Closed-end funds ("CEFs") rebounded in the month of June alongside risk markets after a weaker May. Discounts across the CEF space ended the month at -5.11%, about 27 bps tighter than on May 31. Z-scores continue to inch higher and rose to +0.75 from +0.58.
CEFs have had a bit of a period of tranquility as of late with little in the way of spread widening even when we've seen periods of volatility. The CBOE Volatility Index (VIX), also known as the "fear index," is typically a good barometer of discounts: when the VIX spikes, discounts widen out, and vice versa. The VIX has been meandering lower as the markets ease a bit given a thaw in trade tensions and the Fed coming to the markets' aid.
Discounts today are relatively tight compared to just a few months ago. There's a limit to how much farther they can tighten. NAV gains are also likely topping out as high yield spreads have fallen back towards where they were before the fourth quarter. In other words, we think most funds have now exhausted their capital gains potential, either by NAV gains or discount tightening. We believe it will be coupon clipping for most areas of the fixed income CEF market for the rest of the year.
KKR Income Opps (KIO) is a great example. The fund is a bag of mostly CCC-rated credits. They hold some of the junkiest assets that one could buy which is why the fund pays such a compelling distribution yield. But that yield comes at a cost. The NAV is primarily "equity lite," meaning investors can expect that the volatility would be slightly lower when compared to the overall stock market. With the spread between the high yield master index and treasuries back to under 4%, the capital gains portion of returns is probably over. Meanwhile, discounts are back to the tighter levels seen at the peak last year.
But remember, investors in CEFs here are essentially short a whole bunch of VIX futures. What does that mean? It comes down to the fact that given the low levels of the VIX and the relatively tight discounts, should the VIX spike on renewed volatility in the equity markets, it is possible that discounts could widen very quickly. That is a risk of the markets at these levels and the double-edged sword of CEF investing.
Selling though means you cut off your income flow. Given that you don't know when the VIX will spike, the income lost could completely offset any gain by shifting to cash and waiting out the next bout of market volatility.
In our June newsletter, we discussed some changes we are making to our Core Income Portfolio in response to this environment. This includes reducing our overweight to high yield and floating rate a bit in order to start getting a bit more defensive. That doesn't mean going to cash but rotating our sub-sector bets to areas of the bond market that we feel will be more downturn/recession-proof.
Concentrating our sector bets is something we do occasionally when the risk-return profile is very favorable. Munis and high yield were good examples of those opportunities in the last year. In December, high yield spreads (the amount of yield the market requires above and beyond the similar maturity U.S. treasury bond) reached over 5.50%. It began to contract towards the end of the month and became clear it was time to get in.
We did make the argument that the current discount environment may be warranted, given the shift in the interest rate environment. What do we mean? About 9 months ago, we were at these valuations in CEFs with relatively tight discounts and most funds somewhere near their 52-week highs. The interest rate environment was such that the market was expecting 3 Fed Funds rate hikes in the subsequent 12 months.
Fast-forward 9 months and we are near the same valuations. But today the interest rate environment suggests we could get as many as 3 rate cuts in the next 12 months. With a rising rate environment overhang being largely removed, a key risk for CEFs has gone away.
Leverage costs have been a massive headwind for most CEFs in the last two years. Below is the one-year t-bill rate over the last three years. The climb on a percentage basis is massive, primarily because the rate started from nearly zero. But CEFs run their distributions lean, given that they want to remain competitive among their peers and also they must pay out excess net investment income produced or they are forced to pay an excise tax. When the short end of the treasury yield curve rises, it means leverage costs rise and the spread between earnings and costs shrinks. This sometimes forces a distribution cut.
All in all, the environment has turned very favorable for investors with some key risks eliminated. However, that has been at least partially offset by rising valuations and perhaps some complacency to risk markets.
