Seeking Alpha

The Chemist's CEF Report, November 2017: CEFs Not Joining The Party

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Includes: ACWX, ASG, AVK, AWP, BFY, BGH, BGR, BHV, BIF, BWG, CAF, CEM, CEN, CET, CGO, CH, CLM, CRF, CXE, DMO, DNI, DNP, DSE, ECC, EDD, EDF, EDI, EHI, EMD, EMI, EMJ, ERC, ETV, EVJ, EVN, EVP, FAM, FCO, FEI, FEN, FFA, FIF, FMO, FMY, FTF, FXBY, GAM, GDL, GGZ, GHY, GOF, GRX, GUT, HIE, HTY, IGD, IID, INF, IRL, JLS, JMF, JMLP, JNK, JQC, KED, KIO, KTF, KYN, LQD, MFV, MIW, NBO, NCV, NCZ, NDP, NHF, NMT, NMY, NNC, NOM, NRO, NTC, NUM, NXJ, OXLC, PCK, PCM, PCQ, PGP, PGZ, PHK, PPR, RCS, RIF, RIV, SBI, SPY, SRF, SRV, TDF, TLT, TTF, TYG, USA, VGI, VMO, VPV, VTA, YYY
by: Stanford Chemist
Summary

CEFs are not joining the party, despite stock market indices reaching new highs.

Average discount and z-scores have substantially declined to levels not seen since early this year.

Picks for November are VTA, PPR and KYN.

Author's note: This article was released to members of the Cambridge Income Laboratory one month ago.

For the inaugural issue of The Chemist's CEF Report (September 2016), describing the background and rationale of the Report, please click here.

This edition uses data taken from the close of November 3. Previous editions of the Report can be searched using the keyword "cefrep".

Methodology

A database of CEFs was obtained from CEFConnect. All yields are quoted as the yield on price. All z-scores refer to the 1-year z-score, which I consider to be the most useful time duration for profiting from premium/discount reversion. The 1-year z-score is calculated as the difference between the current premium/discount and the 1-year average premium/discount, all divided by the standard deviation of said premium/discount. Positive z-scores indicate that the CEF's current premium/discount is higher than its historical average, while negative z-scores indicate that the current premium/discount is lower than the historical average. Incorporating the standard deviation into the z-score calculation enables comparison between CEFs that may have different magnitudes of absolute premia and discounts.

In the tables, "distance" refers to the distance between the current premium/discount of the fund and its 1-year historical premium/discount. "Coverage" refers to the ratio between a fund's earnings and its distribution, with coverage ratios greater than 100% indicating that the fund is earning more than it pays out in distributions.

1. Top 10 highest premia and top 10 highest discounts

(May interest arbitrage investors)

CEFs with the highest discounts are potential buy candidates, while CEFs with the highest premia are potential sell/short candidates. The following data show the 10 CEFs with the highest premia and 10 CEFs with the highest discounts. Yields, z-scores and leverage are shown for comparison.

Top 10 highest premia (equity):

CEF Category Premium/discount Yield z-score Distance Leverage Baseline expense Coverage
(GUT) US Equity-Utilities 30.2% 8.39% 1.6 6.8% 29.9% 1.7% 5%
(CRF) US Equity-General Equity 13.0% 18.48% -0.8 -4.9% 0.0% 1.5% 8%
(DNP) US Equity-Growth & Income 12.6% 6.97% 0.8 1.5% 26.0% 1.1% 30%
(CLM) US Equity-General Equity 11.0% 18.61% -0.9 -5.1% 0.0% 1.3% 11%
(MFV) US Equity-Growth & Income 10.0% 9.11% 1.5 9.4% 0.0% 1.4% 39%
(GOF) US Equity-Growth & Income 7.6% 10.26% 1.1 2.4% 20.9% 1.6% 74%
(IID) Non-US/Other-Global Equity Dividend 7.4% 8.08% 1.6 5.1% 0.0% 1.6% 12%
(HIE) US Equity-Dividend Equity 6.9% 10.61% 1.2 5.3% 17.5% 1.8% 29%
(CGO) Non-US/Other-Global Growth & Income 4.7% 8.53% 1.2 7.1% 28.3% 1.6% 21%
(TYG) US Equity-MLP 4.4% 10.08% -0.9 -3.1% 33.3% 1.9% 0%

