Weekly Commentary | April 21, 2019

Stocks were little changed during the holiday shortened week.  The S&P 500 rose 28 bps while the Nasdaq was up 64 bps.  Small caps lagged falling 83 bps.  Bonds were slightly weaker for the week with just the high yield index up 18 bps.  Meanwhile, the VIX continues to trade in the 12s and has flirted with an 11-handle at times.  This is very supportive for risk assets and CEF discounts. 

Interest rates moved higher early in the week (hitting a one-month high) but were halted on Thursday and Friday around 2.56%.  In all likelihood, the run in rates fizzled about the same time North Korean dictator Kim Jong Un fired a couple of missiles.  

The big news on the week was the release of the Mueller Report to the public.  While the release didn't have an effect on the markets (politics usually doesn't) it removed a potential overhang of risk to them.  

Economic news continues to surprise to the upside with stronger March retail sales.  We saw some immediate upward revisions to GDP following the release.  In my mind, the economy is far too strong for a potential rate cut later this year.  I still think we will see a rate HIKE somewhere in the back half of 2019 if the 10-, and 30- year bond yields move higher.  If the 10-year sits above 3% in the fourth quarter, look for the Fed to move in December.

China's economic news has also been stronger as they reported Q1 GDP growth of 6.4%, higher than expected.  Growth was supported by strong industrial production, which was up by 8.5%, as well as increased consumer spending, which grew by 8.7%.  The government has been attempting to stimulate the economy by reducing taxes, spending on infrastructure, and loosening monetary policy.  It seems to be working.

Healthcare stocks continue to get pounded as Democratic Senator Bernie Sanders rises in the polling.  He has called for a Medicare-for-all solution to the healthcare problem.  That has crushed stocks like United Healthcare (UNH) which is down nearly 20% in the last four months.  

Lastly, earnings season kicked of last week with the bank stocks.  The results were largely in line, or slightly better than, expectations.  Earnings will likely be the big driver for stocks over the next month and could be the determinant for equities for most of the summer now that many of the overhangs to the market have been removed.  Trade being the last and final hurdle.  

Closed-End Fund Analysis

Distribution Increase

N/A

Distribution Decrease

N/A

Tender Offer

Blackrock Debt Strategies (DSU):  The results of the tender offer were announced for up to 5% of the outstanding shares.  The tender was oversubscribed and was pro-rated to shareholders.  The pro-ration factor is detailed below and was as expected.

EV Muni Bond (EIM):  The fund commenced their cash tender offer for up to 10% of the fund's outstanding shares or 8.97 million shares at 98% of NAV.  The tender expires on May 17, 2019 at 5pm unless extended.  

Activist Trading

PHD:  Saba is reporting a new stake in this Pioneer fund that is now 5.58% of the fund's outstanding shares.  

EVF:  Saba is reporting a new stake in this EV fund that is now 5.9% of the fund's outstanding shares.  

IVH:  Saba reducing its stake which is now 6.44% of the fund's outstanding shares, down 20% from the last filing.

Commentary

Discounts are no longer tightening on the equity side and are doing so only marginally on the bond side.  Most of that tightening on the bond side is occurring on the tax-free side.  Equity funds reached what is their long-term average (20-year) right around -6%.  Unless the market really takes off and volatility (as measured by the VIX) reaches 2017 levels, I do not expect much additional discount tightening on the equity side.

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On the fixed income side, we are slowly climbing towards par.  The current discount is -5.49%, down from -5.70% last week and 5.82% the week before.  For reference, the discount has tightened from over 9% at the start of the year and 6.6% at the start of February.  We now have 44 funds that trade at a premium, up from just 20 on January 1.

The DSU tender offer was completed last week where just over 12% of our shares were tendered.  Last week, the discount widened out a bit following the expiration, which is typical.  What happens is you have a bunch of investors who purchase solely for the tender and then sell when its completed.  

The discount today is 12.5%, which is now wider than its 52-week average of 11.45% as well as the 3-, and 5- year averages (9.9% and 10.9%).  So far, the discount has only widened by 100 bps.  

