From the non-farm payroll report announcement on July 5, until now, interest rates have stabilized and even steadily declined. Credit heavy indexes such as the iShares High Yield Corporate Bond Fund (HYG) and the PowerShares Senior Loan Portfolio (BKLN) have retraced much of the decline we witnessed in the months following the Fed's now infamous tapering comments. This can largely be attributed to the strength in the equity market, subsequent dovish remarks by Bernanke, and institutions quickly jumping back in to high-yield bonds as spreads widened, and dislocations began to present themselves.
Many large, popular fixed-income CEFs endured declines of 10-15% or more during this period, and swung to considerable discounts not seen in years. Although market prices are off their lows due to the recovery in NAV, we have yet to see the typical discount narrowing most bottom feeders would have hoped for by now.
For clients in our CEF strategy, when I start buying into the fray, when prices are at their most desperate point, I expect to get paid back in two different ways. First, on the recovery of the assets within the fund's portfolio, which to a large extent is currently under way. But secondarily, I want to see discounts narrow or swing to premiums as compensation. Especially, in light of the risk we took in making purchases while in the midst of a correction, and then white knuckling it through the ensuing volatility. Unfortunately at this point, we have yet to see number two come to pass, and on this go around I think it might take some additional time.
At first glance, this underperformance is an obvious side-effect of the retail investor's lack of reentry into the CEF marketplace. Since in a typical environment, discounts should already be starting to narrow after a month of steadily falling volatility as measured by the VIX, in addition to attractive yields and low prices. However, when I look back at what caused the severity of the most recent decline in CEFs, I believe this is due in large part to the oversubscribing of individual investors to CEF vehicles they might not have fully understood. My hypothesis is that many wire house brokers or investment advisors pushed their clients that were complaining about low fixed-income yields into CEFs.
Between mid 2011 and mid 2013, as dividends on most OEFs were falling due to higher coupon bonds maturing or getting called away, many CEFs were expanding their use of leverage, or lowering the credit quality of their portfolios in an attempt to return a healthy cash flow to their investors and avoid dividend cuts. They were in a sweet spot, as equity markets were strong, and interest rates were moving sideways. Investors who might not have considered CEFs in the past, were caught hook, line, and sinker by the steady uptrends, lack of volatility, and near double-digit yields.
Fast forward to today, and the carnage that followed the backup in rates which began in May has left many newly-minted CEF investors deeply in the red. For those educated in the risks and rewards of investing in CEFs, if comes as no surprise that fund prices became more volatile during this period. You naturally want to use them to your advantage, and repurchase positions you dumped for the safety of cash as premiums expanded to record heights earlier this year. But the average late comer who was lured in by greed or misguidance has been left with nothing more than a bad taste in the mouth.
From what I can draw regarding the facts on the current state of the capital markets, we still live in a world where a 8-10% yield is very attractive even alongside the risks of a CEF wrapper. With that in mind, I believe we are in an environment where there is very little money chasing too many securities. The retail demand just doesn't exist on the scale it once did, and there is simply too much risk aversion in fixed income. So I wouldn't count on deep discounts converting to large premiums anytime soon. However, I would focus on making opportunistic purchases in CEFs that still offer the best risk-to-reward for yield and NAV price gains, as these factors have a tendency to "drag" the market price higher. Focus on well managed funds, with healthy NII, and positive UNII. Stay nimble and use price to your advantage, but without sacrificing your risk management plan. A few of my favorite funds include the Western Asset Global High Income Fund (EHI), and the Western Asset High Yield Defined Opportunity Fund (HYI). Implementing a plan dynamically, will always yield the most successful outcome.
Additional disclosure: Fabian Capital Management, and/or its clients may hold positions in the ETFs or mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.