Stable Yield With Closed-End Funds: Term CEF Ladder
- Strategy seeks enhanced income from short-duration fixed income portfolio assets. Sustainable total return on NAV is our objective.
- CEF structures are discussed, including the role of leverage and the possible pitfalls of Z-scores.
- A downloadable table of "Term" and "Target Term" closed-end funds (i.e. funds with expected trust liquidation dates) is presented.
- Term dates help ensure that any individual fund discount (or premium) will compress towards the fund's NAV as the term date is approached.
- Since most term dates are not hard final maturities, we put "ladder" in quotations. Each CEF must be monitored to ensure its managers are following stated investment objectives.
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Background and Investment Objective
First, some personal background, as this is my inaugural article on Seeking Alpha. I have spent 15+ years on institutional fixed income trading desks. The first five were spent learning the corporate bond business while working primarily in operations/systems. In 2007, I moved to trading and analytics, and subsequently spent the next decade trading structured products, ending recently with an 18-month stint selling high-yield corporates. I will probably return to the business at some point, but right now, I am an individual investor without access to Bloomberg. I am a trend-follower, not a soothsayer. I do not seek to predict economic or market cycles, rather, I do my best to be correctly positioned during each stage.
My history with CEFs goes back about ten years. Barron's occasionally puts out decent recommendations, and I have traded in and out of several muni-CEFs, usually with multi-year holding periods, but it is only recently that I started studying the product closely. My current goal is to uncover funds that take advantage of the CEF structure while providing sustainable yield on NAV. By "yield on NAV", I mean total return on a fund's underlying assets. I am not interested in levered ETNs such as MORL which advertise 20%+ yields while cannibalizing their own NAVs in the process. Over the 5-year period ending 3/31/18, MORL produced just over half the annualized total return of the S&P with over 2.5x the risk - a simple long equity strategy would have been much more effective in building wealth:
To avoid "chasing" yield, we must first identify the strengths of the CEF structure. In my view, CEFs afford the retail investor several major advantages, the first being access to cheap leverage. A second advantage is access to less-liquid product types (NA RMBS/CMBS/CLOs/Leveraged Loans) without the risk of forced liquidation. There are plenty of open-ended funds that invest in less-liquid asset classes, but as redemptions hit those funds, they may be forced to sell underlying securities. Excluding CEFs with unsustainably high distributions (often found in funds with "managed distribution" policies), forced liquidation of assets should not be a problem for a properly managed CEF. That said, CEFs are not immune to the whims of the market, and a fund's market price often deviates from its underlying Net Asset Value (NAV).
Many factors contribute to the discount/premium phenomenon. Investors understandably tend to gravitate towards funds with large discounts when evaluating CEFs. A peril of this method is that oftentimes without a catalyst, a fund trading at a large discount to NAV may remain discounted for years. A popular method of analyzing fund discounts (often in the context of expected mean reversion) uses a metric called the z-score.
Z-scores for individual funds are calculated using the formula:
Z = [(Current Discount - Average Discount)/Standard Deviation of the Discount]
This formula gives us a rough idea of a fund's current relative valuation to its own trading history. A "cheap" z-score of -2 theoretically indicates that a fund's discount is two standard-deviations lower than its own historical average over the period analyzed. That said, a CEF with a historically stable discount (or premium) will show low historical standard deviation, and thus may screen as "cheap" even with a small change in discount. Put another way, if a security that has typically shown a stable discount (or premium) suddenly becomes more volatile due to a fundamental change in the underlying assets, the "cheap" z-score may not contain useful information. Considering these factors, we arrive at our first rule for CEF selection:
Rule #1: Minimize exposure to premiums, but don't fall in love with large discounts to NAV. Rather, focus on sustainable NAV total return.
Given our view that properly-used leverage is generally a benefit to the CEF shareholder, we seek to identify specific fund types that may be best suited to take advantage of this structure. Underlying cash flows should be predictable and sustainable. In its pamphlet, Understanding Leverage in Closed-End Funds, Nuveen gives us one example: a municipal bond fund using preferred shares as leverage to purchase additional assets.
The cost of preferred share leverage is equal to the dividend rate demanded by the preferred shareholders. Later in its pamphlet, Nuveen offers this interesting insight: "… [preferred share dividends] usually receive the same tax treatment as the fund's underlying portfolio income, so preferred shares are often used for municipal bond funds." In other words, many Municipal Bond CEFs benefit from some form of tax-free leverage - a benefit not available to the retail investor who purchases individual municipal bonds. This is exactly the sort of structural advantage we should be looking for when evaluating CEFs and leads us to our second rule:
Rule #2: Municipal Bond CEFs are inherently attractive due to tax-free preferred leverage.
Aside from municipals, what other asset classes seem like a good fit for the CEF structure? With their extremely long durations, my personal opinion is that equities are not a natural fit for CEFs. Well-run long-term equity funds such as CET (Central Securities Corp) seem to trade as steep discounts to NAV due to concerns about unrealized capital gains, relatively high fees, illiquidity, etc. Buy-write equity funds such as QQQX seem like a good idea, but the strategy can be fairly easily replicated by the average investor with fewer expenses (and without purchasing assets at a premium). In the future, I will spend more time looking at equity CEFs, but for now, my efforts will be concentrated in the fixed income arena.
