A 23.3% Dividend Yield Makes CEFL Still Attractive

| About: UBS ETRACS (CEFL)

Summary

My projection of a $0.324 monthly CEFL dividend would make it the highest dividend since January 2016.

CEFL has rebounded from the January and more recently the post-Brexit-vote lows, but the discount to book value is still at normal levels.

CEFL is still a good way to play the lower interest rates for longer scenario.

I am still bullish on the UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL) despite the recent rebound in the price from the post-Brexit-vote lows. The annualized yield on a monthly compounded basis is 23.3%, based on calculations including my projected July 2016 CEFL dividend. The weighted average discount to book value for the 30 high dividend closed-end funds that comprise the index upon which CEFL and its unleveraged version, the YieldShares High Income ETF (NYSEARCA: YYY), is based, was 8.2% on June 24, 2016. The discount was greater earlier in 2016.

The two concerns that have depressed high dividend closed-end fund prices over the last year, are fear of higher interest rates and credit concerns. Some of the high dividend closed-end funds hold junk bonds. High yield bonds have been under severe pressure, especially those involved in oil and other natural resources. The rebound in the price of CEFL and some of its components since January 2016 is due mainly to the improvement in the credit outlook for high-yield bonds in the energy and natural resource sector.

All of the CEFL components will have ex-dividend dates in June 2016. Thus, they will all contribute to the July 2016 dividend. Even though 28 of the 30 high dividend closed-end funds that comprise the index upon which CEFL and YYY are based, pay monthly dividends, there is a small seasonal factor involved with the CEFL dividend. Only the Morgan Stanley Emerging Markets Domestic Debt Fund (NYSE: EDD) and the Royce Value Trust (NYSE: RVT) now pay quarterly dividends in January, April, October, and July. Thus, EDD and RVT will be included in the July 2016 CEFL dividend, making it larger than those dividends paid by CEFL in the previous two months.

My projection is that the July 2016 CEFL dividend will be $0.324. This is the highest monthly dividend since the January 2016 dividend, which included some year-end distributions. There was also an increase in the net asset or indicative value of CEFL. As the value of the closed-end funds in the portfolio increase, portfolio assets must be increased to maintain the leverage level. This increases the dividend, separate from any changes in the dividends paid by the closed-end funds in the portfolio. The relationship between the net asset value of a 2X leveraged ETN and the dividend is explained more fully in MORL's Net Asset Value Rises - Implications For The Dividends.

The outlook for CEFL depends both on the level of interest rates and the equity markets. The equity markets themselves seem to be very dependent on the level of interest rates. Many of the closed-end funds in CEFL hold bonds and borrow money and thus do better when interest rates are lower. Short-term rates in particular, will influence the returns on CEFL since the imputed cost of borrowing on the leveraged aspect of CEFL is based on LIBOR.

Everyone knows that short-term interest rates are controlled by central banks. In many industrialized countries, the rates set by the central banks are negative. In Japan and Germany, the 10-year government bond rate is now negative. The USA is an exception in the industrialized world in that the Federal Reserve has increased the rate it pays banks on their excess reserves deposited at the Federal Reserve to 50 basis points. In most other industrialized countries, the deposit rate, which is their equivalent of the rate paid to banks on excess reserves deposited at the Federal Reserve, is negative. What does not get much attention is the question of what risk-free interest rates would be if there were no central bank intervention.

The rates paid to savers in risk-free money market accounts are determined in a free-market, in that each financial institution is free to pay whatever it wants. Politicians in the USA who argue that the rates paid to savers in risk-free money market accounts are too low generally blame the Federal Reserve for the interest rates being too low. That assumes that absent intervention by the Federal Reserve, interest rates would be higher. That assumption may not be correct.

The payment of interest on reserves is a direct transfer of billions of dollars from the American taxpayers to the banks. From its inception in 1913 until a few years ago, the Federal Reserve never paid any interest on reserves, even in the 1980s when short-term risk-free rates exceeded 20%. In her testimony, a number of congress members were very concerned about the transfer of billions of dollars from the American taxpayers to the banks that paying 50 basis points on reserves entailed, Janet Yellen explicitly said that if the Federal Reserve had just raised the target rate on Fed Funds but not began paying 50 basis points on reserves, the market rates in the financial markets on loans and certificates of deposit would not have risen enough to accomplish the goals that the Federal Reserve wanted to accomplish by raising interest rates.

