CEF Weekly Review: Convert Funds Lead

The 13 closed end fund (CEF) types on average were up 2.7% for the week ending 7/24/09. The S&P 500, as measured by the SPDR S&P 500 ETF (SPY), registered an increase of 4.2%.

On an aggregate, unweighted basis, the weekly price increase for 641 CEFs was up 2.6%. The weighted 51 CEFs comprising the Claymore CEF Index registered an advance of 3.2% for the week. The 641 CEFs’ aggregate, unweighted current distribution yield is 7.9% and is trading at a 5.1% discount.

Year-to-date, CEFs on average have extended their price appreciation to 28.6%. (Click here for YTD CEF Performance)

Consistent with the CBOE Volatility Index (VIX) drop of 5.1%, the Eqcome CEF Fear Index subsided for the week. The unweighted average price rose greater than NAV (2.6% versus 1.9%, respectively). The biggest spread between the weekly price and NAV change was for Nuveen Virginia Div Advantage Muni Fund (NGB) at 8.9%; the least was for First Trust Strategic High Income Fund (FHI) at -23.0%. (A positive spread between the price and NAV could be viewed unfavorably subject to other metrics, and visa versa.)

CEF Weekly Fund Type Performance: With equities continuing to add on to last week’s strong gains, equity-oriented fund types continued to outpace fixed income. The one exception was LoanPartFnds which logged in a better than average performance. There was a tilt towards global CEFs even within some of the winning fund types. “Other” fund types (OtherFnds) lagged as they are dominated by “buy/write” or “option/arbitrage” CEFs. These investment strategies are typically considered conservative.

While on average all fund types posted weekly positive price changes, several of the fund types recorded expansions in their discounts, i.e., their price change was less than the change in their NAV. These fund types included InvGrdFnds (7.2%), SpecEqFnds (6.2%) and GenEqFnds (3.6%).

Weekly Comparisons: For sake of weekly comparison, the equity markets rambled on. Better than expected earnings news—sans Microsoft (MSFT), encouraging housing numbers, non-earning money market returns and political gridlock on Obama’s health care plan all bolstered investors’ spirits and increased their appetite for equities. Next week’s economic data will feature a reading on the health of the consumers with retail sales, consumer confidence and housing data. (Click here for next week’s economic calendar)

The debt segment (blue) of the ETF market posted flattish results with no sign of inflation on the horizon. Vanguard Total Bond (BND), iShares Muni fund (MUB) and iShares mortgage backed securities fund (MBB) registered changes of: 0.4%, 0.0% and 0.1%, respectively. Their CEF counterparts were all up 1.0% or better. Next week’s record amount of bond supply ($205 billion) will test the depth of debt markets.

The commodity segment (red) of the market continued to signal an expectation of a global economic recovery. Such gains were also aided by a decline in the US dollar (USD).

Commercial real estate, as measured by Vanguard Real Estate Investment Trust ETF (VNQ), continues to confound.

After posting a surprisingly strong performance of 7.2% the previous week, the ETF tacked on another 8.2% this week. The Ultra Real Estate ProShares ETF (URE) was up 16.1% for the week.

Investors’ general consensus is that while commercial real estate is increasingly worrisome to bank regulators, many of the publicly traded real estate companies have already put their balance sheets in order. It’s likely they will be the acquirers in this depressed real estate pricing environment. (Click here for ETF YTD sector performance)

CEF High & Low: For the sake of data points, Nicholas-Applegate Convertible & Income Fund (NCV) was one of the stronger performing CEFs, up 12.3%. ConvSecFnds was this week’s best performing fund type.

One of the worse performers of the week was First Trust Strategic High Income Fund (FHI), off 22.7%. FHI, a high yield fund, earlier in the week reduced its monthly common share dividend 60% from $.06 to $.025 per share. This should be a cautionary tale for owners of PIMCO High Income Fund (PHK). (See “CEF Focus for the Week” below.)

