Weekly Commentary | February 17, 2019

For the 8th consecutive week in a row, U.S. equity indexes posted gains as optimism spread that a trade deal would emerge with China.  More importantly, crude oil increased over 5% to over $55 on the week helping energy stocks.  Largely underplayed by the media, we also got hints that the Fed will end the balance sheet runoff sometime this year.

Economic growth figures from China were also stronger than expected but that was offset by the very weak retail sales numbers for December here.  Those figures have chopped almost a half a percentage point off GDP estimates due out in two weeks. 

Lastly, the budget resolution appears to be over avoiding another government shutdown.  President Trump will call for a national emergency to fund the border wall.  It will spend the next several years in the courts and likely not get done.  

The VIX ended the week below 15 for the first time since September which bodes well for the risk on strategy.

The ten-year yield finished the week at 2.66% and continues to trade in a tight range between 2.65% and 2.72%.  I do still think the bias is to the upside from here and that we may see a little catch up move in the next few weeks.

Fourth quarter earnings season is now three-quarters done and shows earnings growth of 13.1% yoy with revenues increasing 7%.  Estimates for the first quarter continue to come down and now show a decline around 2.5%.  

US equity macro outlook – the risks of a move >2800 in the SPX are building. The SPX has sprinted ~400 points (or 17%) off the 12/26 low for a variety of reasons, including the Fed pivot, better-than feared/expected earnings, growing anticipation of a US-China trade settlement, stabilizing China growth (thanks to aggressive gov’t stimulus), aversion of another US gov’t shutdown, etc. Based on present fundamentals (including a $172-173 SPX 2019 EPS consensus range) it’s hard to justify a PE much beyond 16x (which corresponds to ~2750). But, the tape still has a technical tailwind in the form of negative sentiment and light positioning and this can easily push the index toward ~2800 (which would represent ~16.2x). While the present landscape puts the SPX at 2750-2800, the risks for a move beyond 2800 are building.

If Brainard’s balance sheet remarks were to be codified formally in the Fed guidance (which could occur at the March FOMC meeting), if the ECB delivers on the market’s LTRO expectations (which seems very likely), if Chinese growth can continue stabilizing and inflect higher (the stabilization part is occurring), if stabilizing Chinese growth can translate into improved Eurozone economic momentum (unclear), if US growth can stay on a healthy trajectory (this seems likely, notwithstanding this week’s retail sales report), if the US and China can reach a trade agreement (this seems very likely), and if Trump can avoid escalating trade tensions away from China (this also seems very likely), the SPX could easily surpass 2800.

Lastly, I haven't showed the 10s-2s spread in quite some time.  The difference between the yield on the 10-year bond and the 2-year note is 14 bps.  The trend is no longer down and has meandered around 10-20 bps for four months now.  With the two-year likely subdued from the notion that the Fed is done, and the 10-year likely to inch higher, the spread could widen back out to the mid-twenties soon.

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Concluding Thoughts

We are back to happy days again where no amount of bad news can derail the market. The S&P is now squarely above the 200-day moving average (with room to spare).   The 400+ point increase on Friday could be the catalyst needed to get to the next level and possibly break out towards the September highs. 

The V-shaped recovery is nearly complete and we are less than 170 points away from the all-time high on the S&P.  The market severely punished those that abandoned ship in December and significantly rewarded those that held on or even doubled-down.  I don't really see anything from a technical perspective stopping it though the market does appear overbought.  

My one concern is the ECRI Weekly Leading Index (WLI) that I follow has been declining.  But that is a fundamental index and this is largely a technical-driven market.  With earnings likely going into an earnings recession.  I've been slowly de-risking and raising cash again.  With another bout of selling on Friday, I ended the week with over 15% cash and will continue to add to it.  On top of that there's another 5% of CEF positions that I rolled into PONAX as a placeholder until better CEF opportunities arise.

Closed-End Fund Analysis

Distribution Increase

N/A

Distribution Decrease

Tekla Healthcare Investors (HQH) decreased the quarterly payout by 19.6% to $0.41 from $0.51.

Tekla Life Sciences Investors (HQL) decreased the quarterly payout 21% to $0.33 from $0.42

Activist Trading

Apollo Tactical Income (AIF): Advisors Asset Management added to AIF and now owns 7% of the shares outstanding. 

Special Opportunities Fund (SPE): Relative Value Partners owns 1.96 million shares or 23.1% of shares.  

Barings Corporate Investors (MCI):  Mass Mutual Life owns 2.01 million shares, approx 10% of the outstanding shares, a 6% increase.  

First Trust Portfolios

Buying:  INB, DHY, LGI, IDE, AGD, IAF, IFN, PGZ, SZC, EVG, BCV

Selling:  ARDC, BGH, BSL, GGM, IVH, KMF, CXE, AFT, BGX

Rights Offering

Renn Fund (RCG):  The fund announced the results of the non-transferable rights offering to holders on Feb 8th.  The aggregate gross proceeds were $2.2 million, the maximum allowed under the offering.  Shareholders submitted subscriptions for 166% of the permitted subscriptions. As a result, the number of shares sold pursuant to oversubscription privileges to shareholders who exercised their oversubscription privileges was prorated according to the terms described in the offering prospectus.

  • Furthermore, since the offering was over-subscribed, no shares will be purchased in connection with the backstop agreement between Horizon and the Fund. The Fund sold an aggregate of 1,487,989 shares of common stock at a purchase price of $1.47 per share. The shares of common stock are expected to be distributed to participants through the Fund’s transfer agent or through the clearing systems of the Depository Trust Company commencing February 12, 2019. Following this offering, the Fund will have 5,951,956 common shares outstanding.

