Weekly Commentary | January 20, 2019

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Stocks notched their fourth consecutive week of strong gains and built on their YTD figures.  The S&P 500 is now out of correction territory (down less than 10% from the peak).  The Nasdaq and small caps remain in correction territory.  We saw technology and financials lead the market while utilities and consumer staples lagged, something you want to see for a healthy market.  The S&P 500 is now up 6.54% YTD, the NAS +7.87%, and Russell 2000 (small caps) +9.80%.

The trade front saw further movement towards a resolution and sentiment continues to improve.  China trade officials offered to eliminate the country's trade surplus by 2024 but U.S. officials want it to be done sooner.  

Interest rates continue to rise back towards 3% (something we said was highly likely) and we do see the 2.90% area as a near-term target.  Given that the economic data is not nearly as dreadful as the markets and the media portrayed it, it made sense that bonds would sell off when the market began to recover.  Investment grade and high yield bonds also saw spreads tighten during the week as the high yield market saw the largest weekly inflow in almost two years.  

HY spreads are down to 4.4% and continue to slowly revert back towards the levels we saw in September.  The effective yield of the Master II index is now sitting right on 7%.  

The VIX (volatility index) continues to subside back towards normal levels hitting 17.8 after peaking on Christmas eve at 36. 

And the correlation with oil hasn't ceased with WTI rising another $1.20 this week to $53.10.

Spreads on the yield curve continue to meander instead of showing signs of further tightening.  The 10s-2s spread hovers in the teens.  While that is not a lot of cushion, the trend perhaps is showing that a recession is not imminent.  

Concluding Economic Thoughts

All in all, it was another solid week of recovery.  The bears are still out in force touting how this is a dead-cat bounce but as each session passes, it is looking less and less like it.  The media is hounding on Brexit, trade deals, and the government shutdown.  But in reality, none of those things matter to the market.  The market is being driven the 1) the Fed, and 2) technicals.  That's it.  However the media can only spend so much time on the Fed (which is also a dry subject) and technicals.  

The events in Europe are likely to play a role in our markets down the road but right now, the unfolding proceedings are just too nebulous.  The end-result is still far too unclear to matter.  When the populist uprisings in UK, France, and Germany (and soon to be Italy) foam to the top, we will likely see some reverberations in our markets.  Until then, they are just a sideshow.

Our markets only care about the Fed.  And with the multitude of Fed officials hitting the speaking-circuit in the last few weeks, all talking pause or doves or lower for longer, it is no surprise that the markets have responded favorably.  Even the most hawkish have come out and surrendered their hawkish tone in factor of "data dependence".  

The cherry on top came this week when Esther George, the Kansas City Fed President, stated that "we are close to neutral" and "we should proceed with caution and be patient as we approach our destination."  

If the Fed is close to the end of its tightening journey, then why are long-term rates rising?  Clearly, like the stock market, there was an overshoot in the flight to safety which sent the 10-year yield all the way to 2.56%, from 3.25% only two months prior.  It is looking more and more that lower for longer dovish policy is back- at least for a short while.  That would be highly supportive of NAVs of bond CEFs.   

Closed-End Fund Analysis

Distribution Increase (over 3%)

None

Distribution Decrease (over 3%)

None

Activist Trading - Buying

Nuveen Credit Strategies (JQC):  Saba continues to build a position and now owns 14.2M shares or 10.5% of the outstanding.  (more below)

Nuveen OH Quality Muni Income (MUO):  Ancora Advisors LLC owns 920K shares or 5.02% of the outstanding.  According to the 13D, they only believe the shares are undervalued.  

Mexico Fund (MXE):  City of London Investment Group own 3.59M shares or 24% of the outstanding, a 29.8% increase.  

Invesco Dynamic Credit (VTA):  Saba Capital owns 4.7M shares or 6.37% of the outstanding.  

Invesco High Income II (VLT):  Saba Capital owns 1.17M shares or 14.5% of the total outstanding.  A 10.2% increase.  