It is not as easy to quantify what a free-market rate on risk-free securities would be absent government intervention. Similarly, it would be difficult to say what the rate on the US 10-year treasuries would be if the Federal Reserve was not asserting that they plan to raise short-term interest rates many times over the next few years. Might the rate on the US 10-year be close to the negative rates that now exist on Japanese and German 10-year government bonds?

Closed-end funds typically trade at either discounts or premiums to book value. On balance, there is a slight bias towards discounts. Because of significant changes in the composition of the index, comparisons of aggregate discounts to book value from previous years are not very meaningful. In attempting to find an explanation for the discount to book values that the closed-end funds that comprise CEFL and YYY are trading at, I considered two possible factors.

One concern with many closed-end funds is that their dividends include a significant amount of return of capital. I ran a regression analysis to determine if there was any correlation between the proportion of the dividend paid by a closed-end fund that represents a return of capital and the discount to book value that the closed-end fund is trading at. For the 30 closed-end funds that comprise the index CEFL is based on, there was no statistically significant relationship.

For many securities other than closed-end funds, such as common stocks, discounts or premiums to book values are logically based on the business prospects for companies. Thus, Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) trades at significant premium to book value, while Bank of America (NYSE:BAC) trades at a significant discount to book value, reflecting differing market perceptions of the future prospects for those companies.

Alphabet trades at approximately 5X book value while BAC trades at about half of book value. In my article, mREITs Impacted By Enormous Price To Book Swing - MORL Yielding 27.6%, I discussed the large discounts to book value that mREITs such as American Capital Agency Corp. (NASDAQ: AGNC) are trading at. The logic behind mREITs such as AGNC trading at significant discounts to book value is primarily based on the possible impacts of higher future interest rates.

Whether one agrees or disagrees with the magnitudes of the discounts or premiums to book for securities such as GOOG, BAC and AGNC, there are facts and logic related to each company's business prospects that could possibly explain or justify changes in the premiums or discounts that have occurred in those stocks. There are no such facts or changes in market forecasts of business prospects that can possibly explain or justify changes in the premiums or discounts that have occurred in the closed-end funds that comprise CEFL.

For closed-end funds, changes in the premiums or discounts to book value should be solely based on the value that investors place on the relative advantages and disadvantages of the closed-end fund structure, rather than the differing market perceptions of the future prospects for the securities in the closed-end funds' portfolios. Investors in closed-end funds could purchase the securities held by a closed-end fund themselves. In most cases, there are also open-end funds available to investors that have risk, return and expense characteristics similar to any given closed-end fund.

Changes in market perceptions of the prospects of the securities that comprise the portfolios of closed-end funds cannot logically explain or justify any change in the magnitudes of the discounts or premiums to book for the closed-end funds. Any such changes in market perceptions of the prospects of the securities in the portfolio should be reflected in the prices of the portfolio securities themselves. Thus, the ratio of the price of the closed-end fund to its book value should not be related to the expectations of the prospects for the portfolio securities held by the closed-end fund.

If investors value the advantages of diversification, management and possibly lower transaction costs associated with owning a closed-end fund rather than owning the individual securities that comprise the closed-end fund's portfolio more than the fees and expenses, which are the primary negative aspect of closed-end funds, then the closed-end fund will trade at a premium to book value. Conversely, if investors feel that the fees and expenses of the closed-end fund outweigh the advantages of diversification, management and possibly lower transaction cost associated with owning a closed-end fund, it will trade at a discount to book value.

The trade-offs between the advantages and disadvantages associated with closed-end funds relative to the securities that comprise the portfolios of the closed-end funds are rational reasons for the closed-end funds to trade at discounts or premiums to book value. However, it is not rational for the discount or premium to be influenced by expectations of future returns on the securities that comprise the portfolios of the closed-end funds. If the market thinks that the securities in a closed-end fund's portfolio will decline, and thus the net asset or book value of the closed-end fund will decline, there is no reason why the premium or discount that the closed-end fund is trading at should change.

