The first article in this series, which introduced the idea of a Term CEF Ladder and takes a more top-down approach to the markets, can be found here.
As a quick refresher, there are 43 CEFs with scheduled “Term” dates around which time each trust is scheduled to liquidate. We postulate that a selection of these funds may help us achieve enhanced yield relative to plain vanilla fixed-income products. Due to the nature of Term CEFs, this enhanced yield may be achieved without assuming much duration risk, if our theory is correct. At the same time, the term date provides a mechanism whereby market price should converge towards NAV as each trust seasons, which, as BlackRock mentions in their commentary for BGIO, may result in more trading liquidity.
Deep Dive #1: Mortgage Funds with Term Dates
As a former institutional structured products trader, I know how hard it is for retail investors to access data on esoteric debt products. Even with access to Bloomberg and various other resources, it was still hard to get access to reliable real-time information. Having a large team of analysts and traders, as well as deep Street relationships, is a decided advantage in this corner of the market. For that reason, I am drawn to both mortgage and senior loan CEFs. It is a sector where institutional size and scope can make a real difference, and CEFs give individual investors a way to participate.
Our first “deep dive” will focus on mortgage funds. I will try to quickly follow up with a discussion of senior loan funds, as I feel that the two complement each other fairly well. Mortgage funds can give the investor broad exposure to both the residential housing and commercial real estate markets with good carry (coupon yield) and moderate duration. Senior loan funds help the investor hedge against increasing rates by offering exposure to floating-rate assets. Floating-rate assets, by their very nature, have extremely low durations. Both asset classes benefit from a strong economy and would be vulnerable in a recession, so these funds are probably not good substitutes for treasury bond funds. If safety of principal is your primary investment objective, none of these funds will likely fit the bill.
These “deep dives” are a work in progress. If you would like to see specific information that I have left out, please let me know in the comments.
I have purposefully removed most of the NAV and market return information from the “Fundamental” spreadsheet below. That information is all contained on the master spreadsheet. The “Fundamental” sheet will grow as I complete my work on more asset classes. Information on the Fundamental sheet may differ slightly from the data on the master sheet. The master sheet contains unedited screener data. I manually updated the Fundamental sheet from individual fund fact sheets.
Sheet #1: Master Term CEF Worksheet
(Source: CEFConnect, Fidelity, Morningstar, Fund Fact Sheets, Author’s Own Spreadsheet)
Sheet #2: Fundamental Worksheet: Mortgage and Senior Loan CEFs
(Source: CEFConnect, Fidelity, Morningstar, Fund Fact Sheets, Author’s Own Spreadsheet)
Individual Fund Discussions
Each individual fund will be broken down into five parts. The goal is to quickly drill down to each fund’s most important characteristics. As investors, we are all prone to performance-chasing, and many investors seem to choose CEFs based on historical returns, assuming manager outperformance will continue. I will present a bit of performance data here for some context, but it will not be the overriding factor that guides our investment process.
The funds are presented in alphabetical order by ticker according to fund type. For reasons that will become apparent as we move through the funds, I believe that the analysis of these types of funds should start with credit risk. I include the Blackrock 2022 Global Income Opportunity Trust as a mortgage fund, although it is more of a “go-anywhere” fund.” Sources are generally fund fact sheets, annual reports, and prospectuses.
Mortgage Fund #1: Blackrock 2022 Global Income Opportunity Trust (NYSE:BGIO)
Investment Objective: According to the BGIO fund homepage, the managers of BGIO seek to “... distribute a high level of current income and to earn a total return, based on the net asset value of the Trust’s common shares, that exceeds the return on the Bloomberg Barclays 1-3 Month U.S. Treasury Bill Index by 500 basis points (or 5.00%) on an annualized basis over the life of the Trust... BlackRock believes BGIO’s limited term structure may support secondary market trading of the Trust’s shares by providing shareholders with a liquidity event in 2022 at net asset value.”