Western High Income (HIO):  Saba Capital owns 13M, or 10.1% of the total outstanding.

MS China A Share (CAF):  City of London Investment owns 2.36M shares or 10.8% of the outstanding.  

Nuveen Muni 2021 Target Term (NHA):  Karpus Management owns 924K, which is 10.7% of the outstanding.  

MFS Govt Market Income (MGF):  1607 Capital Partners owns 5.25M shares or 16.1% of the total outstanding.

First Trust Client Portfolio Trading:

Buying:  LOR, ETJ, KTF, MFM, JTD, NCA

Selling:  MFT, DMF, VVR, JHI, BWG, MSD, MMD, DIAX

Tender Offer

Nuveen Taxable Muni Income (NBB):  The fund commenced its tender offer commencement period which will expire February 12th.  They are tendering 20% of the outstanding shares (an effort to get their fund to a perpetual trust as it was slated to liquidate next year).  The tender is at NAV minus a net repurchase fee which is estimated to be less than $0.03 per share, assuming a fully subscribed tender offer.  

China Fund (CHN):  The fund announced an extension of their tender offer for up to 30% of the fund's outstanding shares.  The tender is at 99% of NAV as of the close of regular trading on the business day immediately following the day the offer expires- February 5th.

Closed-End Fund Commentary

Funds from the Core CEF lists that have made the largest price moves, NAV moves, largest discounts and premiums, and lowest and highest z-scores.

Funds in the entire CEF universe that have made the largest price moves, NAV moves, largest discounts and premiums, and lowest and highest z-scores.

Discounts are continuing to recover as indicated by the chart below.  They have nearly reached the levels achieved in early October.  At a 4.99% discount, it is nearing the one-year average of 4% and is close to the 5-year average of 4.59%.  

More importantly, NAVs are showing strong recoveries as well.  We are seeing investors take advantage of the double-discounts apparent in the CEF world with the underlying bonds at a discount to par and the fund itself at a discount to NAV.  Thus, when the underlying bonds start to appreciate, you get a compounded snap-back.  

I spent some time looking at what Saba has been doing including what they hold in their ETF (CEFS).  While our Core Portfolio has significantly outperformed the ETF over the last year, it could help to cherry-pick some of their best ideas.  For instance, Nuveen Credit Strategies (JQC) is their top holding.  They recently pushed for a new capital return program.  

The holdings for the fund are below with JQC, HIO, and GHY at the top of the list:

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They continue to build positions in JQC, HIO, and EHI. The Saba track record for activism in CEFs has not been great.  Karpus and Bulldog are far more effective in pushing for change and winning.  In my mind, Saba has too many pots on the stove to be as effective on a percentage basis. 

PIMCO Commentary

The monthly release of the PIMCO UNII and EPS report was released this week showing some improvement to the muni side and a mixed report on the taxable.  In December, 7 of the 9 muni funds saw equal or improved coverage and UNII ratios.  On the taxable, 7 of 11 funds saw improvement on coverage ratio with all UNIIs flat or down due to the special distributions paid out last month.  

The average coverage ratio fell for the second straight month to 104.5%, from 116.3% in October.  The fourth quarter did see general weakness across most of the sub-sectors in their taxable CEFs including non-agency MBS, high yield, floating rate, and emerging markets.  

In terms of the absolute coverage ratios, PIMCO Credit and Mortgage (PCI)continues to run higher at 192%, up from 173% last month and 127% in September.  To us, it is likely that the fund has taken off their interest rate hedges that were betting on higher rates and cashed in the gains.  That does flow through net investment income ("NII") on these monthly UNII and EPS tables as they are done on a tax basis, not GAAP. 

PIMCO Dynamic Income (PDI) did not see as much of a coverage bounce.  It could be that they have not taken off the same hedges or simply did not have them in the first place.  Or, PDI has an at-the-market offering (essentially issuing new shares slowly into the market increasing share count).  As the fund increases in size, they may be leaving some of the hedges on as they will naturally decline as a percentage of the total portfolio.  Given the weakness of non-agency, HY, and EM debt, the lower coverage is not a surprise.  