Some closed-end funds employ limited amounts of leverage. As investment companies, closed-end funds cannot have more than 33% leverage and most employ less, if any. That a closed-end fund does or does not employ a relatively small amount of leverage should not impact the premium or discount that the closed-end fund is trading at. Leverage is the easiest characteristic of a security to offset.

Thus, if an investor was interested in a security but did not like the fact that the security employed 20% leverage, the investor could offset that leverage by combining that security with a risk-free asset. For example, if you had $10,000 to invest and you liked a closed-end fund but were unhappy with the 20% leverage, investing $8,000 in the closed-end fund and $2,000 in a risk-free asset will result in the same risk/return profile as investing $10,000 in the same closed-end fund, if that fund did not employ any leverage.

Likewise, if you liked a closed-end fund but would rather that fund employed more leverage, you can buy that fund on margin and get in the same risk/return profile as investing in the fund if it had more leverage. Thus, leverage or lack of leverage should not influence the premium or discount that the closed-end fund is trading at since any leverage in a closed-end fund can be offset by an investor.

There should be some limits as to how far away from book value a closed-end fund should trade. If a closed-end fund is trading at a sufficiently high premium to book value, an arbitrage opportunity could exist. Buying the securities in the closed-end fund's portfolio and simultaneously selling the closed-end fund should generate a profitable arbitrage. Likewise if a closed-end fund is trading at a large enough discount, buying the closed-end fund and selling the securities that comprise the portfolio could generate arbitrage profits.

These types of arbitrage would be risk arbitrage as opposed to riskless arbitrage. In riskless arbitrage, one buys a security or commodity and simultaneously sells something that is the equivalent of what you sold. An example of riskless arbitrage would be after a merger had been approved in which the acquirer is issuing one share of its stock for two shares of the company being acquired. You simultaneously buy two shares of the company being acquired for a total cost less than a share of the acquirer. This would essentially lock in a profit that would be realized when the merger closed and the values converged.

Attempting to take advantage of the discount to book value being irrationally wide for a closed-end fund would be an example of risk arbitrage since there is no terminal event that will make the value of what you buy converge with what you sell. It may be irrational for a closed-end fund to trade at a 10% discount to book value. However, there is always the possibility that it could go to a 15% discount. As Keynes famously said, "The market can stay irrational longer than you can stay solvent."

Closed-end funds do not usually provide convenient opportunities for explicit risk arbitrage transactions where one security is bought and the other security is shorted. Retail investors usually cannot use the proceeds from selling some securities short to buy other securities. Hedge funds and institutions that may be able to use the proceeds from selling some securities short to buy others might find closed-end funds, and especially some of the securities that comprise the portfolios of the closed-end funds, not liquid enough to trade in.

Even market participants who are able to use the proceeds from selling some securities short to buy others might be dissuaded from buying closed-end funds and shorting the securities in the closed-end funds' portfolio because of the fees and expenses charged by the closed-end funds. However, if the discount to book value is large enough, the fees and expenses charged by the closed-end funds could be offset by the discount to book value and thus generate a positive carry for a long closed-end fund - short the fund's portfolio position. This would be especially true for closed-end funds that specialize in securities that generate higher income, such as those in the index upon which CEFL and its unleveraged counterpart YYY are based.

An example of the discount to book value more than offsetting the fees and expenses would be a hypothetical closed-end fund whose portfolio securities yielded 10% before expenses. Most income-oriented closed-end funds have expense ratios lower than 1%. Shorting $100 worth of the securities that comprise the fund would require payments of $10 representing 10% annually to those the securities were borrowed from. The $100 proceeds from the short sale could be used to acquire $100 of the closed-end fund. If the closed-end fund was trading at a 14% discount, $100 of the fund would represent 100/.86 = $116.28 worth of the securities in the fund.

These securities yield 10%, so the gross income from the fund position would be $11.63. The net income, assuming a 1% expense ratio, would be $10.63. Thus, even after expenses and fees, an account long the closed-end fund would generate higher income than the portfolio securities while it waited for the discount to narrow to realize the risk arbitrage profit.