Last year when they did a 10% tender, the discount widened by 200 bps following the expiration on April 13th, 2018.  

Coverage of the fund is okay but not spectacular.  The latest data we have is from February when the fund reported just over 95% coverage and -5 cents of UNII.  March data should be out in a couple of weeks.  

The fund is up 11.8% YTD on price and 9.2% on NAV after losing 10% last year on price and 3.4% on NAV.  We still like the loan space and think it is still the most undervalued segment of the bond market today.  The surprise may come in the back half of the year if the Fed has to raise rates again.  Money will once again rush into floaters and prices will rise towards $99 (it's just under $97 today).

We are watching the trading action on DSU and will likely make a move to 'reinvest' the cash tender proceeds back into the fund if the discount widens back out to 13.25%-13.50% or greater.  

NexPoint Credit Strategies (NHF)

We sold NHF last week out of the Flexible Income Portfolio when they issued a rights offering announcement.  The discount was around 11% at the time.  It has widened another 80 bps but I do think it will continue to widen out a bit as we approach the rights offering date in mid May.  Here's my thinking.  But first, a public announcement.  

Be careful shorting this fund!  Many investors have PM'd me saying they shorted it (or were thinking about shorting it and asking my opinion about doing so) once the rights offering was announced.  If you are short going into the rights offering, you have to pay the lender the details of those rights.  But you cannot buy any rights since they are not transferable so you would have to sell the shares at the deal price. This can get kind of tricky and expensive!  

What's going on?

The fund is issuing its third rights offering of the last three years following the spin off of its real estate assets in 2015 into a separately traded entity which is traded under the ticker symbol "NXRT".  This one is similar to the last two with a non-transferable rights offering entitling the shareholder to purchase one new share of NHF for every three rights held.  For the full release, go (HERE).

If you own the fund on the record date (April 29th), shareholders who fully exercise their rights will subscribe for additional common shares of the fund.  The offering expires May 22, 2019.  We will go through the offering and recommendations below.  

First, the important dates:

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Each shareholder is given a "right" to purchase additional shares based on the shares owned as of the record date.  The ex-date will be two days prior to the record date.  

Remember that NHF has completed similar rights offerings in each of the last two years under very similar terms.  In 2017, shareholders subscribed for $269M worth of new shares.  Current NHF shareholders have through May 22nd to exercise their shares. 

In this particular rights offer, Record Date Shareholders will receive one Right for each outstanding whole common share held on the Record Date. Each Right entitles the holder to purchase one new common share for every three Rights held (1-for-3). For example, if a Shareholder owned nine shares, he/she would receive nine Rights and be entitled to purchase up to three additional shares .

So how dilutive is the offering?

Rights offerings are clearly dilutive when the new shares are issued at a discount. Shares closed this week at $21.60 with a NAV of $24.49. Ignoring offering expenses which will probably be less than one penny per share, the price received is determined by the below formula.  From the press release:

The subscription price per common share will be determined based upon a formula equal to the lesser of (1) 95% of the Fund’s reported net asset value, or (2) 95% of the average of the last reported sales price of the Fund’s common shares on the New York Stock Exchange (“NYSE”) on May 22, 2019 (the “Expiration Date”) and on each of the four trading days preceding the Expiration Date.

The fund will add about 41% more shares to its coffers following the offering when including 25% secondary subscription which is likely to be fully allocated.  The questions come down to, just how cheap it will get and what they will do with the capital.  The dilution is going to be significant.  If we think the discount will bottom out at -14%, then at a 41% increase in shares, then depending on the price, we should expect dilution on NAV to be between $1.15 and $1.30 or approximately 4.7% to 4.9%.  

In 2017, the market price of the fund rose after the rights offering was announced and then fell after it began trading ex-rights.  It then took about four months to bottom out- which is around the same amount of time we observe it takes for large distribution cutters to bottom out on average.  In each of the last two rights offerings, the best time to buy was around the time they traded ex-rights.  

