Weekly Commentary | March 24, 2019

Stocks suffered their largest one-day loss of the year as global growth fears accelerated after manufacturing data was released on Friday.  We had two main events this week:  the FOMC meeting on Wednesday and the preliminary (also called "flash") PMIs Friday morning.  In addition, to those we had some bad earnings releases from Nike, Fedex, and Micron helping drive down the narrative.

On the week, the S&P 500 fell just over 1% while small caps fared the worst losing over 3%.  Bond indices did well thanks to those falling rates.  The Agg was up 0.87%, while high yield was up 26 bps.  Munis did well rising 67 bps. REITs and utilities did the best on the week.  

The 10-yr ended the week at 2.44%, the lowest level this year and down significantly from last Friday's 2.58%.  Oil did not move much on the week ending around $59 a barrel.  But the VIX spiked on Friday to 16.8 from a 12-handle on Wednesday.

The Fed meeting on Wednesday had Chairman Jay Powell dialing back the rate hike outlook to zero for 2019.  This was down from two hikes expected in the December release.  The committee now sees only one hike over the next three years while the market is now pricing in a small cut next year.  More below on the Fed's dovish stance.

Europe continues to look sickly.  The German manufacturing sector ("PMI") sparked the sell-off as their initial reading hit a 6-year low of 44.7 (anything below 50 is a contraction).  The Eurozone as a whole is still above 50 at 51.3, but that reading was below forecast.  

Lastly, we had some terrible earnings releases from Fedex, Nike, and Micron which exacerbated the negative sentiment.  Fedex, an economic bellwether, fell far short of expectations and cut guidance (again).  Micron also issued light guidance but the shares rose on the news.  Nike's report was not bad but spoke to some larger global weakness.  

In reaction to the news, global bond yields plummeted with the 10-yr German bund reaching negative territory for the first time in nearly 3 years.  The terms "recession" and "yield curve" saw some of the largest searched trends on Google on Friday as a recession indicator was triggered.   

The 10s-3m curve (10yr yield minus the 3-month t-bill yield) went negative on Friday thanks to global growth concerns and falling yields globally.  This likely exacerbated the decline in the markets.  When it inverts, investors believe there is a recession coming relatively soon.  The last time the curve inverted was in 2007, near the peak of the market prior to the global financial crisis.

Typically, a recession comes 12-18 months following an inversion.  What is important and often failed to be mentioned in the media is that the curve needs to stay inverted for a full quarter- not just hit for a day or few days.  So technically, we are not there yet.  We will keep watching.  

As of yet, there were no signs of panic in the credit market.  This is a good thing as it could be more algo/sentiment driven market movement in the equity indices.  

As we've been saying, this is late cycle but it is unlikely that the bull market ended on Friday.  We were just a few points from all-time highs going into last week.  It is likely we make another run for them soon.  The key factor is not what is happening here (in the U.S.) but in China and Europe.  Chinese growth is an important domino that could either propel us to new highs or drag down US (and European) growth further.  

Closed-End Fund Analysis

Distribution Increase

FT Sr Floating Rate (FCT):  Monthly distribution increased 4.2% to $0.0625 from $0.06.

Distribution Decrease

N/A

Special Distribution

Insight Select Income (INSI):  Distribution amount of $0.14.  Ex-div date of 04.04.19 and payable on 05.08.19

Name and Investment Policy Change

Highland Floating Rate Opp (HFRO) is changing its name to Highland Income Fund (HFRO).  The cusip and ticker will remain the same.  The policy change simply removes the old requirement of having 80% of net assets invested in floating rate loans.  

  • The Fund will pursue its investment objective by investing primarily in the following categories of securities and instruments:

  • (I) floating-rate loans and other securities deemed to be floating-rate investments;

    1. (II) investments in securities or other instruments directly or indirectly secured by real estate (including real estate investment trusts ("REITs"), preferred equity, securities convertible into equity securities and mezzanine debt); and

    2. (III) other instruments, including but not limited to secured and unsecured fixed-rate loans and corporate bonds, distressed securities, mezzanine securities, structured products (including but not limited to mortgage-backed securities, collateralized loan obligations and asset-backed securities), convertible and preferred securities, equities (public and private), and futures and options.

  • Once effective, the Fund will no longer be required to invest at least 80% of its assets in floating-rate loans and other securities deemed to be floating-rate investments. Highland Capital Management Fund Advisors, L.P., the Fund's investment adviser (the "Adviser"), believes the change will expand the Fund's universe of opportunistic investments and provide additional flexibility when investing outside of floating-rate instruments.

  • Until the effective date, the Fund will continue to invest in accordance with the 80% Policy. Once the changes take place, the Adviser still expects to invest a significant portion of the Fund's portfolio in floating-rate securities.

