The recent volatility has been great for traders, and great for those looking to pick up fixed income investments on the cheap.
Any major shock event leads to mispricings in low liquidity stocks and funds. These are usually corrected fairly quickly, so it helps to have a team, or powerful software to spot the opportunities. Thankfully I have both.
I'll quickly share some trades I like in MLP closed-end funds and demonstrate how I arbitrage extreme premium/discounts from NAV.
First, here are the scan results:
Source: author's spreadsheets
Next I check how often the funds trade at this kind of premium / discount. If they often trade there, or they are close to average levels, there is little reward.
The chart below shows the distribution of premium / discount of the three funds I want to short. The period is 200 days.
Source: author's software
Clearly, the funds are at unusually high premiums. This is exactly what I want to see.
I repeat the process with the two funds I want to go long. Then I check the statistics for all the 5 funds.
Source: author's software
The charts on the left show how the three funds trading at a premium have deviated from their NAV in an unusual way. Taking the NAV long in one portfolio, and a proportional short in the funds in the other, we would expect the same output. This has been the case until recently, but a divergence from normal behavior is clear in recent sessions.
On the right hand side we compare the two funds trading at a discount to the same NAVs we used in the comparisons on the left (the NAV of the funds trading at a premium). You can see how they actually trade in line, even more so than on the left. This is because all the NAVS in the MLP sector have a high correlation. This is just another way of showing how abnormal the divergences are.
The software calculates the correct position sizes to construct the arbitrage. The expectation is for reversion to the mean. Either the funds with high discounts will become "overvalued" or the funds that are overvalued will become "normal" again.
The trade is shown here:
It is best to take the funds you want to short first, so you can check liquidity and hard to borrow costs. Then construct the rest of the arbitrage on the long side.
I consider deviations from average premium/discount levels to be random. The model is based on this assumption. If you have any reason to believe that this is not the case and current valuations are appropriate based on fundamentals I would really like to see your comments, so that I can improve my models. A respected author George Spritzer makes the point that deferred tax liability can be a serious fundamental factor for some funds to trade at a premium. This is a really interesting topic and I will try to prepare an article on this matter. Comments can be seen in my instablog
Volatility in fixed income has a big effect on low liquidity Closed-End Funds. It can be difficult to trade and benefit from the opportunities, but the strategy shown above minimizes risk. There is always the risk of being bought in, but you can always substitute and switch funds. Another good use of the proposed trade is for investors to switch from "overvalued" funds to "undervalued" ones boosting their total return.
Disclosure: I am/we are long CBA, MIE.
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.
Additional disclosure: I am short TYG JMF FEI