CEF Insider Trading: There was a continuation of insider buying in MBIA/Capital/Claymore Man Duration Investment Grade Muni Fund (MZF) in July. Insiders increased their holdings by $1,508,515. Western Investment LLC, MZF’s largest shareholder, picked up an additional $216,303 of stock value (19,100 shares) at an average stock price of $11.31 from July 7^th to the 15th. Western has stated its intention to select two nominees to MZF’s board. MZF has continued to deny Western’s request for its shareholders’ list. Benchmark Plus Management, LLC was the majority inside buyer in July prior to the July 7th.

Insiders also continued to acquire shares of Boulder Growth & Income Fund (BIF). Insiders added another $23,400 of stock value to bring the total purchases in July to $307,017. This brings insiders’ ownership stake to 5.178 million shares; over 20% of the outstanding shares.

A new insiders’ position was established in General American Investors (GAM) in July by Daniel Neidich, a GAM director. Mr. Neidich acquired 4,200 shares at an average cost per share of 19.83 for a total outlay of $83,301. Neidich is a former Goldman Sachs partner and founder of Whitehall Investment, the real estate investment arm of Goldman Sachs.

CEF Focus for the Week: PIMCO High Income Fund (PHK) is the focus stock of the week. The question isn’t whether PHK will reduce its monthly distribution rate, but by how much and when? The market is already anticipating a cut as it is currently trading at a distribution yield of 16.8%. This is contrast to the average 9.5% distribution yield of 53 high yield CEFs. Currently PHK is trading at an unsustainable premium of 45.7% to NAV. This is in contrast to its peer group’s average discount of 3.7%.

Consider the following case. First Trust Strategic High Income Fund (FHI), a high yield CEF, was trading at a distribution yield of 13.7% and at an unsustainable premium of 65.6% at the end of May. At that time its peer group was trading at 10% distribution yield and a 4.2% discount. This week FHI reduced its monthly dividend 58.3% to bring it more in line with its peer group. It is now trading at a 10% distribution yield and a discount of 9.0%. The stock is off 45.7% since the end of May.

If PHK were to reduce its distribution by 58.3%, as did FHI, it would result in an annualized distribution of $.61 per share. Applying the current average peer group distribution yield of 9.5%, its implied price would be $6.42 per share. Coincidentally, that would be around its current NAV of $5.97. This would be about a 26% drop in the stock price.

Is the Market Efficient? If the stock market is efficient, what it could be telling us is that investors are anticipating PHK’s annualized distribution to be reduced around 40% to 45% to an annualized rate of $.84 per share. At an average distribution yield of 9.5% for its peer group, the implied price for PHK would be $8.85. This is where it has recently been trading. However, if investors choose to focus on its premium, it may not be able to sustain that level.

PHK typically declares its distribution the first day of the month. Since August 1^st falls on a Saturday, the first business day in August will be Monday, the 3^rd. It will be an interesting week to see how investors handicap the stock in anticipation of its distribution declaration.

It is possible that it will sustain its current rate; but at some future point a reduction is inevitable. The market is already telling us that.

(For all you Bill Gross fans, please provide some simple math base on observable facts to support your position that PHK's current stock price is the correct valuation when commenting.)

Disclosures: Long SPY, GLD and BIF; Short PHK

Comments

[willydo:]

Thanks Joe; always a great array of information. The more I read about CEF's, the more cautious of them I become. Now there are clearly some flags on funds that have huge premiums, but there are others that seem to trade a bit above average but then drop a bomb and reduce the dividend without much warning.
I was looking at one of your recent articles on FOF (fund of funds) as a way to smooth out the risk of getting hit by a shock to price but even that fund is (according to the article) probably is going to have to reduce its yield. I'm not sure how one is supposed to know that. It put out a consistent .12 per share for 10 months in a row and now went to .27 per share for the last two months for a yield of 9%. Apparently this is not sustainable.
So it looks like the only thing a person can do is pick funds that are paying about avg. yield, otherwise one risks a hit to the fund price; just have to have tight trailing stops and treat exactly like stocks.
Willydo

Jul 27 09:42 AM

[Joe Eqcome:]

CEF Investors

For some reason, the weekly CEF fund type chart, which was origninally included, was not published with this article. For those of you interested, here is a hyperlink to that chart. joeeqcome.web.officeli...

