I Still Like CEFL With Its 20.6% Yield, Though Risks Have Increased

| About: UBS ETRACS (CEFL)

Summary

The primary determinant of the outlook for CEFL and much of the securities markets will be what the Federal Reserve does with interest rates.

Within the Federal Reserve and in the financial community at large there is considerable debate as to what the Federal Reserve should do next.

I think this debate can be characterized as those who want normal interest rates versus those who favor normal monetary policy.

On a year-to-date basis the UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL) has returned 32.4% based on a purchase at the end of 2015 at $15.35, the September 26, 2016 price of $17.92 and the dividends of $2.40 paid this year through to September 2016. This does not include any reinvestment of dividends or any gains or losses on reinvestment of dividends. It also does not include my projected October 2016 CEFL monthly dividend of $0.326.

The December 2015 Federal Reserve interest rate increase caused a dramatic decline in financial markets that resulted in a great buying opportunity in, among many other securities, CEFL which closed at $12.20 on January 20, 2016. CEFL and the closed-end funds that comprise the index upon which CEFL is based are impacted by higher interest rates in various ways. Many of the high yielding closed-end funds employ leverage to boost their yields by borrowing. Additionally, CEFL itself effectively borrows at LIBOR + .40% to achieve its current yield which now exceeds 20% on an annualized monthly compounded basis. Higher interest rates also hurt most of the equity and fixed-income markets and thus the high yield securities held by the CEFL components.

The outlook for CEFL, the high yielding closed-end funds and to some extent the rest of the securities markets depends on future Federal Reserve behavior. Within the Federal Reserve and in the financial community at large there is considerable debate as to what the Federal Reserve should do next. I think this debate can be characterized as those who want normal interest rates versus those who favor normal monetary policy.

Those calling for a normalization of interest rates suggest that interest rates should be returned to somewhere near the averages that prevailed since the end of World War II. In contrast, normal monetary policy has been to raise interest rates when it is clear that unemployment is too low, too many people have jobs and that wages are rising so rapidly that an inflationary spiral is likely.

Those in the normalization camp want the Federal Reserve to hike interest rates now. In the September 2016 meeting, three of the twelve members of the Federal Reserve Open Market Committee dissented from the vote to keep the target federal funds rate unchanged. The dissenters wanted an increase in rates.

The arguments for immediate rate increases are varied. Some claim that monetary policy is either ineffective or we have gotten to a point where it is no longer effective or warranted. Some say that the recovery from the 2008 super-recession has been very sluggish with real GDP growth generally less than 2% on average. They suggest fiscal policy should now be used to boost growth, rather than monetary policy. That some of these people also claim that the economy is strong enough for rates to be raised is puzzling.

In many of the developed countries outside the USA, the central bankers have pushed normal monetary policy far beyond what the Federal Reserve has done. Interest rates have gone into negative territory in many countries. See: More Thoughts On Negative Interest Rates. Many of those other central banks seem more aware of the dangers of using fiscal policy rather than monetary policy in terms of what it does to debt levels which are still a major problem.

The major problem with replacing monetary policy with fiscal policy to boost growth is that it will increase deficits and debt. Again, many of the same people calling for higher interest rates also bemoan the high levels of deficits and debt. Increasing government spending or reducing taxes will increase deficits and debt. Furthermore, higher interest rates also increase deficits and debt as interest expense is an important part of government expenditures. See: Long-Term Federal Budget - It Is Worse Than You Think

While much progress has been made in many areas since the 2008 financial crisis. Debt still remains a problem. An article " The Global Growth Conundrum" in April 2016, noted that since the 2008 financial crisis debt, growth has exploded around the world. In the U.S., debt relative to GDP has risen by about 5% per year with public sector debt nearly doubling relative to GDP while private sector debt actually fell by about 4% per year. In 2014 Dr. Lacy Hunt of Hoisington Economics posited that the growth of public sector debt was and would be a major constraint on U.S. and global growth. His thesis was that growing public sector deficits to finance exploding spending on entitlements would be self- defeating because entitlement spending does not provide a growth dividend.