On the muni side, the bleeding on UNII has abated slightly in recent months.  Of note is PIMCO CA Muni II (PCK) which swung from a -6 cent UNII to +1 cent as coverage rose over 100%, from 91.5%.  That caused us to change the rating on the muni core tab from 'hold' to 'accumulate'.  The price has run up in the last few weeks (like most muni CEFs) and is about 11 cents above our price target for a buy rating.  

The 3-month stacks (essentially the 3-month average vs. the 3-month average from 3-months ago) are showing much reduced changes recently.  Most of the PIMCO muni CEFs are down to the low-single digits in terms of UNII movement.  This compares to double -digit declines that we were seeing for most of the last two years.  But this is to be expected.  

The chart below is from a recent CEFAdvisors webcast showing relative UNII trends going back 6 years.  The recent flattening is to be expected as most muni CEFs have cut their distributions- in some cases significantly- in the last two years.  While calls have been forcing that for the better part of a decade, in the last two years muni CEFs have had to also contend with rising leverage costs- a one-two punch!

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We have discussed this long-term secular cycle that muni CEFs have been in for some time.  They pay out a high distribution rate, refusing to make a cut until they absolutely have to, draining the UNII balance.  As bonds get called away with new bonds yielding far less than bonds issued ten years ago, they are forced to cut the distribution.  At which point, coverage goes back to 100% or higher and UNII balances stabilize.  Then, the cycle begins anew as calls eventually eat away at coverage again.

In aggregate, the muni CEFs have been doing better lately and we like the setup for them going into 2019.  We did last year as well and the first half of the year clobbered us, only to be redeemed later on.  The PIMCO muni CEFs have rallied strongly recently and z-scores, which were soundly negative earlier this year, are now showing slightly expensive.  

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PIMCO Municipal Income II (PML) has run from an 8% premium to almost a 15% premium in the last couple of months.  In terms of municipals, there is much less transparency into the holdings compared to most other fund sponsors.  We get little in the way of call schedules, coupon yield, or most importantly, credit quality breakdown.  All they report is state breakdown, sector breakdown, and % in Puerto Rico.  If we go back to the Merrill Lynch CEF report from early May, Lanik (the analyst) appears to have put the holdings from the annual report into Bloomberg to get that data.  That output shows a lot of calls for 2018  and 2019 totaling 19% through May 2019.  Credit quality is also showing three-quarters investment grade and one-quarter non-investment grade.  

The fund pays out far above what it earns but continues to wind down its UNII bucket.   The UNII figure was 40 cents at the start of 2017 but has bled lower to the current 24 cents.  It was burning off over 1 cent per month for a while but has since been able to slow that burn losing only 1 cent since September.  That pushed out the date for when they would need to do a substantial cut to the payout.  

We prefer, from a fundamental standpoint, PIMCO Muni Income (PMF)currently as the fund is covering the distribution and has stabilized, and recently growing, UNII.  The yield is 5.48% tax free and the NAV has performed well.  Of course, the market has recognized this and sent the shares to over a 6% premium.  Watch this one and stagger your buys at or slightly above par.  

We would be cautious on two of the PIMCO NY munis, PNI and PYN along with PMX among the nationals. 

Getting back to the taxables, we recently launched our PIMCO CEF Comparison Sheet.  This is a quick and easy way to compare the differences in sector allocations of the multi-sector funds (PCI)(PDI)(PCM)(PCN)(PTY)(PKO)(PFN)(PFL).   For simplicity, PCI/PDI/PKO are very similar funds.  Then you have PTY/PCN/PFN/PFL being similar.  After that, you have PCM, which sits between the former funds and the higher-yielding, higher risk funds of RCS, PHK, and PGP.  PIMCO StocksPlus (PGP) is essentially is similar to PFN but with a long futures position in the S&P 500.