Expected Term Date: 2/28/2022
Current Pricing (4/13/18 close):
1yr Z-Score: -1.4
Current Premium / Discount: -4.07%
Market Return YTD: -2.25%
NAV Return YTD: -0.10%
Underlying Assets: Effective duration is 2.4 years. Assets are a nice mix of emerging market, securitized, and corporate debt. From page 6 of the fund's annual report:
(Source: BGIO 2017 Annual Report)
Leverage / Expenses: Effective leverage is 31.43%. The fact sheet lists the current management fee as 0.60%. The screener at CEFConnect lists fees at 0.93% (see spreadsheet), which probably includes “other expenses." This fee is still reasonable for a fund of this type.
As discussed on page 7 of the annual report, most of the leverage incurred by BGIO appears to be in the form of reverse repurchase agreements, whereby securities are pledged as collateral to obtain additional cash. Quoting from page 31 of the same report:
(Source: BGIO 2017 Annual Report)
Manager Commentary: In their February 2018 commentary, the managers of BGIO said: “We expect the synchronized global growth story to persist throughout 2018 as the world economy continues to recover after the financial crisis. At the same time, we can expect inflation to start rising, central banks to reduce their monetary policy accommodation, and hence, yields to start rising...
During the quarter we slightly increased our exposure to emerging markets. We believe emerging markets can absorb a gradual “reflation” and higher developed market rates as long as fundamentals remain supportive...
The strong demand for securitized assets remains as investors seek yield in today’s low interest rate environment. With negative net supply, the sector continues to drive strong performance for the Fund. In collateralized loan obligations (CLOs) we favor junior mezzanine tranches (BBB and BB). In Non-Agency RMBS we’ve been focusing on the top of the capital structure in subprime bonds and adding risk-sharing deals, and in CMBS we are long subordinated classes of single-asset/single borrower deals, which tend to have lower beta and attractive carry...
Finally, in corporate credit we slightly increased our exposure on the view that the passage of the new tax plan could benefit certain sectors. Fundamentals remain strong in the sectors and default rates remain at low levels.”
My Thoughts on BGIO: I like this fund. The investment objective is clear (achieve yield of T-Bills + 500bps). It maintains a short duration of 2.4 years. According to the commentary, the managers are buying senior bonds from non-agency RMBS deals as opposed to chasing “reperforming” loans that have previously defaulted. I also like their strategy of buying subordinate bonds from single-asset CMBS deals. Single-asset deals are much easier to analyze than larger “conduit” deals. Emerging markets can be volatile, so this fund may not be a great replacement for a very high-quality bond fund. Overall, I like the concept, relatively low management fee and diversification afforded by the wide variety of asset classes.
The strategy of using reverse repos for leverage would be a problem if another financial crisis hit. That said, the pledged assets seem to be of relatively high quality.
Mortgage Fund #2: Western Asset Mortgage Defined Opportunity (NYSE:DMO)
Investment Objective: According to the DMO fund homepage, its managers seek to provide "... a leveraged portfolio, consisting primarily of non-agency residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). Seeks current income, with a secondary investment objective of capital appreciation. The Fund intends to liquidate and distribute substantially all of the Fund’s net assets to shareholders on or about March 1, 2022.”
Term Date: 3/1/2022
Current Pricing (4/13/18 close):
1yr Z-Score: 0.8
Current Premium / Discount: 20.36%
Market Return YTD: 7.40%
NAV Return YTD: 3.81%
Underlying Assets: Effective duration is 4.7 yrs.
(Source: DMO Fact Sheet, 12/31/17)
Leverage / Expenses: Leverage is ~ 31.4%, all of which is in the form of loans (no preferred shares or reverse repos). For 2017, it appears that the weighted average interest rate was 2.06%, according to page 29 of the annual report. Management fees and other expenses total 1.61%, according to the fund’s website.