The result according to Hunt would be a never-ending debt spiral which would result in higher interest rates relative to the economy's ability to grow. In June 2015 "Global Debt and Global Growth" we devised a measure of the ability of an economy to service its debt, the difference between nominal GDP growth and the BAA corporate bond rate. For most of the post-World War II period nominal GDP growth exceeded the BAA rate, meaning the U.S. could easily service its debt. In that period up to about 1980 economic growth exceeded 3.5% annually on average. Now nominal GDP growth is less than the BAA rate.

Using fiscal policy rather than monetary policy to address weak growth would certainly raise interest rates all along the quality spectrum. To the extent that higher interest rates relative to the economy's ability to grow poses a threat, the worst think that policy makers could do would be to raise interest rates by reversing the accommodative monetary policy while increasing deficits and debt via expansive fiscal policy.

Some, including Federal Reserve officials think that the current 4.9% headline unemployment rate is a reason to raise interest rates. Even those who don't complain about the sluggish 2% real GDP growth rate question why the relatively low headline unemployment rate is accompanied by the sluggish 2% real GDP growth rate. The answer is the decline in the labor force participation rate. Those who leave the labor force are not counted as unemployed. In previous economic cycles labor force participation was cyclical. Poor labor market conditions caused many to drop out of the labor force. These were called discouraged workers who may have given up looking for work after sending out hundreds of resumes and getting no responses. In prior recessions, as labor market conditions improved many of the discouraged workers rejoined the labor force. This was especially pronounced for prime working age men.

This, time there has been no significant increase in labor force participation as the unemployment rate declined. The labor force participation rate for prime working aged men is about as low as it has ever been since records began being kept in 1948. Many, including some Federal Reserve officials have expressed bewilderment as to why labor force participation has not recovered as it had in prior recessions. I would suggest that for some the answers can be found in the spam folder of their email accounts.

The spam folder in my email account contains numerous emails from attorneys promising that they can get me disability payments. If the labor force participation rate, especially for prime working-age males ages 25-54, had followed its typical cyclical pattern, the unemployment rate would now be well above 5.0%. The headline U-3 unemployment only counts those actively seeking work as in the labor force and unemployed.

As was pointed out in " Disability's Disabling Impact On The Labor Market" historically labor force participation has behaved cyclically in the midst of a slightly declining trend. Dubious and fraudulent disability claims have vastly increased the number of those collecting disability with commensurate decreases in labor force participation and the unemployment rate. A segment on CBS "60 Minutes" quoted employees of the Social Security Administration and administrative law judges who asserted that lawyers are recruiting millions of people to make fraudulent disability claims. One such judge said "if the American public knew what was going on in our system half would be outraged and the other half would apply for benefits."

Generally, Janet Yellen and other Federal Reserve officials do not talk about raising rates, but rather have used the term normalization of interest rates. In the news conference following the September 2016 meeting. Janet Yellen did not use the "N" word. Rather than using the term Normalization, Yellen referred to "removal of accommodation" as a euphemism for raising interest rates. I find this very encouraging. It suggests to me that Janet Yellen and others who I would consider in the normal monetary policy camp, which would call for waiting until inflationary threats are more pronounced before raising rates, may be digging in their heels against those calling for normal, that means higher, interest rates.

My view is that normal interest rates are not appropriate when you have very abnormal economic conditions. There has been a fundamental change world-wide this century that suggests that the rates that prevailed in the second half of the last century should not be considered as normal for the current period.

The economy is growing at a very modest rate around 2% and inflation is still well contained. This modest growth has only been possible because of the Federal Reserve's very low interest rate policy. There are surely some households and businesses that are barely hanging on by their fingernails. They would possibly be unable to meet their financial obligations if the interest rates on their adjustable rate loans were increased by another 25 basis points.

An analogy for the decisions facing the Federal Reserve could be that of a ship that has been damaged by a storm and is leaking. Only by running the engines and the bilge pumps full out has Captain Yellen been able to keep the ship afloat and maintain a speed of only two knots. She convenes a meeting of the ship's officers. Some of the officers urge returning to normal operation of the ship's engines and the bilge pumps. They argue that if there were to be another storm, they would not be able increase engine speed anymore. Some say that a while ago when the ship was higher in the water, they should have reduced the speed and use of the bilge pumps. Saner officers point out that had they not kept the engines going at maximum they would now be under water and that now is a particularly bad time to reduce speed and pumping since there are many sharks circling the ship.