Top 10 highest discounts (equity):

CEF Category Premium/discount Yield z-score Distance Leverage Baseline expense Coverage
(OTCPK:FXBY) US Equity-General Equity -31.1% 0.50% 0.2 0.4% 0.0% 2.6% -42%
(RIF) US Equity-Real Estate (US) -17.5% 6.80% 0.3 0.6% 28.0% 1.7% 34%
(GGZ) Non-US/Other-Global Equity -17.3% 0.96% -2.0 -2.9% 21.3% 1.6% 10%
(CET) US Equity-General Equity -17.0% 3.66% 0.7 0.8% 0.0% 0.9% 12%
(DNI) US Equity-Growth & Income -16.8% 4.57% 0.7 0.6% 0.0% 1.5% 9%
(SRF) US Equity-MLP -15.8% 5.60% -1.0 -1.4% 17.0% 3.8% 0%
(IRL) Non-US/Other-Other Non-US Equity -15.4% 9.40% -3.2 -5.9% 0.0% 1.8% -1%
(BIF) US Equity-General Equity -14.7% 3.83% 1.9 2.8% 4.0% 1.4% 29%
(CAF) Non-US/Other-Asia Equity -14.6% 3.46% 0.4 0.4% 0.0% 1.9% 9%
(GAM) US Equity-General Equity -14.5% 9.12% 1.4 1.5% 14.9% 1.2% 0%

Top 10 highest premia (debt):

CEF Category Premium/discount Yield z-score Distance Leverage Baseline expense Coverage
(PGP) Taxable Income-Multi-Sector 41.5% 10.87% -1.8 -17.3% 31.9% 1.9% 73%
(PCQ) Tax-Free Income-California 21.2% 5.39% 1.2 4.1% 46.5% 1.2% 92%
(NOM) Tax-Free Income-Missouri 16.4% 3.96% 0.5 2.0% 35.7% 1.2% 94%
(PCK) Tax-Free Income-California 16.2% 5.65% 0.4 1.1% 43.0% 1.2% 98%
(ECC) Taxable Income-Senior Loan 16.0% 12.42% 0.4 4.2% 31.4% 6.6% 83%
(RCS) Non-US/Other-Global Income 15.3% 9.55% -1.4 -8.7% 63.8% 1.0% 111%
(BHV) Tax-Free Income-Virginia 15.2% 4.22% 0.9 5.7% 39.7% 2.1% 99%
(PCM) Taxable Income-Mortgage Bond 14.4% 8.01% 1.6 8.1% 38.5% 1.6% 99%
(EDF) Non-US/Other-Emerging Market Income 12.7% 12.78% 1.2 4.3% 31.7% 1.8% 64%
(PHK) Taxable Income-Multi-Sector 11.9% 12.51% -2.1 -18.5% 22.2% 1.0% 68%

Top 10 highest discounts (debt):

CEF Category Premium/discount Yield z-score Distance Leverage Baseline expense Coverage
(VPV) Tax-Free Income-Pennsylvania -13.9% 5.18% -3.0 -2.2% 38.5% 0.9% 107%
(NTC) Tax-Free Income-Connecticut -13.8% 4.48% -2.2 -2.5% 36.6% 1.1% 94%
(NXJ) Tax-Free Income-New Jersey -13.4% 5.08% -2.2 -1.2% 38.0% 0.8% 100%
(EVJ) Tax-Free Income-New Jersey -13.1% 4.62% -3.0 -2.2% 37.8% 1.7% 103%
(NUM) Tax-Free Income-Michigan -13.1% 4.79% -2.7 -1.9% 37.7% 1.0% 95%
(EMI) Tax-Free Income-Michigan -12.8% 3.61% -1.3 -1.8% 36.5% 2.0% 105%
(EVP) Tax-Free Income-Pennsylvania -12.7% 4.23% -1.4 -1.2% 36.8% 1.9% 107%
(NMY) Tax-Free Income-Maryland -12.5% 4.72% -2.0 -1.4% 37.5% 1.0% 95%
(EMJ) Tax-Free Income-New Jersey -12.4% 4.66% -2.8 -2.7% 39.0% 1.4% 106%
(NNC) Tax-Free Income-North Carolina -12.3% 4.04% -1.9 -1.5% 38.6% 1.0% 100%

2. Top 10 highest z-scores and top 10 lowest z-scores

(May interest arbitrage investors)

Similar to premia/discounts, CEFs with the lowest z-scores are potential buy candidates, while CEFs with the highest z-scores are potential sell/short candidates. The following data show the 10 CEFs with the highest z-scores and 10 CEFs with the lowest z-scores. Premium/discount, yields and leverage are shown for comparison.

