sheet suggesting that some changes to it being on auto-pilot could be in store.  

Interest rates moved up after reaching 2.55% on January 3rd.  This compares to the 3.23% hit two months earlier.  Today, the 10-year sits around 2.70%.

Now we turn to earnings season which continue to get marked down providing pressure on the index.  At the start of November, the S&P EPS estimate for 2019 was $178.  We have already seen that decline to $170-$173.  While it doesn't appear to be much, applying a 15x multiple to the variance equates to 120 points on the S&P or nearly 5%.  

During the final two weeks of Christmas, some figures did fall into the $160s but those have since been revised back up to the $170 area.  Assuming a 15x multiple on means that the S&P target is around 2550 on the low end.  Using a 16x multiple would push us up to 2,720.  That appears to be our near-term range.  Of course, if numbers get revised back up, the 'ceiling' will be much higher.  

Bottom line, the fourth quarter was probably correct on the narrative with a lot of headwinds but was likely incorrect in magnitude.  That is, all the negatives that existed (slowing growth, tightening monetary policy, trade wars, fiscal issues, earnings, and political uncertainty) were apparent and not gone today but the move was too violent, overstating the immediacy of the risks.  I personally blame ETFs and algos for exacerbating the moves.

Closed-End Fund Analysis

Distribution Increase

RiverNorth Doubleline Strategic Opp (OPP):  Monthly distribution increased by 22% to $0.1833 from $0.15.

Eaton Vance Enhanced Equity Income II (EOS):  Monthly distribution increased by 13% to $0.0988 from $0.0875

Clough Global Eq (GLQ):  Monthly distribution decreased by 6.5% to $0.1043 from $0.1115.

Clough Global Opp (GLO):  Monthly distribution decreased by 5.6% to $0.0829 from $0.0878.

Clough Global Div & Income (FLV):  Monthly distribution decreased by 4.3% to $0.1003 from $0.1048.

Eaton Vance Enhanced Equity Income (EOI):  Monthly distribution increased by 4% to $0.0898 from $0.0864

Distribution Decrease

Eaton Vance Tax Managed Global Buy-Write (ETW):  Monthly distribution decreased by 20.1% to $0.0727 from $0.091

Eaton Vance Tax Managed Global Div Eq (EXG):  Monthly distribution decreased by 19% to $0.0616 from $0.076.

Conversion Price For SPE

Special Opportunities Fund (SPE):  The fund announced that because of the 2018 year-end cash dividend of $1.45, the conversion price for each share of preferred stock decreased from $16.86 to $15.41.  Holders of the convertible preferreds and whom elect to convert it to common would receive 1.6223 shares of common.  The fund's board may elect to call them at $25 per share as they recently passed the earliest call date.  

Activist Activity

EV Limited Duration Income (EVV): Saba continues to build a position with 6.28M shares, 5.41% of the fund's outstanding.

First Trust High Income LS (FSD):  Saba is now building a position in FSD with over 2M shares or 6.02% of the total outstanding.  

Statistics

Stats of just Core Portfolio funds for the week:

Statistics for all closed-end funds:

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Commentary

The snap back in discounts that we have witnessed in the last few weeks has been the most jarring in memory.  Z-scores continue to heal with the average across all categories at -1.13.  Across all bond and stock categories, real estate is now at the widest discount at 13.8%.  The multi-sector bond category is back to a premium thanks to DMO, PTY, PDI, and a few others. 

Dividend equity funds saw a 7% move on average last week, the largest of any sector.  NAVs of that category were up 3.95%.  The weakest sector was taxable municipals which, on average, saw approximately 39 bps of price decline and 28 bps of NAV decline.  Tax-free munis were also down slightly on NAV (-17 bps) but saw significant discount closing with the average price up 1.83%.  This is exactly what we were thinking would happen.

MLPs were the big winner on a NAV basis rising 8.87% on the week with prices up 6.42%.  All energy did well again last week with the equity energy and resources category rising 4.85% on price and 4.89% on NAV.  

We continue to closely watch the senior loan (floating rate) category which had another good week returning 1.08% on NAV and 1.79% no price, closing the average discount by 71 bps.  NAVs did decline on Thursday and Friday as the index saw some mild weakness again.  