Distribution Increase (>3%)
Invesco Senior Income (VVR): Distribution increased by 9.52% to $0.023 from $0.021
BlackRock Floating Rate Income (BGT): Distribution was increased by 8.1% to $0.0668 from $0.0618
BlackRock Enhanced Equity Div (BDJ): Distribution was increased by 7.07% to $0.05 from $0.0467
PIMCO Dynamic Credit and Mortgage (PCI): Distribution was increased by 6.06% from $0.164 to $0.174
Invesco Dynamic Credit Opp (VTA): Distribution increased by 4% to $0.065 from $0.0625
Distribution Decrease (>3%)
EV High Income 2021 (EHT): Distribution decreased by 9.8% to $0.037 from $0.041
BlackRock Muni Income Quality (BYM): Distribution decreased by 7.7% to $0.048 from $0.052
BlackRock Muni Income Inv (BAF): Distribution decreased by 12% to $0.0515 from $0.0585
BlackRock MuniAssets (MUA): Distribution decreased by 3.7% to $0.0525 from $0.0545
BlackRock Muni Income (BFK): Distribution decreased by 8.55% to $0.0535 from $0.0585
BlackRock Strategic Muni (BSD): Distribution decreased by 3.5% to $0.055 from $0.057
BlackRock MuniEnhanced (MEN): Distribution decreased by 11.4% to $0.039 from $0.044
BlackRock MuniHoldings Inv Quality (MFL): Distribution decreased by 13.3% to $0.0455 from $0.0525
BlackRock MuniYield Inv Quality (MFT): Distribution decreased by 15.25% to $0.05 from $0.059
BlackRock MuniHoldings (MHD): Distribution decreased by 5.93% to $0.0635 from $0.0675
BlackRock MuniYield Quality II (MQT): Distribution decreased by 8.3% to $0.044 from $0.048
BlackRock MuniYield Quality (MQY): Distribution decreased by 5.4% to $0.053 from $0.056
BlackRock MuniHoldings Quality II (MUE): Distribution decreased by 10.2% to $0.044 from $0.049
BlackRock MuniHoldings II (MUH): Distribution decreased by 8.13% to $0.0565 from $0.0615
BlackRock MuniVest II (MVT): Distribution decreased by 6.7% to $0.0555 from $0.0595
BlackRock MuniYield (MYD): Distribution decreased by 5.1% to $0.056 from $0.059
BlackRock MuniYield Inv (MYF): Distribution decreased by 9.7% to $0.056 from $0.062
BlackRock Muni 2020 (BKK): Distribution decreased by 9.43% to $0.0288 from $0.0318
BlackRock MuniHoldings CA Qty (MUC): Distribution decreased by 8.42% to $0.0435 from $0.0475
BlackRock CA Municipal Income (BFZ): Distribution decreased by 6.74% to $0.0415 from $0.0445
BlackRock MuniYield CA (MYC): Distribution decreased by 10.42% to $0.043 from $0.048
BlackRock MuniYield CA Quality (MCA): Distribution decreased by 11.54% to $0.046 from $0.052
BlackRock MD Muni Bond (BZM): Distribution decreased by 23.21% to $0.0364 from $0.0474
BlackRock MuniYield MI Quality (MIY): Distribution decreased by 5.77% to $0.049 from $0.052
BlackRock MuniYield PA Quality (MPA): Distribution decreased by 13.21% to $0.046 from $0.053
BlackRock MuniYield Arizona (MZA): Distribution decreased by 8.51% to $0.043 from $0.047
BlackRock VA Municipal Bond (BHV): Distribution decreased by 14.95% to $0.0455 from $0.0535
Massachusetts Tax-Exempt Trust (MHE): Distribution decreased by 9.09% to $0.04 from $0.044
BlackRock Taxable Muni Bond (BBN): Distribution decreased by 5.89% to $0.1118 from $0.1188
BlackRock Core Bond (BHK): Distribution decreased by 7.69% to $0.06 from $0.065
BlackRock cut across a lot of their tax-free funds. Most of the distribution cuts were not surprising and we had noted at least a few of them recently, namely in "Time to Bank Your MHD Gains." Some of the cuts make little to no sense to outside investors. Obviously, the board and portfolio managers get much more granular information that can provide greater insights.