While explicit risk arbitrage where the portfolio securities are shorted and the proceeds are employed to buy the closed-end fund might not occur in significant quantities to narrow the discount to book value, implicit arbitrage should eventually have an impact. Implicit risk arbitrage would occur as investors holding or wanting to hold securities with similar risk/return characteristics as a closed-end fund or the portfolios held by the closed-end fund shift from other securities to the closed-end fund.

Institutional investors who had portfolios that contained securities similar to or identical to those held in a close-end fund could improve their risk/return profile by shifting out of securities in the closed-end fund to the closed-end fund, if the discount to book value for the closed-end fund was large enough. Retail investors could switch from securities held in portfolios of close-end fund to the closed-end fund and improve their risk/return profile if the discount to book value for the closed-end fund was large enough. More important, investors could shift out open-end mutual funds into closed-end mutual funds with similar objectives and portfolios.

Open-end mutual funds are sold and redeemed at net asset value. Thus, there is never any discount or premium to book value for an open-end mutual fund. Advantages for investors in no-load mutual funds are that there are no transactions costs and the funds can always be redeemed at net asset or book value. Closed-end funds usually require some brokerage commission to buy and sell them, and there is risk that the closed-end fund will fluctuate due to changes in the premium or discount to net asset value in addition to fluctuation in the portfolio securities. The advantages of no-load open-end mutual funds are somewhat offset by the lower fees and expenses that closed-end funds usually have.

When closed-end funds are trading at large discounts to book value, investors can significantly increase their returns by switching from open-end funds to closed-end funds that have similar assets but are selling at discounts to net asset value and typically have lower fees and expenses. When an investor redeems an open-end fund at net asset value, the open-end fund sells portfolio securities to fund the redemption.

That would tend to lower the market prices of those portfolio securities. If the investor uses the proceeds from the redemption of the open-end fund to buy shares in a closed-end fund that holds similar portfolio securities, the net effect would be to put downward pressure on the market prices of the portfolio securities and upward pressure of the market prices of the closed-end funds. Thus, the discount to book value for the closed-end funds will tend to decline.

This discount to net asset value alone is still a good reason to be constructive on CEFL. Although, the discount to book value is not as large as it was earlier in 2016. It should be noted that saying many CEFL components are trading at a discount to the net asset value of the closed-end funds that comprise the index does not mean that CEFL does not always trade at a level close to its own net asset value. Since CEFL is exchangeable at the holders' option at indicative or net asset value, its market price will not deviate significantly from net asset value. The net asset value or indicative value of CEFL is determined by the market prices of the closed-end funds that comprise the index upon which CEFL is based.

My constructive view on CEFL stems not only from the discount to book value of the closed-end funds, but also from the very large dividends paid by CEFL. One troubling aspect of CEFL is the significant amount of the dividends paid by the closed-end funds that comprise CEFL that consists of return of capital. My calculation using available data indicates that 21.8% of the CEFL dividend consists of return of capital. However, there does not seem to be any statistically significant relationship between return of capital and the discounts to book value that the individual closed-end funds trade at.

My calculation projects a July 2016 dividend of $0.324. For the three months ending July 2016, the total projected dividends are $0.835. The annualized dividends would be $3.341. This is a 21.1% simple annualized yield with CEFL priced at $15.82. On a monthly compounded basis, the effective annualized yield is 23.3%.

Aside from the fact that with a yield about 20%, even without reinvesting or compounding, you get back your initial investment in only five years and still have your original investment shares intact. If someone thought that over the next five years markets and interest rates would remain relatively stable, and thus CEFL would continue to yield 23.3% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $284,848 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $23,200 initial annual rate to $66,370 annually.