Manager Commentary: In their 2017 Annual Report, the managers of DMO wrote: “A number of adjustments were made to the Fund during the reporting period. We reduced our exposure to CMBS as their spreads tightened and we found better relative values elsewhere. However, we did increase our allocation to credit risk transfer securities, which are credits issued by Fannie Mae and Freddie Mac. We added to our position in non-agency MBS as housing fundamentals improved and they offered attractive yields. Within the ABS market, we initiated positions in credit cards and rental cars, while increasing our position in manufactured housing. We actively managed our non-agency MBS exposure by selling higher dollar priced issues with limited upside potential in favor of legacy securities (issued pre-2007) that offered more attractive yields and greater upside potential. Finally, we added to the Fund’s position in reperforming loans. These are loans issued prior to 2007 that, at some point in time, were either modified or the borrower had become delinquent. The borrower has since cleared the delinquency and has continued to make their interest payments over the last few years.”
My Thoughts on DMO: The high premium makes this fund off-limits for now. DMO has been adding to its exposure in “reperforming” non-agency RMBS loans, which are loans that have previously defaulted but have now been cured. To me, this seems like a risky strategy, as borrowers who default once are prone to defaulting again. The managers of the two Nuveen funds below also mention reperforming loans as an area of opportunity in NA RMBS, so clearly, some of these managers are being forced to explore riskier areas of the credit markets to obtain yield. I am avoiding DMO and will not consider adding unless the premium drops into negative territory.
Mortgage Fund #3: Invesco High Income 2023 Target Term Fund (NYSE:IHIT)
Investment Objective: According to page 4 of the IHIT 2017 Annual Report: “The Fund attempts to strike a balance between its two objectives: to provide a high level of current income and to return $9.835 per share (the Original NAV) on or about December 1, 2023 (the Termination Date). However, as the Fund approaches the Termination Date, its monthly distributions are likely to decline...
The Fund seeks to achieve its investment objectives primarily by investing insecurities collateralized by loans secured by real properties. To construct and manage the portfolio, the Fund’s investment adviser employs a bottom-up approach that focuses on fundamental analysis of the underlying loans. Under normal market circumstances, the Fund expects to invest at least 80% of its managed assets in real estate debt securities, including commercial mortgage-backed securities (CMBS). Under normal circumstances, the Fund will invest no more than 30% of its managed assets in securities rated below-investment grade at the time of investment.
… The Fund generally invests in a portfolio of real estate debt designed to generate high levels of current income through opportunistic deployment of capital. This includes investment grade CMBS, non-investment grade CMBS and non-rated CMBS, debt and preferred securities issued by real estate investment trusts (REITs), as well as other real estate-related investments. In seeking to return the Original NAV to investors on or about the Termination Date, the Fund intends to utilize various portfolio and cashflow management techniques, including setting aside a portion of its net investment income, possibly retaining gains and limiting the longest expected maturity of any holding (other than perpetual preferred securities) to no later than June 1, 2024. Perpetual preferred securities are not included in this restriction because they do not typically have a maturity date. The average maturity of the Fund’s holdings is generally expected to shorten as the Fund approaches its Termination Date, which may reduce interest rate risk over time but which may also reduce amounts otherwise available for distribution to shareholders due to liquidations or short-term investments made prior to maturity. The Fund anticipates using leverage to achieve its investment objectives.”
Current Pricing (4/13/18 close):
1yr Z-Score: -1.2
Current Premium / Discount: -2.18%
Market Return YTD: 1.95%
NAV Return YTD: 1.41%
Underlying Assets: Effective duration is 5.14 years. According to the 12/17 fact sheet -
Credit Quality: Cash: 1.1%; AAA: 4.5%; A: 6.20%; BBB: 68.6%; BB: 6.4%; B: 2.7%; NR: 10.5%
Type: CMBS: 81.83%; REIT Corp Debt and Preferred: 10.3%; Other: 6.78%; Cash: 1.1%
Note: IHIT appears to have entered into a pay fixed / receive floating swap on $50 million in order to gain some exposure to rising short-term rates. This swap is described in the November 2017 holdings report.
Leverage / Expenses: Leverage is 25%, and appears to be in the form of reverse repurchase agreements (similar to BGIO). Expenses are around 1% for common shareholders. The advisory fee is listed at 0.70% in the fund’s financial statements, but that number does not include some additional expenses.
Manager Commentary: The last commentary appears to be from February 2017, so I will not include it here.