One of our top conviction picks, BlackRock Investment Quality Muni (BKN) did not cut but a few others did. Those include BlackRock MuniYield Quality I (MQY) and BlackRock MuniYield Quality II (MQT) which cut by -7.1%, and -8.3%, respectively.
One of our top convergence selections was BlackRock Enhanced Muni (MEN) which cut the distribution by -11.3%. The key difference between a conviction and a convergence trade is the fundamental strength of the fund. For instance, BKN had strong coverage above 100% and UNII that is positive and growing. After looking at other key factors including yield and call schedule, as well as valuation, the fund became a conviction buy.
The convergence picks are all flawed in some way (which is why they aren't conviction picks) and are viewed more in the lens of a short-term opportunistic play. MEN did cut recently which made it appear safe but the following three months continued to see UNII declines at double-digit rates. It was our contention that this would subside following the April cut and perhaps reverse course. Or that the discount would close to our target of -6% before it would need another cut.
MEN almost made it. You can see the trend below. We had gambled a bit and lost not expecting the leash BlackRock placed on the funds to be that short. Investors who hold MEN still have a nice gain. BlackRock Long-Term Adv Muni (BTA) was another example with similar dynamics that paid off. It hit the sell target before they cut. Same with MHD which we sold before they cut.
As noted above, cuts to many of the funds yesterday were warranted as they were draining their UNII at increasing rates for 3 or 4 months straight (a tell a cut is coming for BlackRock). Each sponsor is a little different and BlackRock has shown that they really do not tolerate negative UNII balances on their muni CEFs. This is the opposite of Nuveen which tends to run many months of negative UNII before cutting. Or Invesco who tends to not only run many negative months but also start paying back capital "RoC" before cutting.
A fund like MEN had just cut on the April 1 distribution. It is very surprising that they conducted another cut so soon. Clearly, BlackRock didn't see the turnaround in UNII that they had expected from the first cut and decided to do another significant one and be done for a while.
MQT and MQY hadn't cut in the last year but still have significant coverage (as shown below) plus several cents of positive UNII. Neither was seeing significant UNII deterioration. Perhaps the portfolio managers and the board could see a significant amount of calls coming and, in the lower interest rate environment, nearly every call would be executed. This was a way to strengthen them significantly for the next year or two.
It is interesting to note the price reaction we are seeing. The reaction across most of the funds is fairly muted. One theory is that the muni market is particularly strong right now and that alternative areas of the bond market are not competitive from an after-tax yield point-of-view. That strength allows BlackRock to cut without much of a reaction from the market and thereby increase the fundamental strength of the funds across the board.
In prior years, cuts this widespread and of this magnitude would have sent prices reeling. Given the vigor of the muni space right now, we are unlikely to see the same kind of reaction. We think investors should wait a few days to monitor price action and then select those funds with the strongest fundamentals that also have seen the largest declines.
Monthly Statistics - Commentary
Sector data shows the only area of the CEF space to see negative price returns was MLP equity funds which fell 37 bps. Floating rate was the second weakest at just +17 bps. The best-performing area of the market was emerging market equity funds, convertible bonds, and biotech funds, rising between 4% and 7%.
More important are the NAV returns. Senior loans, also known as floating-rate loans, performed the worst falling 48 bps. This was due to the money flowing out of the space on the thesis of rates coming down. Those loans will then be reset lower reducing their appeal.
Preferreds remain one of the most expensive sectors. If one were to look back a year ago, with the expectation of higher rates, they would have seen that on the other side of the table. From a z-score perspective, preferreds are the second most overvalued at +1.33. Real estate is now at +1.64 but has started to roll over.
We did see some decent movement in some individual funds with surprisingly some muni funds appearing on the largest decliners by price. For example, Nuveen NJ Muni Value (NJV) was the third largest decliner. The fund saw a rise in price and then a collapse in the last month.
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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.