Holdings of CEFL and YYY as of June 24, 2016 weights end of May

Name

Ticker

Weight

Price

NAV

price/NAV

ex-div

dividend

frequency

contribution

GAMCO Global Gold Natural Resources & Income Trust

GGN

5.11

6.45

6.24

1.0337

6/14/2016

0.07

m

0.0183009

DoubleLine Income Solutions

DSL

4.46

18.16

19.33

0.9395

6/15/2016

0.15

m

0.0121569

Morgan Stanley Emerging Markets Domestic Debt Fund

EDD

4.44

7.61

8.79

0.8658

6/28/2016

0.18

q

0.0346565

Western Asset Emerging Markets Debt Fund

ESD

4.36

15.01

17.41

0.8621

6/15/2016

0.105

m

0.0100649

Aberdeen Aisa-Pacific Income Fund

FAX

4.31

4.97

5.68

0.8750

6/16/2016

0.035

m

0.0100162

Royce Value Trust

RVT

4.29

11.63

13.76

0.8452

6/9/2016

0.25

q

0.0304321

Eaton Vance Limited Duration Income Fund

EVV

4.27

13.33

14.66

0.9093

6/9/2016

0.1017

m

0.0107506

Prudential Global Short Duration High Yield Fund

GHY

4.26

15.1

16.31

0.9258

6/15/2016

0.11

m

0.0102409

AGIC Convertible & Income Fund

NCV

4.22

6.04

6.14

0.9837

6/9/2016

0.065

m

0.0149866

PIMCO Dynamic Credit Income Fund

PCI

4.17

18.91

20.48

0.9233

6/9/2016

0.1641

m

0.011939

Eaton Vance Tax-Managed Global Diversified Equity Income Fund

EXG

4.16

8.51

8.85

0.9616

6/21/2016

0.0813

m

0.013115

Voya Global Equity Dividend & Premium Opportunity Fund

IGD

4.11

6.86

7.5

0.9147

6/1/2016

0.076

m

0.0150261

Calamos Global Dynamic Income Fund

CHW

4.02

6.87

7.88

0.8718

6/8/2016

0.07

m

0.013517

Alpine Global Premier Properties Fund

AWP

3.97

5.42

6.31

0.8590

6/21/2016

0.05

m

0.0120858

Alpine Total Dynamic Dividend

AOD

3.97

7.25

8.52

0.8509

6/21/2016

0.0575

m

0.0103904

PIMCO Corporate & Income Opportunity Fund

PTY

3.7

14.03

13.01

1.0784

6/9/2016

0.13

m

0.0113136

Western Asset High Income Fund II

HIX

3.53

6.89

7.28

0.9464

6/15/2016

0.0615

m

0.0103979

Clough Global Opportunities Fund

GLO

3.48

9.07

11.02

0.8230

6/15/2016

0.1

m

0.0126615

Wells Fargo Advantage Income Opportunities Fund

EAD

3.27

7.81

8.62

0.9060

6/13/2016

0.068

m

0.0093955

Prudential Short Duration High Yield Fd

ISD

3.09

15.68

16.66

0.9412

6/15/2016

0.11

m

0.0071535

Blackstone/GSO Strategic Credit Fund

BGB

2.89

14.26

16.06

0.8879

6/21/2016

0.105

m

0.0070223

Wells Fargo Advantage Multi Sector Income Fund

ERC

2.67

12.65

13.74

0.9207

6/13/2016

0.0923

m

0.0064289

BlackRock International Growth and Income Trust

BGY

2.28

5.66

6.362

0.8897

6/13/2016

0.049

m

0.0065137

BlackRock Corporate High Yield Fund

HYT

2.22

10.28

11.15

0.9220

6/13/2016

0.07

m

0.0049885

BlackRock Multi-Sector Income

BIT

1.99

16.4

18.13

0.9046

6/13/2016

0.1167

m

0.004673

First Trust Intermediate Duration Prf.& Income Fd

FPF

1.83

23

22.94

1.0026

6/1/2016

0.1625

m

0.0042667

AllianceBernstein Global High Income Fund Inc.

AWF

1.63

12.23

12.94

0.9451

6/1/2016

0.081

m

0.0035625

Eaton Vance Tax-Managed Diversified Equity Income Fund

ETY

1.26

10.14

10.93

0.9277

6/21/2016

0.0843

m

0.0034568

Invesco Dynamic Credit Opportunities Fund

VTA

1.12

11.05

12.34

0.8955

6/30/2016

0.075

m

0.0025086

Nuveen Preferred Income Opportunities Fund

JPC

0.93

10.03

10.15

0.9882

6/13/2016

0.067

m

0.0020501

Click to enlarge

Disclosure: I am/we are long CEFL, AGNC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.