My Thoughts on IHIT: In general, I like IHIT’s concept quite a bit, but I have a few concerns. Based on the fund’s holdings report, most of its CMBS positions are at least a few years seasoned. Many bonds were issued in 2013 and 2014, with some even issued in 2012. This seasoning is a strong positive for credit quality, as the real estate cycle was in a much earlier stage when these bonds were issued. That said, having traded CMBS for many years, I know that many deals from those vintages have high exposure to retail properties (malls, anchored shopping centers, etc.). I cannot find anything on the sponsor’s website that breaks out fund exposure by property type or metro area. We definitely want to avoid B-malls in tertiary metro areas, but from the information given, I have no way of determining IHIT’s actual exposure.
Most BBB-rated subordinate CMBS tranches issued since the financial crisis have somewhere between 6% and 10% credit enhancement. Essentially, credit enhancement is the percentage loss that a given CMBS deal can take before a particular bond from that deal begins taking losses. In other words, if a given deal takes between 6% and 10% losses on the original deal balance, the BBB-rated tranche from that particular deal may become exposed to losses. Conversely, to achieve a AAA rating, 30% credit enhancement is generally required.
CMBS deals often “lumpy,” containing several very large loans and a number of smaller loans. It is not uncommon for individual loans to account for over 10% of a particular deal’s underlying collateral. Therefore, to consider buying BBB-rated CMBS bonds using leverage, I would need to know more about the property type and underlying metro exposure. I will reach out to the sponsor this week to attempt to find out more information about IHIT’s underlying securities.
My suspicion is that the folks at Invesco are well aware of the pitfalls surrounding the retail sector and will have adjusted their fund’s holdings accordingly. If that is the case, IHIT may very well become a core position in our CEF ladder. Stay tuned.
Mortgage Fund #4: Invesco High Income 2024 Target Term (NYSE:IHTA)
Investment Objective: IHTA just launched in November 2017. The fund's homepage is found here. The annual report is not yet available on Invesco’s website - the fund seems to be in ramp-up stage.
1yr Z-Score: N/A
Current Premium / Discount: -3.91%
Market Return YTD: -8.15%
NAV Return YTD: 0.01%
Underlying Assets: Effective duration is 4.68 years. IHIT has around $320 million in total assets, while IHTA is around $80 million. The asset breakdown is as follows, according to the fund's latest fact sheet -
Credit Quality: AAA: 11.6%; BBB+: 8.9%; BBB: 7.39%; BBB-: 50.24%; BB-: 2.93%; B+: 1.46%; B-: 4.88%; NR: 12.59%
Type: CMBS: 87.43%; REIT Corp Debt and Preferred: 8.79%; Other: 3.78%
Leverage / Expenses: No documentation that I could find. I will assume that this fund has a similar fee structure to IHIT, which charges management fees of around 1% on common assets.
Manager Commentary: Not yet available.
My Thoughts on IHTA: This fund looks pretty similar to IHIT. IHTA trades on the Nasdaq but does not have a quote page on Seeking Alpha yet. I will keep an eye on it as more documentation becomes available.
Mortgage Fund #5: Nuveen Mortgage Opportunity Term Fund (NYSE:JLS)
Investment Objective: According to the JLS fund homepage, its managers seek to "... generate attractive total returns through opportunistic investments in mortgage-backed securities (MBS). The fund invests at least 80% of its managed assets in MBS, primarily non-agency residential MBS and commercial MBS. The fund uses leverage, and has a 10-year term and intends to liquidate and distribute its then-current net assets to shareholders on or before November 30, 2019.”
Term Date: 11/30/2019
Current Pricing (4/13/18 close):
1yr Z-Score: 0.2
Current Premium / Discount: -3.09%
Market Return YTD: -2.74%
NAV Return YTD: 0.26%
Underlying Assets: Duration is 4.21 years.
(Source: JLS Fact Sheet, 12/31/17)
Leverage / Expenses: According to the fact sheet, effective leverage is 27.28%, with an average cost of debt of 3.00%. Nuveen’s grid indicates that all leverage in JLS is in the form of debt (no preferred shares).
