Recently, we started our quest of keeping you updated more closely with regard to closed-end funds. Members of our service already are seeing this shift in focus. That said, it's no coincidence as these products have been on the move and are finally seeing some volatility that has the capacity to create deviations on which we can act.
As hinted above, we rely mostly on statistics when determining whether a certain fund is of interest, but the fundamental side of things does not go unnoticed. Therefore, these kinds of articles should be of interest both to short- and long-term investors - those interested in the revert to mean and possibly a few dividends, and the ones who are purely interested in the income generated by the stock presented.
The Senior Loan CEFs went from overvalued in the end of 2016 to slightly undervalued in the end of 2017. I view the recent deviation as a return to normal and cannot really say that these CEFs are bargains, but at least they give good entry points if you like the idea of Floating rate bank loans.
What Are Senior Loans?
I really suggest following this link (Source: OppenheimerFunds.com) to get a better idea. In short, a "senior loan" is a bank loan to a company that's usually bellow investment grade, has a floating rate and is higher than corporate bonds in the capital structure. Usually a senior loan would have collateral. Market participants often compare senior loans to high-yield corporate bonds, because of the many similarities.
The market for senior loans is getting more and more liquid and we, retail investors, have a chance to indirectly manage a bank portfolio. The low interest rate environment and the always lasting expectation of rising rates have brought a lot of interest to this asset class.
Since we started our coverage of the Senior Loan closed-end funds, the sector saw a slight rebound - it is beyond our capacity to determine whether it was merely an "oversold" bounce, or the start of a uptrend. What we do know, however, is that there is no directional bias while we screen for new opportunities. And some of you may recognize that the product covered in this article - Nuveen Short Duration Credit Opportunities Fund (NYSE: JSD) - has two sister funds,JRO and JFR, on whose deviation we acted not so long ago.
This CEF popped up on our radar due to its current 200-day Z-Score of -2.20 which translates into a discount of 6.06% as of yesterday, 1/22/2018. This is by no means extraordinary as a deviation, therefore we decided to take a closer look at fundamentals than we usually do.
For reference, those unfamiliar with the metric (Z-Score) can click here and explore Fidelity's take on it. Now, let's start our tour of JSD.
As per the fund sponsor's website:
- The fund's investment objective is to provide current income and the potential for capital appreciation.- The fund cannot assure you that it will achieve its investment objective.
Provides potential for:
- Monthly income and potential capital appreciation from an income-oriented investment.
- Adjustable dividends that can act as a possible hedge against rising short-term interest rates.
- Diversification for an overall income portfolio.
The fund invests at least 70% of its managed assets in adjustable rate corporate debt instruments, including senior secured loans, second lien loans and other adjustable rate corporate debt instruments. Up to 30% of the fund’s assets may include other types of debt instruments or short positions consisting primarily of high-yield debt. The fund maintains a portfolio with an average duration that does not exceed two years. The fund uses leverage.
Source: Nuveen.com - JSD - Overview
Now let us sink our teeth into the portfolio as if it is a ripe apple:
98% of Nuveen Short Duration Credit Opportunities Fund's (NYSE: JSD) assets are in Senior Loans and Corporate Bonds. For this review I will treat them as the same thing. Bonds represent about 14% of the total assets of the fund while the senior loans are around 84%. I have separated the assets into four groups:
- YTM < 7%
- YTM between 7% and 10%
- YTM between 10% and 20%
- YTM > 20%
(YTM == Yield-to-Maturity)
Here you can see the numbers behind the four groups:
Source: Author's spreadsheet
If we exclude the "toxic" group 4 we can say that by holding JSD we are holding an asset that matures in 4.8 years and has a 5.5% YTM that trades at 99% of par. (The assumption is valid only if LIBOR is constant.)
The biggest group of assets (76%) has an average-weighted yield-to-maturity of 4.51%. This is the group with lowest chance of default. This is the maturity breakdown of this largest group of JSD's assets:
Each bubble contains the weighted average YTM in the groups as follows:
- maturity in less than 2 years
- maturity in more than 2 years, but less than 2.5 years
... and so on until we reach maturity in 7 years.
The bigger the bubble the higher the percent of assets that mature in this time frame. The majority of the fund's assets mature in more than four years. The yield curve of the fund's assets as you can see is almost flat.
Here you can see the credit quality of the fund:
Source: Nuveen.com - JSD - Holdings & Detail
The median rating would have to be higher than B and if we include the toxic assets into the calculations the average weighted YTM goes to 7.4%. The problem here is that some of the assets will not mature at par value.
- Return estimates:
We will make several simplistic assumptions here looking at default rates and recovery rates in the past:
Based on these charts, the worst to happen to the portfolio is 2009, the second worst is the oil crisis of 2015-2016, and normal would be everything else.
If we take an 11% default rate, for example, with recovery rate of 50%, we can pretty much estimate that Groups 3 and 4 from JSD's portfolio will go under water. The good thing here is that they are already priced way below par value. This would eventually lower the estimated loss.