My primary interest in holding CEFL is the extraordinarily high yield, still above 20% on a monthly on a compounded basis. The year-to-date total return on CEFL of 32.4% is what could have been expected given that there have been no rate increases by the Federal Reserve in 2016. In January 2016 even those most bearish on CEFL would have probably conceded that if there were no rate increases by the Federal Reserve this far into 2016 then CEFL would have had a high total return at this point in time. Obviously those who were bearish on CEFL at the beginning of 2016 were expecting multiple interest rate increases by now.

My view is that normal interest rates are not appropriate when you have very abnormal economic conditions. There has been a fundamental change world-wide this century that suggests that the rates that prevailed in the second half of the last century should not be considered as normal for the current period.

The primary change that has fundamentally changed the economy can be best described by Warren Buffett CEO of Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) who said "Through the tax code, there has been class warfare waged, and my class has won," Buffett told Business Wire CEO Cathy Baron Tamraz at a luncheon in honor of the company's 50th anniversary. "It's been a rout."

One does not have to be a Keynesian to see that shifts in income to those with lower marginal propensities to consume will cause an increase in savings and a decline in consumer spending. The wealthy clearly have lower marginal propensities to consume. As I explained in a Seeking Alpha article "A Depression with Benefits: The Macro Case for mREITs":

...In free-market capitalism, capital generates income for the owners of the capital, which in turn is used to create additional capital. This is very good. Sometimes, it can be actually too good. As capital continues to accumulate, its owners find it more and more difficult to deploy it efficiently. The business sector generally must interact with the household sector by selling goods and services or lending to them. When capital accumulates too rapidly, the productive capacity of the business sector can outpace the ability of the household sector to absorb the increasing production. The capitalists, or if you prefer, job creators use their increasing wealth and income to reinvest, thus increasing the productive capacity of the business they own. They also lend their accumulated wealth to other businesses as well as other entities after they have exhausted opportunities within the business they own. As they seek to deploy ever more capital, excess factories, housing and shopping centers are built and more and more dubious loans are made. This is overinvestment....

Shifting income to the rich by taxing dividends, capital gains and corporate profits much less than the tax rates on wages also tends to make more funds available for investment since when investment is taxed relatively less, more funds are made available for investment. This also put a downward pressure on interest rates.

The laws of supply and demand apply differently to the market for loanable funds as compared to commodities. With commodities, equilibrium reached when the quantity supplied is equal to the quantity demanded. The debt or loanable funds market is more complex. A simple example illustrates this. An increase in government deficits accompanied by a commensurate increase in the issuance of government debt would normally be thought of as causing an increase in interest rates. However, the cause and/or purpose of the government deficits have a tremendous impact in terms of how interest rates are affected.

A government deficit for the purpose of funding a tax cut for those with high propensity to save has a much different impact on interest rates than the deficit of a similar magnitude whose purpose is to fund an increase in social or defense spending. When the Federal government sells bonds and uses the proceeds to cut taxes on the wealthy, which in turn now have more money to lend, the net effect is to push down interest rates. This is especially true when the central banks are the buyers of much of the government debt.

As long as there is a much greater supply of loanable funds than the demand for them in the risk-free credit market, risk-free and near risk-free interest rates should remain low. Attempts by the Federal Reserve to push risk-free rates higher than what supply and demand would otherwise indicate will only result in weaker economic activity. Lower rates are by far the best environment for instruments such as CEFL that generate their high yields from the spread between the low short-term LIBOR borrowing rate and the high yields that the high dividend closed-end funds that comprise the index upon which CEFL is based. Additionally, many of those high dividend closed-end funds use borrowing and leverage strategies to generate those high dividend yields. Higher short-term interest rates would negatively impact both CEFL and the high dividend closed-end funds.

I am still bullish on CEFL despite the price increases this year. However, some of the factors that made me bullish previously are not as pronounced as before. 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 7.2% on August 24, 2016 up from 6.9% on July 28, 2016. This compares to the record 13.8% discount to book value for CEFL on September 18, 2015. Much of the price increase in CEFL since then has been due to the reduction on the discount to book value that the components were trading at. Discounts to book value in the components will no longer be a source of strength for CEFL in the future.