Have a good week.

Joe Eqcome

Jul 27 11:19 AM

[Jade Bond:]

Ah, I see now, Joe. You're a specialist in CEFs. Sorry, I didn't know that was your specialty. Indeed, there is merit to the point of view that all asset classes behave similar to each other.

Corporate bonds move in generally the same direction, which individual bonds under or out performing based on the internal credit risks of the entity they represent.

Equities move in generally the same direction, which individual bonds under or out performing based on the cash-flow internals of the corporation they represent.

So it makes perfect sense to presume CEFs should move in generally the same direction, with individual funds under or out performing based on internal operations of the portfolio they represent.

PHK is a true outlier among it's peers. By definition, one doesn't even need math to conclude it should revert to the mean. But you've presented numbers to demonstrate that it should, and that's fine. It's a well-founded high level view. But you want "simple math based on observable facts" to demonstrate why it will remain an outlier, or why it's NAV will move toward market price faster than the other way around, or maybe how internal cash flows can support the current dividend.

Unfortunately, you're asking for the impossible. Simple math about individuals is too easily refuted, since it necessarily requires assumptions and generalizations that omit important specifics of the entity under scrutiny.

PHKs portfolio is probably one of the most complicated around, and at the portfolio level not at all like FHI except in name and general description.

But a quick simply math of the credit ratings reveals these two funds aren't alike at all. FHI is around 50% junk grade, and then 20% AAA. There's very little left in the mid-range where credit spreads are most likely to shrink in an recovering economy, asset prices rise, and defaults less likely to occur (relative to junk).
www.ftportfolios.com/R...

Now look at PHK credit mix. There's almost no junk bonds, and they even report short AAA credit, which presumably means they expect rising interest rates on AAA debt. If those are Treasurys, they got that right.
www.allianzinvestors.c...

Furthermore, PHK has 21% of assets in banks. Everyone knows the Federal Government is ensuring the cash flow to bondholders is secure, even if the bonds are rated and priced below AAA.

PHK is nothing at all like FHI. You're comparison seems to me like belief in search of facts, just as mine does. That's not to say PHK won't or can't cut the dividend, but the simple math in your comparison is like predicting GOOG future performance based on YHOO past performance.

The more likely figure, if they cut their dividend, comes from their Section 19 filing, showing distributions at an annualized rate of $1.02 per share.
www.allianzinvestors.c...

I'd like to see the previous Section 19s to find out if net investment income is up, down, or steady. Unfortunately, I can't find it in the SEC Edgar database (PHK's CIK = 0001219360). But if operations can convert low-yielding assets into high-yielding assets, the net investment income might very well make up the current shortfall. You can't predict that with simple math -- you need to find out what their trading activity is by comparing past and present portfolio mix. That would take days.

A short-term short appears to be a good play, but I wouldn't hold that for long unless credit market's collapse again.

FD: Long PHK

Jul 27 02:09 PM

[David Davies:]

Where can I get a list of the individual CEFs included in each of your 14 categories? Thanks.


On Jul 27 11:19 AM Joe Eqcome wrote:

> CEF Investors
>
> For some reason, the weekly CEF fund type chart, which was origninally
> included, was not published with this article. For those of you interested,
> here is a hyperlink to that chart. joeeqcome.web.officeli...
>
>
> Have a good week.
>
> Joe Eqcome

Jul 28 12:14 PM

[Joe Eqcome:]

Jade Bond

Again, thank you for your measured and reasoned response.

While I would agree with you that FHI and PHK are different in many material ways, I keep on getting hung up on the fact that PHK’s premium is so much greater than stock price.

Historically, that premium level has not been maintained for an extended period of time as there is gravitation to the mean. FHI just is just recent proof of that phenomenon--this market sector is littered with them.

The threshold issue is that supporters maintain that the NAV is somehow undervalued. I just want someone to say: “the reason is that the NAV is undervalued is because they have interest rates swap on XYZ Company that can’t be valued until they expire. When they expire they will increase the value NAV by $3.00 per share.”