The resulting performance over the last year has not been overly stellar with a NAV one-year total return of 2.58% and on price of 3.41%.  However, the 3-year number, which now incorporates TWO rights offerings, is a very strong +16.5% on price and +13.9% on NAV.  

The chart below shows the discount of the shares during the last two rights offerings.  As we noted, the best times to buy tend to be right around, or shortly after the rights go ex-.  The chart below clearly shows the dilution to the shares in anticipation of the NAV getting clipped.  In other words, the time line looks like this:  the rights go ex on April 27.  You then have until May 22, 2019 to subscribe.  At that point we will look at what the previous five trading days prices were and you get credited (if you subscribe) at about 96% of that price.  

So what do I do?

If you own the shares at this point, it may behoove you to simply hold at this point and subscribe.  This is especially true if you think NHF is a good investment and think its undervalued.  For investors in this club, you will simply increase your position by 33% - 41% and see no dilution.  

If you have no intention of subscribing, then you will get diluted fairly significantly with a NAV drop of about 4.98% (ick!) so it may be more prudent just to sell now.  But if you own and are going to subscribe, I would wait until closer to the expiration date to actually trigger the rights.  Why would i do that?  

Think of it this way.  If you have to make a decision and the decision outcome is going to be the same whether you make it on April 30th or May 22nd, then why not wait until May 22nd JUST IN CASE SOMETHING CHANGES.  I liken this to when buying shares of a CEF.  If the ex-distribution date is the first of the month, and today is the third, then I already missed the next distribution.  Why buy today when I have a full 27 or 28 days to do so in order to get the next distribution (unless I thought today was the nadir in the discount).  

The same could be said for this rights offering.  

If you want to play this but do not own the shares, wait for the shares to go ex-rights.  At that point, we are likely to see the price incorporate the discount of the diluted NAV.  Remember, the NAV is a unicorn NAV at this point because of the dilution factor.  If the NAV is going to fall by just under 5%, then the true discount is going to be almost 17%.  

As I noted earlier, the price of NHF increased following the announcement last year.  And it continued higher right up until the ex-rights date.  In fact, even after it went ex-rights (May 7), the price moved still higher before topping out on May 14th.  Then it started a long downward trend until the price bottomed on the last day of June.  

And the year before where you can see again that the price rose after the announcement and then again shortly after it went ex-rights.  However, not long later it started a longer trend lower bottoming out towards the end of June. 

Concluding Thoughts

The run-up in the shares post-announcement is the market believing there's some value in the rights and that by subscribing, some long-term value is going to be created.  I am not so sanguine on that thesis of long-term value.  The NAV is roughly the same it was two years ago when they were completing the first of these rights offerings. In addition, the distribution isn't any higher and we've seen what the performance has been in the last 18 months or so.

If that is the result of the prior two, then the case being made for the rights offering - that there are compelling opportunities- doesn't seem to be accurate.  The proceeds from these rights offerings haven't done anything to grow NAV at a faster rate nor lead to an increase in the distribution yield of the fund.  

A poster on the Morningstar forum, Aubergine, wrote the following note:

The core problem is that when someone sells shares with a dividend attached - a reasonable estimate for the cost of equity is the the current div yield. So the issuer has to invest the newly raised monies in projects that cover at least that plus all the fees*. So even if (at NAV) the cost of equity is 10%, one likely needs to find projects yielding 13%+ or so for it to actually be accretive to anything.

This is a spot on observation that should be pondered.  NHF is the ultimate black box and without knowing what they are truly doing, the rights offerings to me are not very shareholder friendly (especially since the rights offerings are non-transferable).  As such, a position in NHF should only be opportunistic in nature and possibly only done for a trade.  

Buying shares on the last day of June seemed to work out very well on a price basis.  For example, here is the performance for the shares when buying at certain dates and going to that particular year end.  

The conclusion from the two data sets would be to wait until the end of May before purchasing shares in the fund.  

We will be watching this one closely for a potential opportunity and of course will keep you guys posted.  

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