Weekly Commentary | January 6, 2018

The big news on the week was the jobs number that came out on Friday showing a surprising 312K new jobs created in December.  In addition, the two prior months were revised higher.  The unemployment rate did tick up to 3.9% because of a boatload of new entrants to the workforce.  On the news, stocks rallied fiercely as did interest rates which hit a 10-month low earlier in the week.  

The other key data points came on Thurday from Apple (AAPL), which warned on their first quarter results, and ISM.  ISM Manufacturing index unexpectedly fell sharply to 54.1 compared to an expectation of 57.5.  The number is still above 50 indicating expansion but the steep drop in the new orders component of the index (a leading economic indicator) definitely spooked investors.  

We also had two former and the current Fed chairpeople hold a panel discussion at the American Economic Association.  The event was expected to be largely benign but early on, Fed Chairman Jay Powell read some prepared notes saying that the Fed would be "patient" in raising rates.  That helped spark the markets. 

All in all, it was an excellent week for risk assets as the S&P 500 rallied 1.90% despite it being a short week.  Small caps did the best rising 3.22%.  Bonds also rallied with the AGG up 0.46% and munis up 0.37%.  

The VIX also hit multi-week lows which is supportive of closed-end fund discounts.  I think if we can break the 18-area, we could be in the midst of a nice rally and have the lows behind us.  

The 10-year rate hit a low of 2.55% during the week, down 70 bps from the highs set in October.  I do think this is the interim low for the rate and that we could see it move back towards 2.80-2.90% fairly quickly- especially if the VIX continues lower below 18.  

The largest headache for the markets has been the Fed and trade worries.  Both seem to be on the wane as Powell has softened his message- something we said was assured after the Dec 14-15 FOMC meeting.   On trade, the spat has been improving slowly ever since the G20 meeting.  Talks resume next week and expect a more conciliatory tone out of the WH following Apple's warning that the trade war was- in part- to blame for their figures.  

JPM- Major events investors are watching over the coming weeks (in order of importance): 1) earnings – more than anything, the CQ4 reporting period (including the mgmt. commentary on the conf. calls) will determine whether the SPX hangs out between 2400 and 2500 or attempts to recoup some of the Dec slump. Earnings kick off w/Citigroup on Mon 1/14 but the season will drag on into Feb; 2) the Fed – the next big events include minutes from the 12/19 FOMC meeting (Wed 1/9), remarks from Powell at the Economic Club of Washington (Thurs 1/10), and the US Dec CPI (Fri 1/11); 3) US economic data – investors will be looking very closely at the upcoming eco numbers for Jan, esp. the Fed surveys and PMIs/ISMs to see if trends rebound from Dec. Empire is out 1/15, Philadelphia is 1/17, and the flash PMIs (for the US, Europe, and Japan) will hit on 1/24. The first look at US Q4 GDP arrives on 1/30; 4) China economic data – imports/exports for Dec hit on 1/14 but the next big round of Chinese eco data arrives on Mon Jan 21 (Q4 GDP along w/Dec retail sales, IP, and FAI) followed by the Jan NBS PMIs on 1/31; 5) US/China trade – investors increasingly anticipate a final détente but nothing has been set thus far. The next round of negotiations is scheduled for 1/7-8 (in Beijing) followed by meetings in Washington later in Jan or early Feb. The ceasefire expires 3/1 but that can always be moved back so long as progress is occurring; 6) Trump – he will travel to Davos for the WEF (1/22-25) and the State of the Union is scheduled for 1/29. Meanwhile, media reports suggest the Mueller probe could be wrapped up by mid-Feb.

The big economic data point will be out tomorrow morning with the ISM non-manufacturing PMI and factory order data.  It will either confirm the slowdown indicated in the manufacturing PMI released last week or show that it's an anomaly.  

Expect the rally in rates to reverse and the 10-year to reverse course and head back towards 2.9%.  That could weigh on muni returns which have been strong in the last couple of weeks.  But the opportunity in that space remains strong given the massive discounts and need for tax-free income amid waning supply.  

Weekend Reading:

Jim Sloan:  How To Read 2019 Forecasts

Fear & Greed Trader

Closed-End Fund Analysis

Distribution Increase (greater than 2%)

Invesco Senior Income (VVR): Monthly distribution increased 7.7% to $0.021 from $0.0195.

Distribution Decreases (greater than 2%)

Lazard Global Total Return (LGI): Monthly distribution decreased by 23.2% to $0.089 from $0.116.

Lazard World Div & Inc (LOR): Monthly distribution decreased by 21.7% to $0.058 from $0.074

RiverNorth Opp Fund (RIV):  Monthly distribution decreased by 19.1% to $0.17 from $0.21

Delaware Enhanced Global Div & Inc (DEX): Monthly distribution decreased by 4% to $0.091 from $0.0945.

