The closed-end fund market was looking extremely dire during the holidays with NAVs peaking just before the start of the fourth quarter. Valuations also peaked then with many funds trading at a premium to NAV. Then nearly all funds saw NAVs roll over as virtually every risky asset declined in the fourth quarter.
That NAV decline was combined with significant tax loss selling throughout the final two months of the year creating a severely oversold condition. Still, despite very wide discounts, if the NAV is in decline mode, it may be too early to buy yet. We saw the capitulation trade occur on Christmas Eve, a day we were at work buying like crazy.
On the Friday before (December 21st), we advised our members to top off or go above target allocation on several of our top funds including PIMCO Dynamic Credit and Mortgage Income (PCI) which hit a rare "strong buy" indicator on our Google Sheet. We wrote:
For those that want to top off or go above the target allocation, the market is giving us an opportunity to really add here at levels that could be extremely lucrative for the next 1-2 years. In the last 30 days, the NAV is down just over 1.4%.
In our weekly missive from Sunday, December 23rd, we discussed the downright dour sentiment and the gloomy narrative afflicting the market. In our economic and market review, we noted:
So where do we go from here? The market swoon is not without any reason to be found. Fundamentals have deteriorated in the last few months as growth has slowed. However, a recession is a long ways away. Most of the weakness is outside of the U.S., especially with China and Europe. Investors believed these markets would have stabilized by now but early data this month appears to show that is not the case. Germany, in particular, appears to be entering recession. Not a good sign for the U.S.
Here's a quote from JPMorgan: 'The present narrative of abject despondency seems incongruous with reality.'
As you know, the VIX Index is a measure of implied equity volatility. The Equity Put/Call Ratio is the ratio of investors buying put options relative to call options. A reading of 1.0 means that for every put there's a call, a ratio greater than 1.0 means more puts being bought than calls.
From Putnam Investments: 'History suggests that VIX readings greater than 30.0 tend to coincide with tradable bottoms. As you can see in the data, the forward returns for the S&P 500 generally bear that out. We have attached the data for your review.'
Forward S&P 500 Return
Average Post '08
Source: Bloomberg, Putnam
As stated above, that turned out to be the capitulation trade. Discounts starting on December 26th started rebounding and did so for the subsequent two weeks. Below is the discount for the CEF Advisors' Taxable Bond & BDC Index, which we like to use as a proxy for the taxable CEF space. The "V" shaped rebound in the discount level is quite apparent. The current rebound is only about 60% of the peak-to-trough decline.
The spread on PCI fell almost 4% in the holiday shortened week from 10.3% to 6.04%. And just 10 trading days later, the shares hit a discount of just 1.50%. While that was still below the ~2% premium levels just before the fourth quarter began, it was still tighter than the 3-year and 5-year average discount levels. This is scene is similar to what occurred across most of the CEF universe.
One heck of a round trip for PDI; the fund hit a rare discount (though didn't reach our strong buy threshold).
As we noted then, while it was only 10 trading days, it felt like forever. This is often how these sharp bear market declines feel.
Should we expect discounts to close further?
You can see the run-up in the valuations prior to the drop in the fourth quarter. We think it is unreasonable to expect the valuations to rise back to those levels unless we see a substantial reduction in both the volatility index (VIX) and high yield spreads. We believe the "cap" on the green line above is likely close to zero leaving little in the way of further discount tightening in the near-term.
The VIX is back below 20 which is a healthy (and healing) signal.
High yield spreads shot up to their highest levels since the early part of 2016. At their peak, they hit 5.37% which was still less than half of the levels reached during the oil market/ high yield swoon. The chart below shows those spreads which tended to bounce around the post-recession lows around 3.30% - 3.60% until the fourth quarter when they shot higher. They have retracted almost half of the move to date but the compression seems to have stalled in the last few trading days.
We run these analyses each week and month to see if any opportunities arise out of the sharp, low-liquidity moves of the CEF space.
While discounts have tightened and investors think they have probably missed the opportunity, there are still pockets of opportunity.
The snap back in discounts that we have witnessed in the last few weeks has been the most jarring in memory. Z-scores continue to heal with the average across all categories at -1.13. Across all bond and stock categories, real estate is now the widest discount at 13.8%. The multi-sector bond category is back to a premium thanks to DMO, PTY, PDI, and a few others.
Dividend equity funds saw a 7% move on average last week, the largest of any sector. NAVs of that category were up 3.95%. The weakest sector was taxable municipals which, on average, saw approximately 39 bps of price decline and 28 bps of NAV decline. Tax-free munis were also down slightly on NAV (-17 bps) but saw significant discount closing with the average price up 1.83%. This is exactly what we were thinking would happen.
MLPs were the big winner on a NAV basis rising 8.87% on the week with prices up 6.42%. All energy did well again last week with the equity energy and resources category rising 4.85% on price and 4.89% on NAV.
We continue to closely watch the senior loan (floating rate) category which had another good week returning 1.08% on NAV and 1.79% on price, closing the average discount by 71 bps. NAVs did decline on Thursday and Friday as the index saw some mild weakness again.
Preferreds, the other category we have been fond of lately, especially on the individual side, saw strength again this week despite interest rates moving higher. The category's average price was up 2.90% and the average NAV was up 2.05%.
Some z-scores are a bit expensive here. EV Enhanced Equity II (EOS) recently raised the distribution which isn't really a surprise given the move in the NAV the last few years. With a big cap tech bent, the fund has benefited from Amazon, Google, Facebook, and others. While those stocks are down from their peaks, they still have significant gains in them over the prior five years. Check out Voya Global Equity Div Prem Opps (IGD) for a possible replacement.
The game plan for 2019 will be a steady de-risking of the portfolio as we near the end of the cycle. For example, on the chat we discussed floating rate securities. They have moved higher significantly in the last couple of weeks from a severely oversold position. But once closer to par, we will likely trim that exposure significantly as short-term interest rates are unlikely to head significantly higher.
On Friday, I sold out of my DMO position given the sharp move higher (it hit a preset limit order price) along with about 10% of my PCI position (~2.6%). I'll continue to opportunistically trim that position back to the target weight (18%) over the next week or so. I do think that given the ex-distribution date being Friday, we could see a bit of a pull back in the PIMCO CEFs in the first half of next week.
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Disclosure: I am/we are long PCI. 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.