In the February Monthly YH CEF report we highlight distribution cuts for February that were significantly reduced with only two funds reducing their payout this month by more than 2%. This was down from 5 funds last month and the 27 we saw in December. Last month, there was only one fund increase of 3% or more while February had six. Have we turned a corner?
Last month, the big winners were municipal funds as interest rates fell back from interim highs and the safety of munis were once again realized. At the start of January, the average muni fund traded at an 11.4% discount to NAV. Today, that number is down to just over 6%.
We recently gave a muni update where we highlighted the funds that were likely to make the largest 'convergence trade.' Those are funds that were trading well below their 52-week average and likely to close that spread (as there was no fundamental reason for the spread widening other than tax loss harvesting in December and thin trading). One of those funds (number 2 on our list) was the Eaton Vance Muni Opps Trust (EOT). At the time, the fund was trading over a 7% discount, well below the 52-week average, which was less than 2%. Often when we see that type of spread in a muni fund, it is due to a recent distribution cut but that was not the case for EOT.
Well, EOT rose from that large discount to a recent premium (hitting a 1% premium on Friday February 3rd). We then got hit with a distribution cut after the market closed to the tune of 5.8%. It remains to be seen how the price will react on Monday morning.
Here are the rest of the distribution changes from February 1st:
Distribution Increase (greater than 2%)
Templeton Emerging Market Income (TEI): Monthly distribution increased by 8.9% to $0.0713 from $0.0655.
Templeton Global Income (GIM): Monthly distribution increased by 8.1% to $0.0401 from $0.0371.
Eaton Vance CA Muni Income (CEV): Monthly distribution increased by 5.9% to $0.0446 from $0.0421.
Nuveen Floating Rate Income (JRO): Monthly distribution increased by 3.31% to $0.0625 from $0.0605.
Nuveen Senior Income (NSL): Monthly distribution increased by 2.8% to $0.0365 from $0.0355.
Nuveen Floating Rate Income (JFR): Monthly distribution increased by 2.5% to $0.0615 from $0.06.
Distribution Decrease (greater than 2%)
Eaton Vance NY Muni (ENX): Monthly distribution decreased by 7.4% to $0.0415 from $0.0448.
Eaton Vance National Muni (EOT): Monthly distribution decreased by 5.8% to $0.0809 from $0.0859.
The Nuveen floaters saw another round of modest distribution increases in February after they increased it in October of last year- again modestly. We wrote in mid-January in "Why Floaters Look Attractive Despite Lowered Rate Expectations" that we were likely to see a rebound in floaters and potentially higher distributions given the continued increases (at the time) in libor.
Discounts on taxable and tax free bond funds continue to contract as calm returns to the market. We use the VIX (volatility index) as a gauge for discounts. On Friday, the VIX fell to a two-month low of 16.1, supporting the trend.
The chart below shows the weekly discounts for bond CEFs going back to early November.
All 34 sectors on the CEFConnect database showed positive performance on price and NAV for the month of January. In addition, all 34 sectors saw discount tightening. The best performer was the MLP sector which had a price increase of 23.7% and NAV increase of 21.6%. The worst performer was taxable munis which saw prices rise by 2.7% while NAVs were essentially unchanged.
Latin American equity finished the month at the largest discount to NAV at -13.9%, followed by global real estate at -12.8%, and convertibles at -12.6%.
Few sectors finished the month with a negative z-score and those that did were only at a marginally negative value. This is a far cry from where we were 31 days ago as nearly all sectors were negative and most below -1 with several at -3 or lower. Today, the most expensive sectors are the Taxable Muni space, Asian Equity, Latin American Equity, and Preferreds. The most undervalued are non-US Equity, Global Growth and Income, and Senior Loans.
The question now becomes, is the January effect all but over?
We opined to our members in December that this year (2019) could be the largest 'January Effect' in quite some time. The January Effect is the rebuying of closed-end funds after the wash sale window passes. Many investors sell their losers in November/ December and rebuy them in January in order to capture the tax loss. The chart below shows the movement in discounts in the given months. November typically sees the greatest amount of tax loss selling while January sees a sharp snap back.
We will have a report out shortly discussing various top ten statistics in the fourth quarter and so far YTD.
As we have been discussing, we do think that discounts could tighten beyond their 52-week averages and likely rival their 52-week highs. We recently issued a convergence trade report that we will now do regularly on a monthly basis. Those are a great start to hunt for some total return opportunities with idle cash that you want to put to work.
There are two narratives here. The first is that there aren't many screaming bargains anymore. Discounts have tightened back towards their averages and those that were too fearful to buy during the depths of the bear market are now kicking themselves for now doing so. It is always very difficult to buy when everything is dropping and the financial press is calling for Armageddon. I mean, how many people were calling for a recession just 30 days ago?!
The fourth quarter was a great lesson in behavioral trading and contrarian investing. Buying when these funds are at a deep discount can reap significant rewards. While I didn't expect that to be one month later, it is always impossible to know with foresight how exactly things will play out.
The second, and probably more important lesson, are the distribution changes and where they were derived. Floating rate funds again saw some distribution increases which gives us some confidence in our call about floating rate funds being severely undervalued despite given that the Fed appears to be on hold. On the same note, municipal funds again saw little in the way of distribution cuts for the second month in a row. Are we done with those given the move higher in rates?
The chart below shows the relative UNII for tax-free muni funds over the last several years. The flattening of the trend is not a surprise. In fact, it is expected after all the distribution cuts were saw in the last year. It gets back to the cycle that we continue to see. 1) Pay out a higher dividend and drain UNII until calls force you to cut the payout. 2) Coverage goes back to 100% or greater and UNII balances stabilizes (perhaps grow a little). 3) Calls then erode earnings and distribution coverage falls again. Repeat back to 1.
In other words, we are sanguine on the cessation of distribution cuts to the muni space. On the taxable side, we could be seeing less simply due to average yields on corporate bonds rising back to the 5-7% range. When you combine the wider spreads and overall higher rates on treasuries, effective yields across the corporate yield curve is higher. Those higher yields could be enough to stem the headwinds from rising leverage costs.
The fourth quarter was frustrating for many investors. Countless noobie CEF investors gave up and decided to "change investment strategies" or "go in a different direction for yield." Those are the marginal CEF investor that really shouldn't be in the space in the first place. We wrote an article last year titled, "CEF Investing: Is Your Stomach Strong Enough?". Investors should read it twice before considering investing in closed-end funds. That said, the opportunities that were apparent a month ago are gone. However, we do think there is still significantly more upside to go.