Top 10 highest z-scores (equity):

CEF Category z-score Premium/discount Yield Distance Leverage Baseline expense Coverage
(FIF) US Equity-Energy/Resources 3.0 0.4% 7.1% 5.7% 26.7% 1.5% 26%
(ASG) US Equity-General Equity 2.8 0.2% 7.9% 9.3% 0.0% 1.4% -1%
(TTF) Non-US/Other-Asia Equity 2.8 -3.4% 7.3% 9.1% 0.0% 1.1% 7%
(FFA) US Equity-Covered Call 2.4 -4.5% 7.3% 4.7% 0.0% 1.1% 6%
(USA) US Equity-General Equity 2.2 -9.0% 8.4% 4.7% 0.0% 1.1% 3%
(CEF) US Equity-Commodities 2.2 -2.5% 0.1% 3.9% 0.0% 0.3% -39%
(NRO) US Equity-Real Estate (US) 2.1 -4.8% 9.8% 3.7% 2.1% 1.4% 54%
(IGD) US Equity-Covered Call 2.1 -2.0% 9.2% 6.3% 0.0% 1.2% 15%
(NHF) US Equity-Growth & Income 2.0 -5.9% 10.1% 4.2% 14.8% 2.1% 81%
(CH) Non-US/Other-Latin American Equity 2.0 -8.4% 6.3% 4.8% 0.0% 2.1% #DIV/0!

Top 10 lowest z-scores (equity):

CEF Category z-score Premium/discount Yield Distance Leverage Baseline expense Coverage
(IRL) Non-US/Other-Other Non-US Equity -3.2 -15.4% 9.4% -5.9% 0.0% 1.8% -1%
(KYN) US Equity-MLP -2.8 -3.7% 12.3% -5.4% 34.5% 3.8% 0%
(ETV) US Equity-Covered Call -2.7 2.0% 8.8% -3.8% 0.0% 1.1% 7%
(GGZ) Non-US/Other-Global Equity -2.0 -17.3% 1.0% -2.9% 21.3% 1.6% 10%
(FEN) US Equity-MLP -1.8 -0.6% 10.2% -3.3% 27.2% 1.5% 0%
(FEI) US Equity-MLP -1.8 0.4% 10.0% -2.8% 25.1% 1.5% 0%
(FMO) US Equity-MLP -1.8 -2.1% 14.6% -4.5% 28.0% 1.7% 0%
(HTY) US Equity-Equity Tax-Advantaged -1.5 -1.1% 10.0% -8.9% 0.0% 1.3% 16%
(KED) US Equity-MLP -1.5 -6.0% 11.0% -3.1% 33.5% 3.5% 0%
(NDP) US Equity-MLP -1.4 -4.1% 13.9% -6.0% 24.6% 1.7% 0%

Top 10 highest z-scores (debt):

CEF Category z-score Premium/discount Yield Distance Leverage Baseline expense Coverage
(BFY) Tax-Free Income-New York 2.7 1.0% 4.7% 4.3% 40.6% 1.3% 92%
(FTF) Taxable Income-Limited Duration 2.2 -4.8% 10.6% 2.3% 23.6% 1.3% 42%
(JLS) Taxable Income-Mortgage Bond 2.2 -2.1% 5.2% 1.9% 26.0% 1.7% 82%
(NMT) Tax-Free Income-Massachusetts 2.1 -0.4% 4.5% 4.2% 37.3% 1.1% 95%
(FMY) Taxable Income-Mortgage Bond 2.1 -7.2% 5.5% 1.6% 7.1% 1.4% 1%
(VGI) Taxable Income-Multi-Sector 2.0 5.8% 10.2% 9.2% 26.1% 1.7% 49%
(BGH) Taxable Income-High Yield 1.7 -3.0% 9.0% 3.5% 26.4% 1.5% 109%
(CXE) Tax-Free Income-High Yield 1.7 -0.9% 5.8% 3.4% 36.5% 1.4% 99%
(PCM) Taxable Income-Mortgage Bond 1.6 14.4% 8.0% 8.1% 38.5% 1.6% 99%
(FCO) Non-US/Other-Global Income 1.6 -2.0% 9.3% 4.4% 28.2% 1.9% 54%