We would avoid PIMCO Strategic Income (RCS) which has rallied strongly but is likely going to need a significant distribution cut this year.  As a reminder, this fund is attempting to reclassify the way they account for mortgage rolls for income tax purposes.  PIMCO wants to classify them as a sale or exchange to use up their tax loss carryfowards in the fund.  This would increase the proportion of the distribution that would be classified as return of capital.  While most shareholders will sell because of the likely massive distribution cut, it is good for investors over the long-term.  Why is that?  The current payment is likely already ROC but being taxed to them as ordinary income.  So while it will benefit them long-term, in the short-term the price is going to get creamed.  

For the first crop of PIMCO CEFs including PCI and PDI who are exposed primarily to non-agency MBS, they struggled in the fourth quarter along with everything else.  This despite the fact that they were able to ignore the high levels of volatility earlier in the year.  Even with the slowing housing market and weaker prices, continued payments towards loan amortizations continues to reduce loan-to-value ratios.  The likelihood of default should another severe downturn occur characterized by skyrocketing unemployment is reduced.  

The non-agency MBS market is now down to approximately $400B, from $500B earlier this year, and $2.1T as the crisis began.  In addition, new issuance is starting to pick up for the first time since the crisis, exceeding the roll off from legacy issues.  This could be why PIMCO chose to reduce their allocation to the space.  Or, given how high yield, leveraged loans, and emerging market debt had been decimated in the fourth quarter, perhaps they see better relative value compared as non-agencies fell far less.  

With high yield spreads and leveraged loans recovering, we still believe the non-agency sector has one of the best risk-adjusted returns in the fixed income market.  Another area that PIMCO has allocated significantly is the asset-backed securities market, specifically the federally guaranteed student loan space.  

Valuation

From a valuation standpoint, the recovery in the PIMCO taxables has been sharp and quick.  The values we saw around Christmas are all gone.  We were able to pick up some PIMCO Corporate and Income (PTY) very close to par.  It was then announced that the fund would be added in closed-end funds indexes.  That news and buying helped push the fund quickly back to a 10% premium.  

PCI reached a premium again on January 17th after hitting a 10% discount less than a month prior.  To us, the fund is fully valued.  The chart below shows the NAV total returns in the last year with the three non-agency MBS-based funds at the top of the list.  

Overall, this last PIMCO CEF tantrum was a very profitable one and now we will likely reduce our overweight and wait for the next one to occur.  It is always difficult to buy when the market is falling 500+ points and your quotes screen is a 'sea of red'.  However, that is the best way to make money- being a contrarian and putting emotions aside.  The Google Sheet helps with that as it takes the emotion out of buying and selling.  By ignoring the market noise and positioning the portfolio towards those target allocations and using the buy/sell flags, you can go against the grain.   

Member Comments - "Should I Sell?"

We are currently reducing our stake, slowly, in PCI and PDI to target or slightly below target levels.  Valuations are high and we want to be positioned for another downturn.  We get the question, "should I sell?" often, especially when the Google Sheet flips to a "sell" rating.  Remember, the sheet is formulaic with real-time quotes that calculate the discount/premium perpetually.  Once the discount/premium reaches the "sell over" level, the flag flips to a "sell".  

The answer to the question is a personal one.  If you are a buy-and-hold/rent investor, preferring the income and not caring much about the day-to-day changes in value, then holding is the answer.  Simply prefer to collect the income and consider the fund an annuity.  If you are a total return investor, or a more tactical trader that tends to go to cash and wait when valuations are high, then trimming/selling is the answer.  

Right now, there aren't many places to allocate that capital if you do indeed sell. The January effect is in full force and lifting all boats.  Discounts across the board have tightened materially in just 3 weeks leaving little behind.  We obviously would not be adding here.  Additionally, the NAVs of most of these funds are performing well from a technical standpoint with strong RSI and MACD indicators.  In other words, it's not just a recovery of discounts occurring, but a recovery of NAVs as well.  This could shift the decision on when to sell as, even though the discount isn't closing any more, the NAVs are rising further pulling up prices.  