Management and other expenses on common shares: 1.58%
Manager Commentary: The sub-adviser for both JLS and JMT is Wellington Management. Wellington is a very well-respected NA RMBS / CMBS manager and provides thorough comments on a quarterly basis for both JLS and JMT. Manager comments quoted below are as/of 12/31/17:
Wellington's Non-Agency RMBS / Residential Housing Comments
“Among the major fixed income sectors, the non-agency residential mortgage-backed securities (RMBS) sector generated some of the strongest returns for the quarter. Persistent investor demand, particularly for higher-yielding assets, combined with strong housing market fundamentals, boosted the sector’s performance. The credit risk transfer (CRT) market recovered from its post-hurricane selloff and spreads proceeded to compress, reaching their tightest levels of the year. In fact, spreads on the mezzanine tranches reached their tightest levels since issuance began in 2013. The legacy RMBS sector also performed well with positive excess returns across all subsectors (subprime, Alt-A, pay-option adjustable-rate mortgage (ARM), prime). Data released for the quarter indicated that the U.S. housing market had gained momentum heading into year-end; sales and homebuilding activity rebounded strongly as the effects of the hurricanes subsided. Additionally, the low supply of existing homes coupled with consistent demand for housing continued to fuel year-over-year home price gains, as measured by the S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index, in the 5.9% to 6.4% range.”
Wellington's CMBS / Commercial Real Estate Comments
“Commercial mortgage-backed securities (CMBS), as measured by the Bloomberg Barclays CMBS Index, returned 0.35% for the quarter, outperforming duration-equivalent U.S. Treasuries by 0.78%. The sector had a strong quarter, thanks to positive U.S. economic data and optimism about a fiscal boost from tax reform. Spread tightening within the sector was most pronounced in the lower-rated tranches, which would be expected given investors’ increased risk appetite. Technical factors were also broadly supportive; and, although new issuance continued at a healthy pace, demand was substantial enough to easily absorb the supply. Performance of CMBX indexes (synthetic CMBS indexes), on the other hand, was mixed. Retail headlines reinforced the broader trend of dominant malls surviving at the expense of weaker ones. As a result, spreads on synthetic CMBX Series 6 subordinate tranches - the segments most exposed to weaker retail - widened 5 to 15 basis points (bps) over the course of the quarter while spreads on similar tranches in other CMBX series tightened by 5 to 30 bps. National property prices gained 8.9% year-to-date through November as the Real Capital Analytics National Commercial Property Price Index pushed to new highs.”
JLS/JMT Fund Allocation at 12/31/17:
“The Funds’ allocation to non-agency residential mortgage credit was the primary source of relative performance during the quarter. Within non-agency RMBS, the allocation to CRT (the portfolios’ largest allocation) was the biggest contributor, followed by allocations to legacy RMBS (Alt-A, prime and subprime). The portfolios’ allocation to CMBS, particularly post-crisis deals, agency multifamily credit bonds and legacy subordinated bonds, also benefited results. Within asset backed securities (ABS), positions in subprime auto loans and collateralized loan obligations (CLOs) contributed to positive results. Holdings in agency collateralized mortgage obligations (CMOs), however, detracted slightly from relative performance.
The Funds utilized U.S. Treasury futures to manage duration and yield curve positioning in the portfolios. This positioning had a negative impact on performance over the quarter.”
Manager's Outlook for JLS/JMT:
“Our approach to sector allocation has remained consistent since each Fund’s inception. Both Funds seek to generate total returns by investing in a diverse portfolio of mortgage-backed securities (MBS) consisting primarily of non-agency RMBS and CMBS. We continue to favor residential credit from a relative value perspective and maintained the Funds’ risk positioning throughout the quarter.
We have a constructive outlook on most non-agency RMBS, given the robust U.S. housing market and positive technical tailwinds. Considering the continued spread tightening, especially in the CRT and legacy sectors, near-term return potential has moderated. Therefore, we expect income will be the main source of near-term return potential.
Securitizations in such non-traditional sectors as nonperforming and re-performing loans, re-securitizations and non-qualified mortgages are also attractive opportunities to provide financing on assets historically financed on bank balance sheets.