Top 10 lowest z-scores (debt):

CEF Category z-score Premium/discount Yield Distance Leverage Baseline expense Coverage
(KTF) Tax-Free Income-National -3.2 -5.8% 5.3% -9.9% 37.5% 0.9% 110%
(VPV) Tax-Free Income-Pennsylvania -3.0 -13.9% 5.2% -2.2% 38.5% 0.9% 107%
(NYSEMKT:EVJ) Tax-Free Income-New Jersey -3.0 -13.1% 4.6% -2.2% 37.8% 1.7% 103%
(NBO) Tax-Free Income-New York -2.9 -12.2% 4.2% -2.2% 40.5% 1.3% 108%
(EMJ) Tax-Free Income-New Jersey -2.8 -12.4% 4.7% -2.7% 39.0% 1.4% 106%
(SBI) Tax-Free Income-National -2.8 -7.0% 4.3% -2.6% 25.4% 1.2% 94%
(VMO) Tax-Free Income-National -2.8 -7.2% 5.3% -3.6% 41.3% 1.0% 110%
(EVN) Tax-Free Income-National -2.7 -7.0% 5.2% -3.7% 41.6% 1.4% 106%
(NUM) Tax-Free Income-Michigan -2.7 -13.1% 4.8% -1.9% 37.7% 1.0% 95%
(VTA) Taxable Income-Senior Loan -2.5 -10.9% 6.8% -3.2% 31.0% 1.9% 104%

3. Top 10 highest yielding CEFs

(May interest buy-and-hold income investors)

Some readers are mostly interested in obtaining income from their CEFs, so the following data presents the top 10 highest yielding CEFs. I've also included the premium/discount and z-score data for reference. Before going out and buying all 10 funds from the list, some words of caution: 1) higher yields generally indicate higher risk, 2) some of these funds trade at a premium, meaning you will be buying them at a price higher than the intrinsic value of the assets (which is why I've included the premium/discount and z-score data for consideration), and 3) beware of funds paying out high yields from return of capital in a destructive manner.

Top 10 highest yields (equity):

CEF Category Premium/discount Yield z-score Distance Leverage Baseline expense Coverage
(CLM) US Equity-General Equity 18.6% 11.0% -0.9 -5.1% 0.0% 1.3% 11%
(CRF) US Equity-General Equity 18.5% 13.0% -0.8 -4.9% 0.0% 1.5% 8%
(DSE) US Equity-MLP 15.3% -0.2% -0.7 -2.6% 36.0% 1.9% 0%
(FMO) US Equity-MLP 14.6% -2.1% -1.8 -4.5% 28.0% 1.7% 0%
(NDP) US Equity-MLP 13.9% -4.1% -1.4 -6.0% 24.6% 1.7% 0%
(CEN) US Equity-MLP 13.0% -0.2% -0.7 -1.0% 34.6% 2.0% 0%
(JMF) US Equity-MLP 12.5% -0.8% -0.7 -2.2% 28.0% 1.5% 0%
(KYN) US Equity-MLP 12.3% -3.7% -2.8 -5.4% 34.5% 3.8% 0%
(RIV) US Equity-Growth & Income 12.2% 1.0% 1.4 3.6% 0.0% 1.4% 84%
(JMLP) US Equity-MLP 11.9% -1.3% -0.7 -2.4% 26.5% 1.7% 0%

Top 10 highest yields (debt):