The two concerns that have depressed high dividend closed-end fund prices over the last few 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 and diminished fear of interest rate increases.

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. Essentially, holders of CEFL receive the dividend yield in excess of 20% in return for incurring the risk of higher interest rates. That bet paid off so far in 2016 as the projections of multiple rate hikes by the Federal Reserve proved to be wrong.

All of the CEFL components had ex-dividend dates in September 2016. Thus, they will all contribute to the October 2016 dividend. Even though 28 of the 30 high dividend closed-end funds that comprise the index upon which CEFL and YYY is 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. My projection is that the October 2016 CEFL dividend will be $0.326. Some readers have asked to see the details of my dividend calculations. I use the contribution by component method. An example of that methodology using actual numbers can be seen in the article: "MORL Yielding 24.7% Based On Projected June Dividend."

There were 5 closed-end funds in the index upon which CEFL is based that reduced their dividends in September 2016 as compared to prior levels. EDD reduced its' quarterly dividend to $0.18 from $0.20 last quarter. RVT reduced its' quarterly dividend to $0.24 from $0.2499 last quarter. Eaton Vance Limited Duration Income Fund (NYSEMKT:EVV) reduced its' monthly dividend to $0.18 from $0.20 last month. Prudential Global Short Duration High Yield Fund (NYSE:GHY) reduced its' monthly dividend to $0.10 from $0.11 last month. Prudential Short Duration High Yield Fund (NYSE:ISD) reduced its' monthly dividend to $0.1025 from $0.11 last month. Clearly, the case for investing in CEFL is not helped when 5 of the closed-end funds in the index reduce their dividends, while none increase theirs. Realistically, if the yields on the closed-end funds are high enough that even now the yield on CEFL is above 20% it is likely that those dividends are more likely to be reduced than increased in the future. The question is will an investor be able to be compensated for the risk of dividend and price reductions via high yields now.

Another troubling and in some cases related aspect of CEFL has been the significant amount of the dividends paid by the closed-end funds that comprise CEFL that consists of return of capital. Paying dividends out of capital in many instances can be a precursor to dividend cuts. That concern may have lessened with the most recent numbers. My calculation using available data as of September 25, 2016 indicates that on a weighted basis 27.3% of the CEFL dividend consists of return of capital.

I am still bullish on CEFL despite the price increases this year. However, some of the factors that made me bullish previously are not as pronounced as before. 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. Although month-to-month comparisons can be useful. As of September 26, 2016 the weighted discount to book value of 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 8.3%. It was 7.2% on August 24, 2016 up from 6.9% on July 28, 2016. This compares to the record 13.8% discount to book value for CEFL on September 18, 2015. Much of the price increase in CEFL since then has been due to the reduction on the discount to book value that the components were trading at. Discounts to book value in the components will no longer be a source of strength for CEFL in the future.

There should be some limits as to how far away from book value a closed-end fund should trade. The reduction in the weighted average of the discount to book value of the 30 high dividend closed-end funds that comprise the index upon which CEFL is based from 13.8% in 2015 to the September 2016 level 8.3% demonstrates that extreme discounts to book value cannot persist indefinitely. 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.

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.

My calculation projects an October 2016 dividend of $0.326. To properly annualize the yield, a three-month moving average should be employed to take into account the small seasonal effect whereby the two quarterly payers do not pay every month. For the three months ending October 2016, the total projected dividends are $0.8463. The annualized dividends would be $3.285. This is a 18.9% simple annualized yield with CEFL priced at $17.92. On a monthly compounded basis, the effective annualized yield is 20.6%.

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 20.6% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $255,265 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $20,600 initial annual rate to $52,620 annually.