Preferreds, the other category we have been fond of lately, especially on the individual side, saw strength again this week despite interest rates moving higher.  The category's average price was up 2.90% and the average NAV was up 2.05%.  

Some z-scores are a bit expensive here.  EV Enhanced Equity II (EOS) recently raised the distribution which isn't really a surprise given the move in the NAV the last few years.  With a big cap tech bent, the fund has benefited from Amazon, Google, Facebook, and others.  While those stocks are down from their peaks, they still have significant gains in them over the prior five years.  Check out Voya Global Equity Div Prem Opps (IGD) for a possible replacement.

The game plan for 2019 will be a steady de-risking of the portfolio as we near the end of the cycle.  For example, on the chat we discussed floating rate securities.  They have moved higher significantly in the last couple of weeks from a severely oversold position.  But once closer to par, we will likely trim that exposure significantly as short-term interest rates are unlikely to head significantly higher.  

On Friday, I did sell out of my DMO position given the sharp move higher (it hit a preset limit order price) along with about 10% of my PCI position (~2.6%).  I'll continue to opportunistically trim that position back to the target weight (18%) over the next week or so.  I do think that given the ex-distribution date being Friday, we could see a bit of a pull back in the PIMCO CEFs in the first half of next week.  

Blackrock Credit Allocation (BTZ) Annual Report

The annual report for BTZ came out a few days ago.  We'll go through some of the changes and any red flags that are evident.

  • Leverage ticked up 1% to 33%

  • The corporate bond allocation increased to 74% from 69%

  • Credit quality improved slightly to 72% IG from 71%

  • Net investment income was virtually unchanged in the last year

The company did utilize the share repurchase program to buy back nearly $31M of shares during the year.  That is up substantially from the prior year's $8.8M in repurchases.  Overall in the year, net assets fell by $158M driven by the change in unrealized values (depreciation of assets) from wider spreads and higher interest rates.  

The decline of total net assets is approximately 9.9%.  That was offset by some of the timing of distributions and other factors.  The fund earned on a net per share basis $0.81 and paid out to shareholders $0.80 covering the distribution.  This is the first year without a return of capital since 2014. 

Total expenses continue to tick up from 1.23% to 1.82% as interest expense (borrowing costs) have increased.  

The fund has increased its derivative positions but it is still relatively small compared to total fund assets.  They have a very small long position in the 2-year and 5-year treasury note space.  But they have some short futures positions in the 10-year.  

Overall, no red flags or big changes in the last year (or last several years).  This fund tends to set it and forget buying an array of credit quality corporate bonds with 4-8 years to maturity.  The effective duration of the portfolio is 5.8 years.

We're not overly wild about the industry breakdown with 21% coming from the banking sector, 14% from communications, and 13% from energy.  Of all the industries we dislike currently, that is three of them (add in utilities).  

Coverage in November was 102% (December numbers out in a couple of weeks).  UNII grew in the last month to 1.1 cents.  

Concluding Thoughts

This is a generic way to gain access to the corporate credit market with plain vanilla corporate bonds to mostly higher quality companies.  The credit quality breakdown remains decidedly investment grade with more than half of the portfolio in the BBB-rated debt.  That is debt that resides at the lowest rung of the investment grade category and could be downgraded in the next crisis. 

I did go through the holdings and there weren't any significant holdings of the larger bad players.  There was no holdings in AT&T (T) and only one smaller position (0.25%) in General Electric. The fund also has a small allocation to the upper tranches of some CLOs.  

PIMCO Comparison Report

We created a spreadsheet to compare the PIMCO taxable CEFs.  There is a lot of confusion about the funds many of which are primarily different flavors of the same multi-sector exposure you would get in the open-end PIMCO Income (PONAX) fund.  

We will likely have this in the tools drop down fairly soon.  

The non-agency MBS totals are down approximately 15-20% over the last several months.  We are trying to find out why they are reducing that allocation and where they are adding.  Right now it appears that high yield and emerging markets are the beneficiaries of that capital.  

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