Tender Offer

China Fund (CHN):  The fund's tender offer expired on the 5th of Feb and accepted 4.71 million shares for payment on Feb 12th at $20.61, equal to 99% of the fund's NAV.  

  • The Fund will make prompt payment to participating stockholders of the Purchase Price for Shares accepted in the tender offer. The 4,716,803 Shares represent 30% of the Fund's outstanding Shares as of January 4, 2019. A total of approximately 11,586,494 Shares were properly tendered and not withdrawn by February 5, 2019, the final date for withdrawals. Therefore, on a pro rata basis, approximately 40.71% of the Shares so tendered have been accepted for payment.

Conversion From Open-End To Closed-End

Highland Global Allocation (HGLB):  Highland Capital Management decided to conver its open-end fund, a series of the Highland Funds II, into a closed-end fund.  Conversion was approved back in early November.  

  • As a result of the Conversion, the Fund will effect a reverse stock split of Class A, Class C and Class Y shares of the Fund and will combine such shares into a single class of common shares under the CUSIP 43010T104 with an initial net asset value of $15.00 per share.

  • Conversion ratios will be available on February 14, 2019.

  • Shareholders will not receive fractional shares because of the Conversion, but instead will receive a number of shares, rounded down to a whole number. Shareholders will receive a cash-in-lieu check related to the fractional portion of their shares shortly after the Conversion.

  • The shares will be listed under the ticker "HGLB" and at an initial listing price of $15.00. Any shareholder seeking to move shares to a brokerage account will need an adviser or broker dealer to transfer the shares through the Depository Trust Company's ("DTC") Profile System. Shares of the Fund are DTC Eligible.

Statistics

First, the stats on the Core funds showing the top and bottom 5 price movers, NAV movers, highest premiums, largest discounts, highest and lowest yields, and z-scores.

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We extend that to all ~580 closed-end funds and show the same statistics across the entire CEF space.

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The largest NAV gainers by sector this week:

The largest NAV decliners on the week:

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The largest price gainers on the week:

The largest price decliners on the week:

The top ten funds that saw the most discount change in the last week to the positive side (meaning discount tightening or premia build):

The top ten funds that saw the most discount change in the last week to the negative side (meaning discount widening):

The ten lowest z-scores of the CEF universe:

The ten highest z-scores of the CEF universe:

Commentary

Discounts continued their tightening trend this past week and now are clearly near 52-week averages.  For instance, below is the discount of the multisector bond index from CEFAdvisors.  The current premium level of the index is 4.82%, close to the levels reached in late September.  Using the prior highs as a benchmark, we have another 1.2 points to go.  We have moved over 10 points above the lows set near Christmas.  This shows us clearly on the expensive side of valuations of the last year.  The easy money has been made.

The S&P Leveraged Loan Index is still well below par at $96.85.  At these levels, there is still a decent implied default rate.  One of the most attractive funds right now is the THL Credit Senior Loan (TSLF).  At a -12.7% discount, it is still 3.5 points away from its 52-week average.  The fund yields nearly 8% and just raised its distribution two months ago (albeit slightly).  From a NAV basis, it is up 2.7% YTD after eeking out a fractional gain last year.  

For those that own the Tekla Healthcare CEFs (HQL)(HQH), the distribution cut should not be a surprise.  Whenever these equity funds have a managed distribution policy as a percentage of NAV, the movement in the NAV will dictate the next distribution.  With a sharp decline in the fourth quarter, it was assured that they would lower the distribution for March.  They have a policy to distribute 2% of NAV each quarter so simply take the December 31st NAV and multiply by 2%. 

We talked about hedging last November and that the optimal time would be when the VIX is below 15 and HY spreads back below 3.5%.  We have one of those criteria finally met with the VIX with a 14-handle.  HY spreads, however, are still above 4% at 4.17% (as of Feb 14th) and slowly coming down.  I have to imagine we took off another few bps on Friday given the market move.  

You can see the HYG (iShares IBoxx High Yield Bond ETF) is nearly back to the early October levels.   

Hedging using options is now relatively cheap again.  Using HYG put options, you can hedge for the rest of the year for approximately $8,500 of portfolio value for about $200-$300.

We screen the taxable bond space each week for the funds the exhibit what we believe are undervalued characteristics.  That is, a higher yield supported by the financials, a larger discount than average, and a low z-score compared to other funds (very similar to the Power Rankings Report).  The top scoring fund was John Hancock Investors Trust (JHI) which yields 8.21%, a discount of 10.6% (compared to an average of 8.1%) and a one-year Z-score of -1.60.  The fund straddles the investment grade and non-investment grade space with 23% BBB (investment grade), 30% BB (non-investment grade), and 28% B (non-investment grade).  Be warned that CEFConnect places it in the "investment grade" category even though only one-quarter of the fund is IG.  

There are two negatives on the fund: it pays quarterly and has very low trading volume.  The fund is now good for larger accounts with only 20K shares traded each day.  Rule of thumb: never own more than one-quarter of the daily trading volume.  Still, the NAV is nicely rising and the price flat creating a good setup. 

A better candidate for those with larger accounts would be Credit Suisse High Yield Bond (DHY) which trades over 300K share per day.  We are moving down the credit spectrum a bit with 35% BB, 37% B, and 20% in CCC.  Compared to JHI, we've moved down about one rung in quality.  Still, the yield is nearly 9.7%, so we are being compensated.  

One final note:  There is a wealth of information in the statistics section and we study it vigorously each week but that doesn't mean we catch everything.  If you think you see an opportunity- both to buy or to sell- comment below!

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