CEFs: Overvalued And Undervalued Multisector Funds - Second Quarter 2016

| About: DoubleLine Income (DSL)

Summary

This is the first of our series of quarterly valuation analysis on each of the taxable bond CEF sub-categories.

We like to use a combination of factors and continue to refine the process.

There is no one-size-fits-all quantitative metric, especially in multisector funds given the disparity in holdings, leverage and trends.

Given the run in closed-end funds since the start of the year, we thought we would visit the industry and do an overview of each of the underlying segments. We are looking at the multisector taxable bond funds today using a fairly simple calculation in order to incorporate several factors which we think SHOULD drive valuation of the funds. However, given the investor base of closed-end funds, distribution yield and discount tend to be the primary, and in many cases the only, factor looked at.

We are not big fans of a one-size-fits-all quantitative screen in order to create some rank of the value of respective funds. Our process involves a screening component as a starting rank which we then use to dig deeper with a more qualitative analysis. Anyone who ranks closed-end funds via a one or even two-variable ranking system is likely misleading the investor.

Our initial ranking system utilizes the current discount or premium, the current distribution rate and the earnings in excess over net investment income yield. Our adjusted annual total return assumption (which we simplistically call 'adjusted yield') includes the price equaling NAV by year five. In other words, we include the discount closing to zero over a five-year period. To us, this is a mechanism that helps incorporate a margin of safety. There are flaws with any ranking system and we certainly know some exist with this system but feel that it makes one of the better starting points in analysis.

For one, we are calculating in a potential capital gain via the closure of the discount over an extended and fairly reasonable period of time. Second, we include the all-important distribution rate into the ranking. And lastly, we include what the fund is currently generating in terms of earnings which can help us anticipate distribution cuts or increases.

Without further ado, here we go starting with multisector bonds.

Multisector Bond CEFs Analysis

Our database has 17 multisector bond CEFs which are the general, go-anywhere, core bond funds. Some do have skews in their holdings to one sector or another, which will come into play under qualitative analysis. For instance, PIMCO Dynamic Income (NYSE:PDI) is included as a multisector bond CEF but has a significant amount of exposure to the non-agency MBS sector- as does PIMCO Income Opportunity (NYSE:PKO). We have written about several of the top funds including BlackRock Multi-Sector Income (NYSE:BIT) and PIMCO Dynamic Credit Income Fund (NYSE:PCI), recently.

The ranking system finds that DoubleLine Income Solutions (NYSE:DSL) is the most undervalued (see our recent article on the fund) while, and no surprise here, PIMCO Global StocksPLUS&Income Fund (NYSE:PGP) is the most overvalued. But this is where our analysis begins, not ends. For instance, DSL, which has our largest adjusted yield within the category, is not currently covering its distribution. Earnings coverage is 96% with both UNII and earnings trending lower. Additionally, UNII is negative and excess of NII yield over distribution yield is negative 0.39%.

All told, the fund is a cheap value but an investor must ascertain if it is cheap for a reason. This goes back to the portfolio composition we discussed earlier. DSL has a significant amount of EM debt which has been a strong headwind to performance until recently. The fund has a total return on NAV of just 12.85% over the last three years compared to a category average of 18.30%. So while our yield calculation makes it one of the cheapest, from a total return perspective historically, it has underperformed. The question becomes how one feels about EM debt going forward.

In comparison, PIMCO Income Opportunity, the second on the list, has about 50 bps of less 'adjusted yield.' However, the NII yield is stronger at 9.85%, with excess being exactly zero. UNII has been trending lower but earnings have trended up with 100% earnings coverage currently. The shares do trade nearly 6% more expensive given they trade at a 2.3% premium. The fund is skewed towards asset-backed securities, mostly non-agency MBS and only 6% in EM debt. Overall, while PKO trades at small premium versus a 3.6% discount for DSL, it carries several characteristics that make it more attractive than DSL. This is the qualitative judgment that must come in and possibly some assumptions by the investor to make the ultimate buy determination.

The third spot is occupied Guggenheim Credit Allocation (NYSE:GGM) which trades just above NAV. The fund's three-year average discount is 2.5% so the fund is currently trading marginally above that figure, which is much less egregious compared to many CEFs today. In comparison, as displayed on the image above, DSL and PKO trade at 4.34% and 4.93% above their three-year averages, respectively.

GGM's adjusted yield is 9.23%, 16 bps below that of PKO but it does have a negative excess yield of 92 bps. But as we noted, we must use qualitative analysis to determine differences. Here, the NII yield which we use to calculate excess is quite stale coming from an 11/30/2015 filing, compared to 3/31/2016 and 5/31/2016 for DSL and PKO, respectively. A new report is likely to be released in the next few days or weeks and that excess number could be positive or further negative. This is one of the risks of closed-end fund investing.

On the overvalued side, we have PIMCO Global StockPLUS which trades at a ridiculous 103% premium to NAV as the most expensive. This compares to a one-year average discount of 68% and a three-year average discount of 64.6%. Our adjusted yield is a negative 13.7% due to the premium amortization headwind. Additionally, earnings coverage is just 76% with UNII trends declining and the excess a negative 2.6%. Even adjusting the premium headwind declining *just* to the three-year average results in a negative adjusted yield of 3%.

Doubleline Opportunistic Credit Fund (NYSE:DBL) makes up the second most expensive fund in the category. It trades at a 14.8% premium to NAV which is 11% above the three-year average. Adjusted yield is just under 4%, UNII a negative 13.6 cents, and NII yield just 6.94% with excess also negative at 54 bps. Both UNII and earnings have trended lower although total return over the last three years is the second best in the category (behind PDI. See An Update On "The Greatest Bond CEF Ever.") at 41% on price and 29% on NAV. We believe this fund is trading based on name (DoubleLine and Gundlach) and return momentum while investors ignore underlying fundamentals.

Lastly, the third worst fund in the group is the MFS Government Markets Income Trust (NYSE:MGF). Interesting enough, this fund trades at a discount to NAV despite being overvalued by the screen. The reason being is leverage is just 8% (negative 8% cash balance) which severely limits the yield of the fund. The fund is only 126 bps and 167 bps above its three-year average discounts, one of the lowest on the table. But NII yield is just 3.05% with adjusted yield of 4.03%. Additionally, the distribution appears likely to see a cut as excess is a negative 4.5%, UNII is slightly negative and earnings are trending lower.

In the current interest rate environment, we do think it is a negative for a fund not to use borrowing in order to increase the yield of the portfolio. Many funds borrow for less than 30 bps and can reinvest into coupons generating 3-5%. That spread is a significant contributor to the yield of the fund. It does, however, increase the volatility of the fund. For instance, MGF, which we noted at single-digit leverage of 8%, has a three-year standard deviation of 9.32% on price and 3.78% on NAV. That is much lower than the 12.5% on price and 5.15% on NAV for DSL. But the yield differential, we contend, more than makes up for that lower volatility.

Conclusion

In the multisector category, our screening process shows DSL, PKO and GGM as the cheapest based on our ranking system. The same system shows PGP, DBL and MGF as the most expensive. Quantitative analysis can only get you so far. Deeper investigations are needed to make an accurate comparison among funds within the same category. But the information can be a good starting point in establishing how we evaluate funds within each category and address the always difficult question of valuation.

Disclosure: I am/we are long PDI, PKO, PCI, DSL , BIT.

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.