Delaware Dividend and Income (DDF): Monthly distribution decreased by 4% to $0.091 from $0.095.

MFS Special Value (MFV): Monthly distribution decreased by 3.6% to $0.0436 from $0.0452.

MFS CA Muni (CCA):  Monthly distribution decreased by 2.86% to $0.034 from $0.035.

MFS High Income (CIF): Monthly distribution decreased by 2.34% to $0.01919 from $0.01965.

Activist Alert:

Saba is building a position in Western Global High Income (EHI) with $5.327M shares, 11.9% of the outstanding, a 127% increase from their previous filing.  The fund was also removed from the YYY ETF which could have helped produce a wider discount.  

Tender Offer

Nuveen Taxable Muni Income (NBB):  The fund's tender offer measurement period from December 14th to December 28th concluded.  The merger agreement for the elimination of the term provision, name change, and shift in investment policy announced in November stated that if the fund was at a discount during the measurement period, it would conduct a 20% tender offer.  The fund's average discount was 7.97%.  

  • Accordingly, the fund will conduct a tender offer and will purchase up to 20 percent of its outstanding common shares for cash at a price per share equal to 100 percent of the net asset value determined on the date the tender offer expires. The net asset value that shareholders receive will be net of a repurchase fee which is estimated to be less than $0.03 per share, assuming the tender offer is fully subscribed. The fund currently expects its tender offer to commence on January 14, 2019 and expire on February 12, 2019, unless extended.

Statistics

Core top and bottom 5 movers in respective categories:

Entire CEF universe weekly movers:

3.PNG

Commentary

CEFs rallied hard this week thanks to a risk-on attitude plus the change in the calendar moving us out of tax loss harvesting season.  The list below shows the sectors (as indicated by CEFConnect) and the NAV and price changes in the last week.  

  • The big winner on the week were MLPs as oil rallied and the severely beaten up sector recovered a bit.  Prices there were up over 11% with NAVs up 6.9%.  

  • Preferreds were also up nicely rising 1.91% on NAV.  We suspected that there was a lot of retail tax loss selling in November and December causing a dislocation in prices.  This could be the start of a reversal.  We still like playing this from the individual side.  (again, new report out this week).

  • Taxable Munis saw not a ton of NAV movement higher (+0.15%) but there was definitely buying as prices rose by 1.81% closing discounts by 1.55%.

  • Tax-free munis fared better with NAVs rising 0.50% and prices jumping 2.57%.  Almost 2 points of discount closing were realized last week.  Single state munis did even better with 2.73% of price appreciation.

  • High yield saw both NAV and price rally along with equities jumping higher.

  • Floating rate also saw a nice boost with NAVs rising by 1.52% and prices jumping by 3.02%- in a week!!

4.PNG

As we suspected, CEFs rallied hard in the first week of January.  We expect this could be a substantial January effect this year (there wasn't much of one last year).  The wide discounts could close further but in the first week, we have already surpassed the average January effect realized over the last 20 years.  

The moves in floating rate funds were especially welcoming and hopefully they continue.  Check out Nuveen Floating Rate Income (JFR):

Both the price and NAV jumped this past week as we suspect money finally stopped or slowed flowing out of the leveraged loan space.  Other floaters have jumped as well.  TSLF for example, is up 6.6% since Christmas ever.  JSD is one of the best up over 8%.  DSU is up over 5%, ARDC is up 4.7%.  Others haven't jumped nearly as much:  AFT +2.6%, BGX + 1.2%, BGB +3.4%.  HFRO, which was one of our top picks for January is up 8.8% (some of this return came before we recommended it). 

Volatility is likely to remain the name of the game this year Investors need to assess their true risk tolerance in light of the last three months.  Many CEF newbies were shocked by the price volatility and others by the NAV volatility as this was their first experiences.  If we have another week or so of this kind of rally, we would be using it to reduce overall risk levels and improve credit quality and/or augment safe buckets.  The cycle is likely to be over in the next 9-18 months.  As such, adding protection and improving overall portfolio quality will be the name of the game in 2019.  

We will be doing a full muni review as well as an individual preferred review this week.  As noted above, we do think interest rates will move back up.  The muni sector is hot right now as it is a safety trade.  Those looking to add here should consider simply adding existing holdings or even a broad ETF as it is more important to have exposure to it over worrying about the perfect fund choice.  Distribution cuts won't be announced again until February 1, more than 3.5 weeks from now.  

First Trust Inter Duration Preferred (FPF) Annual Report

FPF recently issued their annual report for the period ending October 31, 2018.  The preferred space spent most of the year in negative territory thanks to the rising interest rate environment we had been in.  But even when that reversed course in the last two months of 2018, preferreds sold off again as tax loss harvesting and credit risks were the catalysts.  