Our longer-term outlook for CMBS is positive due to favorable commercial real estate and economic fundamentals. But, given pockets of structural weakness such as we see in the retail segment, regions of the U.S. affected by soft oil prices, and hurricane-stricken metropolitan areas, we are especially judicious in our credit analysis and security selection. We favor select single-borrower credit bonds, seasoned (2010-2013) credit bonds, certain interest-only bonds, agency multifamily credit bonds and high quality new issues.”
My Thoughts on JLS:
I decided to quote extensively from Wellington’s recent commentary, as I thought it gave an excellent summary of both the residential and commercial mortgage markets.
With risk appetite soaring into the end of last year, asset prices followed suit. It will be interesting to see what Wellington has to say about the volatility we experienced during the first quarter of 2018. I found this quote above to be particularly revealing: “... near-term return potential has moderated... we expect income will be the main source of near-term return potential.”
When the manager basically tells you that asset prices in their sector are rich, it is not time to jump in with both feet.
Wellington also made sure to highlight in their above comments the "broader trend of dominant malls surviving at the expense of weaker ones," a theme that has ramifications for many asset classes.
Note on Capital Gains and Term Dates:
Both JLS and JMT passed through about $1.60 in capital gains in the past 12 months, according to Fidelity's screener (see spreadsheet above). As CEFs with termination dates approach liquidation, most warn that income from the portfolio holdings will decline. Therefore, investors should expect to see capital gains increase as the termination date is approached, as managers seek to maintain distribution levels. Both JLS and JMT show slightly negative UNII balances, supporting this theory. For those of you curious about how term funds will perform in the last few years prior to the term date, JLS and JMT will be good funds to follow.
We may be a little late to both JLS and JMT, but both appear to be well-managed and could be good income funds for the shorter legs of our contemplated CEF Ladder. I hope this manager considers launching a new term fund once JLS and JMT are wound down.
Mortgage Fund #6: Nuveen Mortgage Opportunity Term Fund 2 (NYSE:JMT)
Investment Objective: According to the JMT fund homepage, the fund seeks to "... generate attractive total returns through opportunistic investments in mortgage-backed securities (MBS). The fund invests at least 80% of its managed assets in MBS, primarily non-agency residential MBS and commercial MBS. The fund uses leverage, and has a 10-year term and intends to liquidate and distribute its then-current net assets to shareholders on or before February 28, 2020.”
Term Date: 2/28/2020
1yr Z-Score: 0.1
Current Premium / Discount: -3.51%
Market Return YTD: -2.67%
NAV Return YTD: 0.21%
Underlying Assets: Duration is 4.17 years.
(Source: JMT Fact Sheet, 12/31/17)
Leverage / Expenses: According to the fact sheet, effective leverage is 28.43% at an average cost of 3.00%. Similar to JLS, leverage is in the form of debt (no preferred shares).
Management and other expenses on common shares: 1.75%
Manager Commentary: See above for the commentary on JLS/JMT (Wellington manages both funds - the commentary is identical).
My Thoughts on JMT: Other than being curious about why Nuveen started two separate funds with term dates only three months apart, my comments on JLS mirror those on JMT. Both seem to be good income fund candidates. 3-4% discounts on these funds may actually be an attractive pricing level.
We looked at six term CEFs with exposure to mortgages: BGIO, DMO, IHIT, IHTA, JLS and JMT. BGIO, a go-anywhere fund with exposure to a variety of asset classes, including emerging markets, looks attractive. DMO’s premium makes it too rich for our blood. IHIT and IHTA are both essentially levered bets on subordinate commercial mortgage-backed securities, and we will require more information on the underlying holdings before investing. JLS and JMT are both well-run income options that provide excellent ongoing market commentary, but due to their late 2019 / early 2020 term dates, probably don’t have much upside.
Our next installment in this series will discuss senior loan funds with term dates. From there, we will move on to corporate and municipal bond funds. If you have any suggestions on the format of these articles, please list them in comments. I have tried to make the tables and basic information both timely and easily accessible. Thank you for reading.
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.