A potential strategy now begins to emerge. We will avoid extremely long-duration securities such as equities for the income portion of our portfolio. We will take advantage of the advantages afforded by the CEF structure (including leverage and the ability to buy assets at a discount). We will look at asset classes in which institutional size and scale can be used to our benefit (structured products, corporates, munis, etc.). Finally, we will seek catalysts whenever available. This method brings us to our CEF "ladder" idea:
Rule #3: Term and Target Term CEFs should "pull" market price towards NAV over time.
Two quick definitions:
1) "Term" CEFs generally have a stated termination date, around which time the trust is projected to liquidate at NAV.
2) "Target Term" CEFs go a step further and generally seek to return the fund's original NAV (or better) at the termination date.
Upon review of the CEF universe provided by CEFConnect's screener, there are 43 CEFs that are either "Term" or "Target Term" funds. (Note: I have compiled most of these statistics on my own, so any data should be double-checked, and my numbers may contain errors). Most of the funds focus on fixed income. There is a good variety among High Yield, Municipal, Mortgage and Senior Loan funds (click table to enlarge - you may need to save the image and open in a separate image viewer to see the entire table).
Sources: Morningstar, CEFConnect, Fidelity, Fund Fact Sheets, Author's Own Spreadsheet.
These are all the funds on CEFConnect with a designated termination date. The term date itself has been pulled manually from each fund fact sheet. I sorted the funds first by "strategy," then by "term date." These funds should all be excellent candidates for a "CEF Ladder." The idea will be to choose a selection of funds with ascending term dates. We won't get rich with this strategy, but we may be able to increase the yield on the fixed income sleeve of our portfolio compared to other short to intermediate-duration alternatives. The embedded term dates within each fund should help close any persistent discounts to NAV over time, ensuring that our total market return does not lag our total NAV return. At the same time, if we time our initial purchases correctly, we will enjoy the benefits of purchasing leveraged assets at a discount.
Some initial brief thoughts on the various fund sub-classes:
Senior Loans/High Yield Bonds:
Senior (aka Leveraged) loans are one way to hedge against rising rates (at least until the cycle rolls over), as they are generally floating-rate assets. Rising rates (aside from a supply shock) generally indicate a strong economy, so high yield bonds should also be expected to perform reasonably well in the current benign economic environment. High yield bonds also generally have shorter durations than investment-grade securities.
According to Invesco:
"Since 1987, there have been 17 quarters where yields on the 5-year Treasury note rose by 70 basis points or more. During 11 of those quarters, high yield bonds demonstrated positive returns; during the six quarters where high yield bond returns were not positive, the asset class rebounded the following quarter."
At this point in the cycle, it does make sense to minimize exposure to the weakest credits. We will seek to avoid funds with high exposure to B and CCC-rated bonds.
The AAA Muni GO scale is still fairly steep from 5-10 year (about 2% for 5 year bonds and 2.5% for 10-year bonds). Intermediate municipals should continue to benefit from "rolling down" the curve, even if prices have been temporarily dislocated by the recent tax law changes. There may be an opportunity in deeply-discounted intermediate municipal bond CEFs.
As for the housing market, Bill McBride at Calculated Risk made the following comment on February 21st:
"In the existing home sales report released this morning, the NAR reported months-of-supply at 3.4 months in January. Based on the historical relationship, months-of-supply could double before house prices started declining.
My current expectation is inventory will increase this year, and house price growth will slow a little."
Source: Calculated Risk, House Prices and Inventory
McBride's track record is excellent, and he seems to think residential housing still looks pretty good.
Commercial real estate also continues to look solid:
Source: CoStar CCRSI
Both the residential and commercial real estate markets continue to show strength. The next few charts attempt to place that strength in context by examining underwriting standards.
February 2018 Federal Reserve Senior Loan Officer Survey data:
These charts are interesting - both commercial and residential real estate have seen slightly flagging demand recently, but lending standards seem to have remained relatively stable, even tightening somewhat in CRE from 2015 to 2016 before loosening again recently. Looking at the C&I loan chart, we see that banks were quickly tightening lending standards beginning in 1998 and 2006-07 - in other words, just prior to the last two cycle peaks. In the current cycle, there is no evidence of tightening (yet).
Bottom line: I see no reason to avoid mortgage-backed securities in the current environment, especially bonds backed by loans with some seasoning.
We are clearly "late-cycle" in terms of the economy. However, as investors, we cannot simply stuff our cash under the mattress and expect to build long-term wealth. My philosophy is to manage the downside. With proper asset allocation, the upside usually takes care of itself.
In future pieces, I will take a closer look at some of the individual funds listed in the table above. I believe this strategy will be best applied to the fixed income portion of one's portfolio. The main goal of this writeup was to help me gather my thoughts and hone my investment objective. If you found any of these ideas helpful, or if you also seek assets that generate sustainable total return on NAV, please consider clicking the "Follow" button. Happy hunting!
This article was written by
Analyst’s 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.
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