CEF Category Yield Premium/discount z-score Distance Leverage Baseline expense Coverage
(OXLC) Taxable Income-Senior Loan 14.9% 5.6% 1.5 1.4% 35.3% 7.9% 37%
(EDF) Non-US/Other-Emerging Market Income 12.8% 12.7% 1.2 4.3% 31.7% 1.8% 64%
(PHK) Taxable Income-Multi-Sector 12.5% 11.9% -2.1 -18.5% 22.2% 1.0% 68%
(ECC) Taxable Income-Senior Loan 12.4% 16.0% 0.4 4.2% 31.4% 6.6% 83%
(DMO) Taxable Income-Mortgage Bond 11.4% 11.7% -0.7 -3.4% 31.1% 1.8% 81%
(EDI) Non-US/Other-Emerging Market Income 11.1% 4.4% 0.7 3.0% 32.1% 1.0% 74%
(NCZ) Taxable Income-Multi-Sector 11.0% 5.0% 1.1 4.2% 38.2% 1.4% -89%
(NCV) Taxable Income-Multi-Sector 11.0% 6.9% 1.3 5.1% 37.9% 1.3% -88%
(PGP) Taxable Income-Multi-Sector 10.9% 41.5% -1.8 -17.3% 31.9% 1.9% 73%
(FTF) Taxable Income-Limited Duration 10.6% -4.8% 2.2 2.3% 23.6% 1.3% 42%

4. Top 10 best combination of yield and discount

(May interest buy-and-hold income investors)

For possible buy candidates, it is probably a good idea to consider both yield and discount. Buying a CEF with both a high yield and discount not only gives you the opportunity to capitalize from discount contraction, but you also get "free" alpha every time the distribution is paid out. This is because paying out a distribution is effectively the same as liquidating the fund at NAV and returning the capital to the unitholders. I considered several ways to rank CEFs by a composite metric of both yield and discount. The simplest would be yield + discount, however I disregarded this because yields and discounts may have different ranges of absolute values and a sum would be biased towards the larger set of values. I finally settled on the multiplicative product, yield x discount. This is because I consider a CEF with 7% yield and 7% discount to be more desirable than a fund with 2% yield and 12% discount, or 12% yield and 2% discount, even though each pair of quantities sum to 14%. Multiplying yield and discount together biases towards funds with both high yield and discount. Since discount is negative and yield is positive, the more negative the "D x Y" metric, the better.

Top 10 best D x Y (equity):

CEF Category Premium/discount Yield z-score D x Y Distance Leverage Baseline expense Coverage
(IRL) Non-US/Other-Other Non-US Equity -15.4% 9.4% -3.2 -1.45 -5.9% 0.0% 1.8% -1%
(GAM) US Equity-General Equity -14.5% 9.1% 1.4 -1.33 1.5% 14.9% 1.2% 0%
(RIF) US Equity-Real Estate (US) -17.5% 6.8% 0.3 -1.19 0.6% 28.0% 1.7% 34%
(SRV) US Equity-MLP -10.7% 9.9% 0.3 -1.06 0.7% 31.8% 2.7% 0%
(INF) Non-US/Other-Global Equity -13.0% 7.7% -1.2 -1.00 -2.8% 27.4% 1.8% 41%
(TDF) Non-US/Other-Asia Equity -11.3% 8.5% 0.6 -0.96 0.9% 0.0% 1.3% 1%
(PGZ) US Equity-Real Estate (US) -12.2% 7.7% -0.9 -0.94 -2.6% 31.3% 2.0% 123%
(GDL) Non-US/Other-Global Equity -14.0% 6.4% 0.5 -0.90 0.9% 38.0% 2.9% -10%
(AWP) US Equity-Real Estate (Global) -9.7% 9.2% 1.1 -0.89 3.4% 3.4% 1.3% 21%
(SRF) US Equity-MLP -15.8% 5.6% -1.0 -0.89 -1.4% 17.0% 3.8% 0%

Top 10 best D x Y (debt):

CEF Category Premium/discount Yield z-score D x Y Distance Leverage Baseline expense Coverage
(BWG) Non-US/Other-Global Income -12.2% 8.3% 0.8 -1.01 0.9% 35.9% 1.6% 101%
(EMD) Non-US/Other-Emerging Market Income -12.2% 7.7% -0.1 -0.94 -0.1% 21.7% 1.2% 94%
(KIO) Taxable Income-High Yield -10.1% 9.0% -1.2 -0.91 -3.4% 25.4% 2.2% 110%
(ERC) Taxable Income-Limited Duration -9.1% 9.9% -0.6 -0.90 -0.9% 23.9% 1.0% 76%
(EHI) Non-US/Other-Global Income -10.5% 7.8% -0.3 -0.82 -0.3% 25.1% 1.3% 98%
(FAM) Non-US/Other-Global Income -10.3% 7.9% -1.4 -0.81 -2.0% 27.4% 1.7% 79%
(EDD) Non-US/Other-Emerging Market Income -10.4% 7.7% 0.2 -0.80 0.3% 31.8% 1.8% 32%
(GHY) Taxable Income-High Yield -10.7% 7.3% -1.2 -0.79 -1.0% 27.2% 1.3% 101%
(AGC) Taxable Income-Convertible -8.3% 9.2% 0.2 -0.76 0.4% 40.9% 2.2% 39%
(VTA) Taxable Income-Senior Loan -10.9% 6.8% -2.5 -0.75 -3.2% 31.0% 1.9% 104%