Commentary

The Fed announced that they are essentially done in this cycle- for the time being- both in raising rates and in reducing the balance sheet.  The Fed Funds curve is now flat and even assumes a very slight cut through 2020.  That means it's better for the market that the Fed will not act for the next two years.  

Any CEF investor must incorporate the current and anticipated interest rate environment when assessing where to allocate capital.  One thing we looked at this week is the possibility of raising 'sell threshold' figures on the Google Sheet to incorporate the new benign rate environment.  It is clear that the previously established thresholds were built under a different paradigm.  

Other things we will be looking at is the allocation to floating rate.  While it has helped us the last few months given how oversold it was in December/January, I do think it is time to consider reducing that allocation.  If you want to maintain exposure to securities with a lower duration, then look at hedged fixed income strategies and high yield alternatives instead.  Some that come to mind at PPT, ISD, and PIMCO twins. 

Muni CEFs and non-agencies in the mortgage sector continue to be the best positioned in this current environment given the falling rates and inverted curve.  Munis especially are attractive and continue to provide a natural hedge to the market moves.  While we do not see a substantial leg lower in the near-term, the inverted curve and the slowing global economy does increase the likelihood.  

Below are some one-day changes in NAVs for different funds.  You can see why we focus on the MBS funds.  While PCI and PDI saw NAVs decline a bit, largely because of the exposure to high yield, the heavier MBS open-end mutual funds were either flat or up on the day.

The last two securities on the list (HYG and MBB) show the differing performance of the sectors on Friday.  High yield, which has been performing well, lost 36 bps on the day while MBB, a mortgage focused ETF, was up 33 bps.  That helps drive the NAVs of the open end funds like PTIAX (+31 bps), IOFIX (+8 bps), and CLMFX (+40 bps).  

This continues to be an area we like.  Unfortunately in the CEF space, there aren't many cheaper options so we've been using open-end funds.  Watch JMT/JLS for a better opportunity to get in.  Remember, these funds are merging and becoming perpetual trusts with a 100% tender offer.  Any discount greater than 1% is a buy for me.

PIMCO UNII Report

PIMCO released their monthly UNII and earnings report on Thursday after the close.  The big news from it was the revision to the four prior months for both PCI and PDI.  This was not a huge deal as it looks like PIMCO essentially, starting in October, reversed the data points for (PCI) and (PDI).  In other words, the PDI data was placed in the PCI field starting in October and vice versa.  The table below lays it all out.  

The $1.06 net investment income number for PCI prior to the revision was the PDI number for October.  PCI's NII should have been $0.87.  The same mistake was made for both coverage ratio and UNII.  This appears to be more of a data entry error rather than an accounting error.  

PIMCO muni CEFs continue to shed valuable UNII.  PCQ (CA Muni) lost another two cents of UNII in February for the second straight month.  At this rate, it will exhaust its UNII balance in 18 months.  PML, the other high UNII fund, lost 1 cent.  PNF and PYN, both NY muni CEFs, each lost a penny too.  Average UNII across all funds fell by one cent to 8 cents.  

Overall, coverages were down a bit with the average muni CEF ratio at 91.1% compared to 93.2% in January.  Still, the 3-month stacks (February 3-month coverage ratio versus November's 3-month coverage ratio) are nicely positive, in many cases double-digits.  

The coverage ratios and UNII levels for the taxables aren't very valuable given the unrealized gains are not incorporated into net investment income until realized.  For the muni CEFs, they are more valuable.  

For the taxables, as I've said a hundred times, I like to look at NAV changes for indications into distribution health.  

Valuation is clearly another story.  The premium on PDI seems more warranted today than it was a month or two ago given the Fed's pivot.  Still, the NAVs have struggled as of late. I like to look at trailing 30 day periods for clues as to NAV performance.  For example, for PDI the NAV was $27.76, about $0.10 cents above where it stands today.  This during a time of mostly improving credit spreads.  But during the prior 30-day period, the NAV increased by $0.22.  And the 30-day period before that, by $0.30.  So clearly the rate of change (second derivative) is slowing.

A key indicator for us would be it going negative for several 30-day periods.  

Some of the other taxable CEFs look weak on the tax UNII report including PKO.  But the NAV is still positive over the last 30 day period and is comfortably positive over the YTD period with $0.59 of growth.  

Roughly the same dynamic is occurring with PFN and PFL, which both still have nice cushions on NAV YTD growth.  

Still, I probably wouldn't be adding to any PIMCO CEF here.  And I looked back and haven't purchased any shares in almost three months.  There's still a possibility that the market will see this report and sell on it providing another entry opportunity.  But that is looking less and less likely as time passes.  The PIMCOs taxables do tend to sell off around ex-distribution dates (around the 8th-12th of each month).  

In terms of the 'buy under' and 'sell over' figures for the PIMCOs, we will likely do some minor adjusting to incorporate the new interest rate environment.