A very important thing to note is that in a 2008-2009 scenario all asset classes will lose a lot of value regardless of whether they default or not.
Here is a simplistic table of the potential NAV loss based on the scenarios mentioned:
Source: Author's spreadsheet
The 2.67% loss to JSD in a 2008-2009 has to be treated very cautiously. This is an estimate of how much value the fund will lose only by defaults. If 2008-2009 happens the fund will lose way more than 2.67%, so do not think this is a fund with crisis protection.
In the next part of the article I will assume that the risky part of the assets earns 5.5% - same as Groups 1 and 2 - because of the default rates (this is down from 13.5% and 39% for Groups 3 and 4).
- Liabilities of the fund:
Source: Nuveen.com - JSD - Fund Data
The fund has term preferred stock and a credit line to boost its returns. The last reported rate on the leverage was 2.4%. The debt borrowing as per last annual report stands at LIBOR + 0.85% while the preferred stocks were at 1.5%. For our calculations I will use 2.4% as we are researching the exact rates.
Simplified balance sheet of JSD and a simplified DCF model
Source: Author's spreadsheet
If these are to be constant:
Source: Author's spreadsheet
It looks like the leverage effect is just inline to pay for the management fees. The very important question here is if a retail investor can get exposure to senior loans cheaper? I seriously doubt it. My personal expenses for trading exchange listed products are around 0.3%. Trading does not come without expenses. The model here is very simplified. One needs to run a lot of scenario analyses to have a clearer picture of what the possible outcome would be.
Wait, what monies would I get from this deal if I was a income investor? Good question!
- Distributions of the fund:
Dividends paid out to shareholders of Nuveen Short Duration Credit Opportunities Fund are bound to vary over the long run due to the nature of this closed-end fund's portfolio.
Here is a snapshot of how distributions have varied since the fund's inception:
Source: Nuveen.com - JSD - Distributions
As is often stated in the industry, past performance should not be taken at face value in terms of what one can expect from the future. And there is no way we can forecast LIBOR's trajectory, although it has been creeping up in a slow and steady fashion over the last year or so.
- Sentiment toward the fund:
Having gone through the back-end, let us take a look at the market price:
Source: Barchart.com - JSD Daily Chart (1 year)
Does not seem pretty, but those who know what a closed-end fund is do not draw any conclusions before examining the Market Price vs. net asset value.
It is relatively easy to spot the downtrend - increasing discount - over a 200-day time frame. But this is not "conclusion material" by any means.
Let us use a different perspective here:
A discount around 6% is definitely something out of the ordinary. Revert to mean here would imply that it should narrow to around 3%.
Those who are not feeling comfortable with our software can see the data as per CEFConnect:
Source: CEFConnect.com - JSD
As reported on our favorite website for these products, we are hovering around the 52-week low.
And now we will proceed with our favorite part.
- 200-day: JSD vs. XJSDX (the Net Asset Value):
The market price and underlying portfolio clearly move in unison over the significant time frames - 80-days, 150-days, 200-days - but the highlighted area shows a bigger than the usual divergence between them and it is noticeable in the lack of correlation over the 20-day and 40-day. In this regard, a revert to mean trade should be a good idea, indeed.
Two standard deviations are not something impressive to us, yet they seem to act as a level of support, at least for now.
The best thing we can do to seek confirmation is to increase our time frame.
- 500-day: JSD vs XJSDX:
The correlation over this tame frame is rock solid. Additionally, the deviation seems more significant here:
As you can see, the 500-day gives us a confirmation. In fact the Standard Deviation observed here is even better for a revert to mean trade and for us, respectively.
Do Not Mix LIBOR with Treasury Yields or Alternative Yields
One should closely monitor the spread between the five-year treasury and the LIBOR rate. The LIBOR rate provides a perfect hedge for a rising LIBOR rate, but if Treasury yields rise while LIBOR does not, the fund's assets will lose value because of the shift in the yield curve. Imagine a five-year Treasury yield of 10% and LIBOR at 2%. The interest rate protection of the portfolio does not seem so strong in this kind of scenario. Take a look at these charts:
Five-year Constant Maturity Rate vs 12-Month LIBOR and JSD and its NAV XJSDX, respectively:
Source: CEFConnect.com - JSD
To me it looks that when the spread widens, the discount widens. This partly explains why all senior loan CEFs rallied hard in 2016. LIBOR was a leading indicator at the time. This put all Senior Loan CEFs in a favorable position.
JSD is a good enough candidate for a mean reversion trade. One would have to consider a lot of variables and built much better models to determine its long term value.
Trade With Beta
At 'Trade With Beta' we also pay close attention to Closed-end Funds and are always keeping an eye on them for directional and arbitrage opportunities created by market price deviations. As you can guess, timing is crucial in these kind of trades, therefore you are welcome to join us for early access and the discussions accompanying this kind of trades.
Disclosure: I am/we are long JSD. 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.