It’s that inability to pinpoint the missing value I believe may be a flawed investment assumption. Not necessary incorrect, but in the words of Donald Rumsfeld, “it’s an unknown knowable”.

It would also seem that the fair value accounting requirement provides a mechanism for valuing such exotic assets. There is both Tier II & Tier III that allow for valuation based on private market and model assumptions. So, I’m not sure I can buy into the complexity theory of value.

I think your dividend argument is probably the strongest regarding support for the value.

I hope I’m wrong regarding the estimate of value, because individual can’t eat high yield. They rely on the nominal value of the distribution. If the dividend is reduced significantly, it would add insult to injury for those investors who purchased the stock based on the current distribution. They have already experienced a destruction of capital but will also experience a diminution of income.

For investors who buy at these levels with the knowledge that the dividend will be reduced, I believe they can make money in the long term.

So, I don’t necessarily disagree with your longer term assumption.

Joe Eqcome (Disclosure: I’ve short positions in the stock.)



On Jul 27 02:09 PM Jade Bond wrote:

> Ah, I see now, Joe. You're a specialist in CEFs. Sorry, I didn't
> know that was your specialty. Indeed, there is merit to the point
> of view that all asset classes behave similar to each other.
>
> Corporate bonds move in generally the same direction, which individual
> bonds under or out performing based on the internal credit risks
> of the entity they represent.
>
> Equities move in generally the same direction, which individual bonds
> under or out performing based on the cash-flow internals of the corporation
> they represent.
>
> So it makes perfect sense to presume CEFs should move in generally
> the same direction, with individual funds under or out performing
> based on internal operations of the portfolio they represent.
>
> PHK is a true outlier among it's peers. By definition, one doesn't
> even need math to conclude it should revert to the mean. But you've
> presented numbers to demonstrate that it should, and that's fine.
> It's a well-founded high level view. But you want "simple math based
> on observable facts" to demonstrate why it will remain an outlier,
> or why it's NAV will move toward market price faster than the other
> way around, or maybe how internal cash flows can support the current
> dividend.
>
> Unfortunately, you're asking for the impossible. Simple math about
> individuals is too easily refuted, since it necessarily requires
> assumptions and generalizations that omit important specifics of
> the entity under scrutiny.
>
> PHKs portfolio is probably one of the most complicated around, and
> at the portfolio level not at all like FHI except in name and general
> description.
>
> But a quick simply math of the credit ratings reveals these two funds
> aren't alike at all. FHI is around 50% junk grade, and then 20% AAA.
> There's very little left in the mid-range where credit spreads are
> most likely to shrink in an recovering economy, asset prices rise,
> and defaults less likely to occur (relative to junk).
> www.ftportfolios.com/R...
>
>
> Now look at PHK credit mix. There's almost no junk bonds, and they
> even report short AAA credit, which presumably means they expect
> rising interest rates on AAA debt. If those are Treasurys, they got
> that right.
> www.allianzinvestors.c...
>
>
> Furthermore, PHK has 21% of assets in banks. Everyone knows the Federal
> Government is ensuring the cash flow to bondholders is secure, even
> if the bonds are rated and priced below AAA.
>
> PHK is nothing at all like FHI. You're comparison seems to me like
> belief in search of facts, just as mine does. That's not to say PHK
> won't or can't cut the dividend, but the simple math in your comparison
> is like predicting GOOG future performance based on YHOO past performance.
>
>
> The more likely figure, if they cut their dividend, comes from their
> Section 19 filing, showing distributions at an annualized rate of
> $1.02 per share.
> www.allianzinvestors.c...
>
>
> I'd like to see the previous Section 19s to find out if net investment
> income is up, down, or steady. Unfortunately, I can't find it in
> the SEC Edgar database (PHK's CIK = 0001219360). But if operations
> can convert low-yielding assets into high-yielding assets, the net
> investment income might very well make up the current shortfall.
> You can't predict that with simple math -- you need to find out what
> their trading activity is by comparing past and present portfolio
> mix. That would take days.
>
> A short-term short appears to be a good play, but I wouldn't hold
> that for long unless credit market's collapse again.
>
> FD: Long PHK

Jul 29 08:41 AM