In my personal portfolio, I had reached a 28% allocation to PCI when including the Flexible Portfolio allocation.  I have been reducing that allocation back towards the 18% level slowly.  I also did take some gains in PDI which was over target but did sell to below target, ~9.2%.  The proceeds of which are currently being allocated to cash while looking towards other opportunities, especially in the individual preferred space.  

A side note on the above chart which has PGP near the bottom of the list for NAV total return.  If you look at the corresponding price total return chart, PGP is near the top of the list, (fourth place) showing the benefit of buying funds cheap!  Even if they do not perform well on a NAV basis.  

Z-scores are back to being decidedly positive, a condition that we experienced for most of the summer.  They range from +2.60 (PNF) to 0.00 (PFL).  Only PCN, PTY and PCM are in negative territory at -1.2, -0.80, and -0.50.  Nothing that screams bargain but closer to that hold level mentioned earlier.  Most of the funds have simply returned to where they were towards the end of the third quarter.  If that is the case, then Z-scores won't show strongly positive and overvalued.  But, were the funds overvalued then as well?  The fourth quarter would suggest so as the funds sold off quickly at the sign of danger.  Or perhaps the anomaly was the fourth quarter- a non-recessionary bear market brought on by extraordinary exogenous factors.    

Certainly the dovish tone out of the Fed suggests a re-rating is needed for leveraged fixed income products.  That is supportive of both NAVs and spread products.  The question is, what valuation are you willing to pay?  There are a few alternatives paying that juicy yield but none with the long-term track record of the PIMCO twins.

JQC Commentary on New Capital Return Plan

Nuveen Credit Strategies (JQC) has adopted a capital return program meant to enhance the fund's competitiveness and reduce the large discount.  The fund will return 20% of its common assets or $240M over the next three years through supplemental distributions (essentially ROC).  The supplemental will be about twice the monthly income distribution. 

As of December 14, 2018, the total distribution of $0.1015 would result in distribution rates of 14.1% and 16.4% on net asset value and market value, respectively. Closed-end fund historical distribution sources have included net investment income, realized gains and return of capital.

The extra distributions would amount to approximately $1.75 per share.  The fund is attempting to increase the demand for their shares thanks to the increased yield thereby closing the discount materially.  Additionally, the fund revamped their portfolio last year in response due to the poor investment returns compared to the benchmark and peer group. 

From their Q&A release:

Q. How does the Plan enhance shareholder total returns? A. To the extent JQC continues to trade at a market yield comparable to current levels, the Plan enables JQC’s common shareholders to effectively capture, via an overall increase in the value of their overall JQC investment, a portion of the differential between the market price of the Fund’s common shares and their underlying net asset value. This represents a potential source of significant incremental common shareholder return in the current market environment. Based on the 14.3% discount to net asset value of the Fund’s common shares as of December 14, 2018, if common shareholders were to receive 20% of their portion of JQC’s capital under the Capital Return Plan they would receive a potential cumulative incremental return of approximately 3.3% over the life of the Plan.

The plan is clearly in response to Saba's activism which noted in their 13D SEC filing that they planned to engage in discussions with management about "strategic plans and matters relating to the open or closed end nature of the Issuer and timing of any potential liquidation of the Issuer."

To us, it looks like a bit of an opportunity as the activist are not likely to let up if the discount does not close in the next year.  In the meantime, you have a juiced up yield, similar to what drives the premium valuation of Western Mortgage Def Opp (DMO) to a premium.  That fund has a NII yield of approximately 7% but then is paying out capital gains to push the yield north of 10%.  That double-digit yield is like a siren song for many retail investors creating significant demand for the shares, and sending the valuation higher.

The same result could be seen with JQC and its SUPER-juiced 15.82% distribution yield.  

Coming This Week:

  • Open-End Fund Review

  • Screen of Tax-advantaged CEFs

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