The NAV for FPF over the trailing twelve months through October was -2.23% compared to the benchmark of -1.67%.  The main under-performance of the fund is because of leverage- both because of decompounding but also because of leverage costs rising.  For the fiscal year, the retail market fell 1.23% while the institutional market lost 2.14%. 

As we noted about a month ago, there was an emerging opportunity in the individual preferred stock space as retail investors sold off anything in the turmoil of the market.  FPFs management noted that they also saw this opportunity in the retail preferred space ($25 par).  

The fund's performance was aided by the floating rate allocation as well as the hedging strategy- primarily interest rate swaps.  Performance was negatively effected by the international holdings including UK, Italy, and other European banks.  Only 43% of the holdings are U.S. with the majority of the remainder coming from Europe (UK 11.6%, France 10.3%, Italy 5.6%, Canada 5.2%, etc).  

This is why we have been favoring individual U.S.-based preferred stocks over the funds.  For one, you do not have the leverage problem where by interest expense is rising much faster than earnings from holdings.  Second, the rising dollar and weakness in Europe does not become a factor like it has for FPF.

Fundamentals:

Net investment income fell by $8M to $105.2M (-6.9%) or $0.144 per share per month.  The current distribution is $0.1425 for a coverage ratio of 101%.  But in all likelihood that earnings figure was not static but under a falling glide path through the year.  Leverage costs as a percentage of net assets rose to 1.16%

The fund cut the distribution last May (April announcement) for the second year in a row.  It is certainly possible that they may do this again this spring as current earnings are likely under the current distribution rate.  

The fund has closed its discount materially in the last month going from a 15+% discount to just 5.8% as of Friday.  That rally has helped close the negative performance over the last three months to just 1.28%, down from over 6% not long ago.  

At these levels, the fund is not very attractive, especially relative to individual preferreds which continue to trade far below par.  We will be doing a full review of the preferred space next week.  

Ares Dynamic Credit Opportunities (ARDC) Annual Report

The fund recently released its annual report (yesterday) and we read through it to see if there was any material changes, red flags, or highlights worth mentioning. 

Over the last year, the fund increased exposure to bonds by 236 bps in order to increase income production.  During periods of volatility, they have picked up longer-dated, higher-quality bonds that have sold off.  On the loan side, despite the increase in libor by 1.18% over the last twelve months, they have decreased their exposure by 5.21% to the space.  This was because the majority of the loans in the loan market were trading above par.  They believed the potential for loan repricing was high and saw bonds as being the cheaper relative value.  

They also increased their CLO debt and equity exposure by 139 bps and 221 bps, respectively.  Management believes they have opportunistically adding double-B tranches and some secondary equity positions at good values.  Duration is still very low at 1.5 years.  

CLO comments:

In regard to the CLO market, difficult arbitrage conditions have slowed the pace of new issue supply in recent months. While year-to-date 2018 global issuance of $140.6 billion is tracking in line with full-year 2014 issuance of $143.0 billion (a record year), there exists today something of a "buyers strike" on primary issue CLO equity. The proximate cause of all the trouble is the CLO debt spread widening stemming from heavy refinancing and reset activity, which stood at $161.1 billion across 326 deals year-to-date as of October 31st. This supply has weighed heavily on primary issue spreads, making arbitrage conditions persistently difficult. Triple-A spreads have also been affected by higher hedging costs for non-U.S. investors, especially Japanese investors who have seen deteriorating relative value in U.S. CLOs vs. European CLOs as a result. Until and unless CLO debt spreads contract, we expect relatively modest new issue activity through year-end.

In terms of the fundamentals, net investment income (NYSEMKT:NII) was virtually unchanged in the latest fiscal year compared to the year prior.  However, that is where the similarities between the funds ends.  Realized gains on investments and currencies was $+4M compared to $+1.6M the year before.  However, unrealized gains/losses was down $16.8M in 2018 versus a $+18M gain in 2017.  So while net assets rose $22M in 2017, it lost $11M in 2018. 

NII per share has been very stable and while unrealized losses have increased this year, not surprisingly, as spreads have blown out.  

Distribution coverage increased to 104.4% so no distribution cut is likely in the near-term.  UNII is $0.12 which is highly supportive of the distribution as well. 

Concluding Thoughts

ARDC put up another solid report and the distribution is very safe at this point.  The NAV fell during the last two months of 2018 like all risk assets did with the NAV down 5.76% in the fourth quarter.  We've seen a capitulation trade in the shares back on the 21st when the discount fell to 20%, from 14% the week before.  

The current discount is attractive still at 15%+ compared to the one-year average close to 10% and the 3-year average of 11.5%.  The distribution yield is also very compelling for the risk at 9.3%.  

We would not hesitate to add to the position here.

--------------------------