5. Top 10 best combination of yield, discount and z-score

(May interest buy-and-hold income investors + arbitrage investors)

This is my favorite metric because it takes into account all three factors that I always consider when buying or selling CEFs: yield, discount and z-score. The composite metric simply multiplies the three quantities together. A screen is applied to only include CEFs with a negative 1-year z-score. As both discount and z-score are negative while yield is positive, the more positive the "D x Y x Z" metric, the better.

Top 10 best D x Y x Z (equity):

CEF Category Premium/discount Yield z-score D x Y x Z Distance Leverage Baseline expense Coverage
(IRL) Non-US/Other-Other Non-US Equity -15.4% 9.4% -3.2 4.63 -5.9% 0.0% 1.8% -1%
(KYN) US Equity-MLP -3.7% 12.3% -2.8 1.29 -5.4% 34.5% 3.8% 0%
(INF) Non-US/Other-Global Equity -13.0% 7.7% -1.2 1.20 -2.8% 27.4% 1.8% 41%
(CEM) US Equity-MLP -7.0% 10.6% -1.4 1.04 -3.2% 29.8% 1.9% 0%
(KED) US Equity-MLP -6.0% 11.0% -1.5 0.98 -3.1% 33.5% 3.5% 0%
(SRF) US Equity-MLP -15.8% 5.6% -1.0 0.89 -1.4% 17.0% 3.8% 0%
(PGZ) US Equity-Real Estate (US) -12.2% 7.7% -0.9 0.85 -2.6% 31.3% 2.0% 123%
(GRX) US Equity-Health/Biotech -13.0% 5.4% -1.2 0.84 -1.2% 22.0% 1.6% -12%
(NDP) US Equity-MLP -4.1% 13.9% -1.4 0.80 -6.0% 24.6% 1.7% 0%
(BGR) US Equity-Energy/Resources -10.3% 6.8% -0.9 0.63 -0.8% 0.0% 0.0% 0%

Top 10 best D x Y x Z (debt):

CEF Category Premium/discount Yield z-score D x Y x Z Distance Leverage Baseline expense Coverage
(VPV) Tax-Free Income-Pennsylvania -13.9% 5.2% -3.0 2.16 -2.2% 38.5% 0.9% 107%
(VTA) Taxable Income-Senior Loan -10.9% 6.8% -2.5 1.86 -3.2% 31.0% 1.9% 104%
(EVJ) Tax-Free Income-New Jersey -13.1% 4.6% -3.0 1.81 -2.2% 37.8% 1.7% 103%
(NUM) Tax-Free Income-Michigan -13.1% 4.8% -2.7 1.69 -1.9% 37.7% 1.0% 95%
(EMJ) Tax-Free Income-New Jersey -12.4% 4.7% -2.8 1.62 -2.7% 39.0% 1.4% 106%
(NBO) Tax-Free Income-New York -12.2% 4.2% -2.9 1.50 -2.2% 40.5% 1.3% 108%
(NXJ) Tax-Free Income-New Jersey -13.4% 5.1% -2.2 1.50 -1.2% 38.0% 0.8% 100%
(JQC) Taxable Income-Senior Loan -10.0% 6.9% -2.1 1.45 -2.7% 36.1% 1.3% 96%
(NTC) Tax-Free Income-Connecticut -13.8% 4.5% -2.2 1.36 -2.5% 36.6% 1.1% 94%
(MIW) Tax-Free Income-Michigan -12.3% 4.3% -2.5 1.31 -2.0% 37.0% 1.6% 108%

6. Summary statistics

The average premium/discount of all the CEFs in the database is -4.47%, a large decrease from -3.53% in the previous month. The following chart shows the average premium/discount over the past 12 months.