Holdings of CEFL and YYY as of September 26, 2016

Name

Ticker

Weight

Price

NAV

price/NAV

ex-div

dividend

frequency

contribution

GAMCO Global Gold Natural Resources & Income Trust

GGN

4.99

6.36

6.14

1.0358

9/14/2016

0.07

m

0.0194861

Morgan Stanley Emerging Markets Domestic Debt Fund

EDD

4.67

8.13

9.19

0.8847

6/28/2016

0.18

q

0.0366845

Western Asset Emerging Markets Debt Fund

ESD

4.63

16.28

18.09

0.8999

9/21/2016

0.105

m

0.010595

Allianzgi Convertible & Income Fund

NCV

4.53

6.66

6.67

0.9985

9/8/2016

0.065

m

0.0156863

Doubleline Income Solutions

DSL

4.49

18.89

20.53

0.9201

9/14/2016

0.15

m

0.01265

PIMCO Dynamic Credit Income Fund

PCI

4.38

20.21

21.46

0.9418

9/8/2016

0.1641

m

0.0126154

Aberdeen Aisa-Pacific Income Fund

FAX

4.31

5.04

5.82

0.8660

9/19/2016

0.035

m

0.0106194

Royce Value Trust

RVT

4.29

12.48

14.61

0.8542

9/9/2016

0.24

q

0.029271

Eaton Vance Limited Duration Income Fund

EVV

4.22

13.61

15.07

0.9031

9/8/2016

0.0867

m

0.009538

Prudential Global Short Duration High Yield Fund

GHY

4.15

15.01

16.68

0.8999

9/14/2016

0.1

m

0.0098096

ING Global Equity Dividend & Premium Opportunity Fund

IGD

4.09

7.21

7.78

0.9267

9/1/2016

0.076

m

0.0152963

Calamos Global Dynamic Income Fund

CHW

4.03

7.35

8.36

0.8792

9/8/2016

0.07

m

0.0136176

Eaton Vance Tax-Managed Global Diversified Equity Income Fund

EXG

3.91

8.66

9.14

0.9475

9/21/2016

0.0813

m

0.0130237

Alpine Global Premier Properties Fund

AWP

3.89

5.63

6.69

0.8416

9/21/2016

0.05

m

0.0122573

Alpine Total Dynamic Dividend

AOD

3.84

7.53

8.87

0.8489

9/21/2016

0.0575

m

0.0104037

PIMCO Corporate & Income Opportunity Fund

PTY

3.65

14.59

13.51

1.0799

9/8/2016

0.13

m

0.0115389

Western Asset High Income Fund II

HIX

3.53

7.09

7.53

0.9416

9/21/2016

0.0565

m

0.0099807

Clough Global Opportunities Fund

GLO

3.42

9.62

11.71

0.8215

9/14/2016

0.086

m

0.0108476

Wells Fargo Advantage Income Opportunities Fund

EAD

3.35

8.3

9.07

0.9151

9/12/2016

0.068

m

0.0097378

Prudential Short Duration High Yield Fund

ISD

3.02

15.79

16.95

0.9316

9/14/2016

0.1025

m

0.0069556

Backstone /GSO Strategic Credit Fund

BGB

2.88

14.81

16.58

0.8932

9/21/2016

0.105

m

0.0072445

Wells Fargo Advantage Multi Sector Income Fund

ERC

2.7

12.93

14.34

0.9017

9/12/2016

0.0923

m

0.0068383

Blackrock Corporate High Yield Fund

HYT

2.22

10.67

11.72

0.9104

9/13/2016

0.07

m

0.0051674

BlackRock International Growth and Income Trust

BGY

2.17

5.83

6.61

0.8820

9/13/2016

0.038

m

0.0050183

Blackrock Multi-Sector Income

BIT

1.99

17.11

18.88

0.9063

9/13/2016

0.1167

m

0.0048157

First Trust Intermediate Duration Prf.& Income Fd

FPF

1.78

23.23

23.93

0.9707

9/1/2016

0.1625

m

0.0044178

Alliancebernstein Global High Income Fund Inc

AWF

1.63

12.58

13.51

0.9312

9/7/2016

0.081

m

0.0037237

Eaton Vance Tax-Managed Diversified Equity Income Fund

ETY

1.22

10.55

11.2

0.9420

9/21/2016

0.0843

m

0.0034587

Invesco Dynamic Credit Opportunities Fund

VTA

1.14

11.59

12.81

0.9048

9/12/2016

0.075

m

0.0026174

Nuveen Preferred Income Opportunities Fund

JPC

0.9

9.97

10.55

0.9450

9/13/2016

0.067

m

0.0021459

Click to enlarge

Disclosure: I am/we are long CEFL.

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.