This article was first published to Systematic Income subscribers and free trials on October 8th.
Welcome to another installment of our weekly Closed-End Fund (“CEF”) Market Review where we discuss CEF market activity both from the bottom up – highlighting individual fund news. and events – as well as top-down – providing an overview of the wider market. We also try to provide historical context as well as relevant themes that seem to be driving the markets or that investors should be aware of.
This update covers the period up to the first week of October. Be sure to check out our other weekly updates covering the BDC as well as the preferred/baby bond markets for insights across the entire income space.
It may not have felt like it, but the broader income market was up this week, including the CEF space which gained almost 1.5% after three difficult weeks that combined for a decrease of 10%. The CEF index remains down around 20% over the year.
Fixed income CEF haircuts have traded within the range and remain historically attractive, while equity CEF haircuts have tightened.
A number of sectors remain attractively valued in absolute terms (i.e. discounts – y-axis) as well as in relative terms (i.e. discount percentile – x-axis). These include Munis, Loans, High Yield and others. Utilities are in la la land valuation mainly because of the GUT – the median discount in the sector is a still expensive zero.
Evaluating a CEF’s performance appeared on the service, specifically, how to determine whether a given CEF has overperformed or underperformed. We can use the example of the high yield fund AllianceBernstein Global High Income Fund (AWF).
It can be very tempting to simply benchmark the fund against popular ETF benchmarks such as JNK over the longest possible time frame. On this metric, AWF is an outperformer. However, this kind of comparison can easily lead to the wrong conclusion.
First, comparing a CEF to ETFs is not really apples to apples as it ignores leverage and other performance factors. Second, a comparison of CEF prices and ETF prices will largely depend on what CEF rebates have done during the period in question, which is often driven by general market sentiment and is not always indicative of the value that management generates (what we are after in performance evaluation).
Third, using a very long comparison period is not always correct because there are many examples of funds that generated a lot of alpha early on, but ran out of gas so to speak and consistently underperformed. more recently.
The way we would assess the performance of a CEF on the service is to take a look at the performance of the fund over the 3-year and 5-year periods against the sector (both median and average) in terms of total net asset value which are highlighted below from our CEF tool.
What we see is that AWF has underperformed the sector by 0.5% per year and 0.8% per year over the past 3 and 5 years in terms of total net asset value. This is more of an apples to apples comparison as it compares a CEF to other CEFs in the industry. Second, the focus on total net asset value returns rather than price returns provides a cleaner way to assess management alpha. Finally, it looks at some shorter periods, which is useful for assessing recent performance as well as any changes in performance.
This would, of course, be a starting point – other key performance factors include consistency of performance (i.e. how many years the fund has outperformed the sector), time-adjusted performance risk, performance over certain periods such as the COVID crash and many others. It’s always tempting to look for a single convenient metric in CEF analysis, but that can lead to the wrong conclusion.
There were a lot of CEF distribution announcements as usual at the beginning of the month. Many of the usual distribution patterns we’ve seen before appear. Funds with managed distributions like some of the MFS funds (e.g. MMT, etc.) continue to reduce distributions as their NAVs fall (or higher NAVs fall outside the averaging window). Fixed coupon asset/floating rate liability funds like Muni funds continue to shrink – there were a few dozen funds on BlackRock and Nuveen that cut yesterday, many by significant amounts of around 20%. Calamos convertible funds (CGO, CHW) which tend to rarely adjust their distributions to their NAV levels also fell. As expected, floating rate funds held up well.
Angel Oak Financial Strategies Income Term Trust (FINS) shareholder report is out. Net investment income increased by 17% compared to the previous six months. It’s still lower than the current payout rate, but the average Libor that entered the last net income period was around 1% and the Libor is around 3.75% now and heading towards 4.5% +. In other words, there’s another 3.5% increase in the fund’s net income, which should push its price yield towards 8-9%, which is pretty good for a primarily investment-grade portfolio. .
The Virtus Convertible & Income Fund II (NCZ) has postponed its October and November distributions because its preferred asset coverage is less than 200% (i.e. its leverage is greater than 50% ). The last time this happened was in July, when his leverage was only slightly above 50%. This time the leverage is still over 50% – around 51%, so it will take a bit longer to get it back online. The red line below shows the previous suspension of the dividend and the green line shows when it was reinstated. If/when the leverage line drops below 50%, the dividend will be paid.
Previously, NCV and NCZ had announced a tender offer for their preferred shares at the allotment rate (ARPS) at 99.95% of “par”. It makes a lot of sense. The way these preferred stocks work is that they pay 2x short-term rates (7-day AA CP rate to be precise). It was great when short-term rates were around zero (2x zero is still zero), but not so great when short-term rates were around 3-4%.
It really would have been better to make a takeover bid at the end of 2021 when the interest on these was zero so that the holders would have an incentive to buy back. It is not at all clear that anyone would offer higher quality preferred stocks that pay 6-8%, especially below par. Of course, the other reason this makes sense is that it will reduce the leverage profile of the fund, making these distribution suspensions less likely.
Position and takeaways
The market has struggled in recent days after a big rebound and a number of stocks are trading near their year-to-date lows. We continue to favor investment grade funds as long as high yield corporate credit spreads remain below 5%. This includes funds like JPI, PTA, FINS, DMO and others.