The average distribution yield of all the CEFs in the database is 6.48%, a significant increase from 6.37% in the month prior.

The average 1-year z-score of all the CEFs in the database is -0.02, a large decrease from its value of +0.60 a month ago.

Commentary

In last month's commentary The Chemist's CEF Report - October 2017: CEFs Continuing To Break To New Highs, we noted that CEFs were pushing to new highs along with U.S. stock market indices. However, CEFs bucked the market trend this month, and were unable to join the stock market indices at new all-time highs. The chart below shows the YTD performance of U.S. stocks (SPY), international stocks (ACWX), high-yield bonds (JNK), long-duration treasuries (TLT), and corporate bonds (LQD). A basket of high-yielding CEFs, the YieldShares High Income ETF (YYY), is also shown for comparison - note the decline in the total return price of the ETF over the past month.

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SPY Total Return Price data by YCharts

The discount and z-score numbers reflect a decrease in CEF sentiment rather than a deterioration of the underlying portfolios. The average discount dropped by nearly 1% to -4.47%, reaching levels not seen since April, while the average 1-year z-score slumped all the way from +0.60 to -0.02, a level not seen since January. The average yield also increased by 11 bps, to 6.48%. With CEFs valuations become overstretched across the board, I think such a correction in premium/discount values is quite healthy. At the risk of stating the obvious, this isn't "blood on the streets" territory for CEFs yet, not by a long shot.

What are the reasons for the decline? One could be the continual contraction of the interest rate spread. Shown below is the 10-2 year treasury spread, which touched a new low of 0.74% this month. This decidedly hurts leveraged bond CEFs, which tends to borrow at short rates and lend at the long rates. Ways to mitigate this could be to invest in unleveraged CEFs, however, this does not fully insulate oneself from the secular decline in long rates that has forced funds to reinvest in lower-yielding debt as older, higher-yielding paper matured. Both of these facts may act to reduce CEF distributions in the short to medium, at the very least. Another potential strategy may be to switch to equity CEFs, which are not as affected by interest rate issues, although these funds do supplement their distributions with a hefty dose of return of capital (ROC). Moreover, many equity option-income funds are trading at very high valuations compared to most debt funds, making a direct switch an unattractive proposition from a value point of view.

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I intend to give a list of my top 3 CEF picks each month, which is based on my consideration of the data as well as my qualitative judgment. Note that me designating a fund as a top pick does not mean I am encouraging subscribers to buy the fund, nor am I necessarily going to include the fund in our portfolios. Moreover, note that some of the picks may have a narrow mandate (e.g. utilities stocks or MLPs), and therefore each investor should consider their own investment objective and risk tolerance before deciding to invest money into any of the picks. Furthermore, note that these are intended to be short/medium-term picks (to take advantage of mean reversion) rather than long-term holds.

For November 2017, my top 3 picks are:

  • Invesco Dynamic Credit Opportunities Fund (VTA): 6.8% yield, -10.9% discount, -2.5 z-score, -3.2% distance, 31.0% leverage, 1.9% baseline expense, 104% coverage.
  • Voya Prime Rate Trust (PPR): 5.2% yield, -10.0% discount, -2.3 z-score, -3.8% distance, 27.9% leverage, 1.6% baseline expense, 116% coverage.
  • Kayne Anderson MLP Investment Company (KYN): 12.3% yield, -3.7% discount, -2.8 z-score, -5.4% distance, 34.5% leverage, 3.8% baseline expense, 0% coverage.

As with the last two months, state muni funds and senior loan funds dominated the top "D x Y x Z" debt category, however, I did not want exposure to idiosyncratic state risk so I went with two senior loan funds as top picks. Both VTA and PPR are deeply discounted (<-10% discount) and have z-scores of under -2, indicating temporary undervaluation. For the third pick, I went with an MLP fund, KYN, which had a -2.8 z-score and is trading -5.4% below its 52-week average premium/discount. It's not the same MLP fund as I recently added to our portfolio, as I envision KYN being more of a short-term play to exploit mean reversion and hopefully a rebound in MLP prices, rather than a medium/long-term hold.

For past performance of picks, see "The Chemist's CEF Report Picks Continue To Outperform Over Benchmarks (Updated Sep. 2017)". Past performance is no guarantee of future results.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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 long the portfolio securities.