This article was first published to Systematic Income subscribers and free trials on July 17.
Welcome to another installment of our weekly CEF Market Review where we discuss CEF market activity from both 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 second week of July. 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.
CEFs were fairly flat this week as the rally in Treasuries was offset by a modest decline in equities. Most sectors remain in the green so far in July as the market continues to recover from its terrible June.
The CEF total market return of around 1% in July is a small start to reversing the nearly 6% drop we saw in June. Interestingly, discounts have been very resilient and are tightening for the third month in a row despite weak NAV performance.
On a longer-term horizon, CEF haircuts on fixed income securities remain fairly valued but not outright cheap, while CEF equity sector haircuts are expensive.
The beta of fixed income CEFs relative to equities has declined significantly over the past two weeks – a result that is likely due to Treasuries and equities starting to offset each other, diversifying their impact on CEFs on fixed income. The beta of CEF shares remains high as it does not benefit from the recent diversification brought by Treasury bills.
A quick look at the CEF sector rating chart in our CEF tool shows that the average sector discount is 3.2%. Some sectors that look attractive on a z-score or 5-year discount percentile basis, such as preferred stocks or multi-sector funds, do not look very good on an absolute discount basis – the average preferred CEF discount n is only 2.4% and the average multi-sector CEF reduction is only 2.7%. That said, there are wide variations within sectors, but it’s hard to say that the overall valuation of CEFs is excellent. If the consensus is correct and most of the macro crisis is well ahead of us, CEF valuations are likely to be more attractive over the next 3-6 months.
We have recently encountered a number of investors who view the allocation to leveraged EFCs as a mistake in the current environment of rising leverage costs. And if it is true that increasing leverage costs can reduce the income profile of leveraged fixed income CEFs and lead to distribution reductions. However, it is important not to lose sight of the bigger picture. Specifically, given that returns on the underlying assets have risen sharply this year, the increase in CEF returns since the start of the year far exceeds the increase in leverage costs over the same period and will do so at the peak. probable of the Fed’s key rate.
The following chart shows that for a typical CEF high yield corporate bond, the increase in asset returns of 4.4% (actually, this is the increase in the yield of the corporate bond index high-yield business at worst year-to-date) is nearly double the increase in debt costs so far this year. The picture for tax-exempt bonds isn’t quite as bleak, but the direction is similar.
And in fact, the argument highlighted above is exactly backwards. One would think that when leverage costs were at their lowest levels (about 1% for taxable CEFs, i.e. Libor + about 0.85% at the end of 2021), taxable CEFs were an excellent purchase, but it is not correct.
The basic allocation, using high yield corporate bonds, is as follows.
At the end of 2021, high yield corporate bond yields were around 4.35%. This means that our hypothetical HY CEF earned 4.35% on its leveraged assets less the leverage cost of 1% (Libor + about 0.85%) less fund expenses of about 1 %, leaving 2.35% go to the investor on the leveraged part of the fund.
Today, high yield corporate bond yields are 8.6% and Libor is around 2.5%. This translates to approximately 4.1% go to the end investor.
At their peak, leverage costs should be around 4.5% (i.e. when Libor hits 3.5% or around 1% above current levels). With management fees, we get a number of 3.1% accruing to the end investor at the probably maximum Fed Funds policy rate – still well above the figure at the end of 2021.
However, things are looking even better for CEF investors today. First, leverage is higher the lower asset prices have fallen (mechanically, a fall in asset prices increases the leverage of the fund unless borrowings also fall, i.e. say if the fund is not getting out of debt). This means that the leveraged part of the fund is still generating more relative to the fund’s net assets than at the end of 2021, all other things being equal.
And second, the rebates are wider, allowing CEFs to now generate even more yield at their price point. Taking all of these factors into account, we see that our hypothetical HY CEF (which owns the high yield corporate bond market) generates a return more than double that of the end of 2021.
The key point here is that investors need to keep the big picture in mind rather than using hackneyed income market heuristics in order to make the right allocation decisions in the current environment.
The Saba Capital Income & Opportunities Fund (BRW) has published its report to shareholders. The fund took over from a Voya CEF loan and sold all of its loan positions in 2021, which was not a crazy thing to do for a more tactical manager like Saba. While the loans offered upside coupons since the Fed was going to raise rates, they didn’t offer much capital gains because the loans don’t trade much above par (because they can be easily refinanced by the borrower).
The fund replaced its loans with SPACs trading below $10 (ie at a discount to the value of the trust), which had two advantages. First, SPAC trusts hold treasury bills, so they will tend to remain very resilient during times of risk. And second, if the SPAC returns to the confidence value, the fund could generate additional alpha.
It’s unclear what the fund currently holds – the latest data is as of April 30. In terms of performance, the fund outperformed the lending sector, delivering a total NAV performance of -3.3% versus an average total NAV performance of -10% for lending CEFs.
However, we also need to keep in mind three possible consequences of its allocation change. First, the fund generates virtually no income – it has less than 20% non-SPAC credit assets, but some of them appear to be zero coupon. Second, given that the fund generated a negative total net asset value return, it is not clear that its alpha generation strategy is working very well. And third, credit valuations are attractive now, so it would seem appropriate for him to start turning to credit assets again, but his NAV volatility suggests that hasn’t happened. It is unclear how long the fund can continue with this low return, low risk strategy.
The two Eagle Point CEF CLOs have published their June NAVs. The CLO Equity ECC June NAV fund came in at $10.08 (our estimate was $10.18 in the CEF tool) – down 8.4% from its $11 level in May. EIC NAV fell 6.6% to $13.66 (estimate was $13.13). This puts ECC at an 18.5% premium and EIC at a 15% premium. Neither fund ever traded at such high premiums before June, so these are very odd numbers. There may have been some hope that fund NAVs would be good in June, but it clearly didn’t turn out that way given what happened to credit spreads. We haven’t seen a similar move in other floating rate funds – discounts on CEF loans are quite depressed. It’s unclear why these are as expensive as they are.
Position and takeaways
Although the valuation of the CEF market has deteriorated overall, we continue to see pockets of value in the space. Specifically, we continue to like the non-agency MBS Western Asset Mortgage Opportunity Fund (DMO), which is trading at an 11% discount and a current yield of 10.1%.
The fund mainly holds variable rate assets and fixed rate liabilities, which makes its profile very attractive in the current environment of rising short rates. Its discount is significant in absolute terms as well as relative to the sector, and its holdings provide diversification from high-risk corporate income portfolios.
On the higher quality corporate side, we also continue to like the preferred fund Nuveen Preferred and the Income Term Fund (JPI), which are trading at a discount of 5.5% and a current yield of 8.2%. The fund will most likely offer investors an exit to NAV in 2024, which would bring an additional tailwind of 2.6% per year on top of its return.