3 Quick CEF Rotation Opportunities

Sep. 03, 2019 1:57 PM ETDIAX, FLC, HPF, HPI, HPS, NRO, RNP, SPXX37 Comments20 Likes

Summary

  • HPI or HPF could be swapped for HPS.
  • SPXX could be swapped for DIAX.
  • NRO could be swapped for RNP.
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Rotating between overvalued closed-end funds into less overvalued ones is a cornerstone strategy at CEF/ETF Income Laboratory which we call "compounding income on steroids" (see this link for a step-by-step manual on how to execute this strategy).

As I was looking through the closed-end fund database today, I spotted three quick rotation opportunities that could be relevant for those holding these funds.

Note: Data are from August 2, 2019 when the report was first released to members but updates to the trades are presented below.

1. John Hancock preferreds CEFs

  • Sell: John Hancock Preferred Income Fund (HPI) - or - John Hancock Preferred Income Fund II (HPF)
  • Buy: John Hancock Preferred Income Fund III (HPS)

As the data above shows, the three funds are all extremely similar in terms of coverage, leverage, baseline expense ratio, and historical performance.

However, there has been a significant divergence in the share price returns of the three funds (but not their NAV returns) over the last couple of months. HPI and HPF have provided total return values of +14.03% and +12.20%, respectively, compared to only +7.89% for HPS. Yet, all three funds have NAV returns that are within 30 bps of each other over the same time frame.

Chart

Data by YCharts

Of course, experienced members will know that this is because HPI and HPF's premiums have expanded significantly over that of HPS. HPI and HPF are now trading at double-digit premium levels, which are in fact record highs since the Great Financial Crisis, while HPS is at a much more conservative +3.35% premium.

Chart

Data by YCharts

Hence, a swap from HPI or HPF to HPS is recommended. Of course, there are some preferred CEFs such as Flaherty & Crumrine/Claymore Total Return Fund (FLC) (which we own in our Income Generator portfolio) that are even more discounted than HPS, but keeping the swap within the same fund family reduces risk.

[September 2, 2019 update: HPS (-0.91%) has slightly outperformed (63 bps) the average of HPI (-0.65%) and HPF (-2.42%), so the trade is in profit. Given that HPI (+11.77% premium) and HPF (+9.00% premium) are still much more expensive than HPS (2.41% premium), I think that this trade has some room to run still, even though the opportunity is now slightly less than before.

2. Nuveen option-income CEFs

  • Sell: Nuveen S&P 500 Dynamic Overwrite Fund Common Stock (SPXX)
  • Buy: Nuveen Dow 30 Dynamic Overwrite Fund (DIAX)

What's SPXX doing all the way up at a +5% premium? Granted, it's been there before, but it wasn't sustainable then and I don't think it's sustainable now.

The swap candidate I chose for SPXX is another Nuveen closed-end fund, DIAX. This fund tracks the Dow rather than the S&P 500, but the correlation between these two indices is extremely high. DIAX can be currently bought at a -2.74% discount, compared to a +4.93% premium for SPXX.

As the chart below shows, SPXX has outperformed DIAX by over 6% over the past 3 months; however, its NAV returns are slightly worse. Swapping from SPXX to DIAX could be an easy way to generate a few percentage points of returns on this position.

Chart

[September 2, 2019 update: DIAX (+1.32%) has outperformed SPXX (-0.30%) by 162 bps, a decent outperformance for only a 1 month holding period (nearly 20% annualized). However, the chart below shows that the trade was in the red for the first couple of weeks. This goes to show that you sometimes have to be patient with rotation trades. Given that SPXX (+4.18% premium) is still significantly more expensive than DIAX (-1.45% discount), I think that this trade has some room to run still, even though the opportunity is now less than before.]

3. Real estate CEFs

  • Sell: Neuberger Berman Real Estate Securities Income Fund (NRO)
  • Buy: Cohen & Steers REIT and Preferred Income Fund (RNP)

For the last rotation trade, we're increasing the risk level a little bit by going outside of a single fund family, but it's okay this time around because I view Cohen & Steers as a superior real estate manager to Neuberger Berman. Indeed, RNP outperforms NRO across all time frames, yet it is still available at an over 3% wider discount than NRO (-3.58% vs. -7.19%).

In terms of portfolio, NRO has about 60% in equity (mainly REITs) and the rest in preferreds, while RNP has only around 50% in equity and the rest in preferreds, so that's a minor difference but close enough in my book.

As we can see from the chart below, NRO has outperformed RNP by about 4% in price over the last 3 months, even though its NAV performance is actually around 1% worse. One member told me that NRO was recommended by another newsletter author a few weeks back (which could explain its price increase), but I don't see anything that would justify the selection of NRO over RNP right now. A final advantage for RNP, besides its superior performance and better valuation, is its lower baseline expense ratio (1.05%) versus NRO (1.39%).

Chart

Data by YCharts

Note that we own RNP in both our Tactical Income-100 and Income Generator portfolios. Nick recently profiled RNP for us here.

[September 2, 2019 update: This was our biggest winner! RNP (+7.18%) outperformed NRO (+2.43%) by a whopping 475 bps in only 1 month, for an annualized IRR of 57%. Another way of framing this is that one could have earned the equivalent over 6 months worth of distributions from NRO in only 1 month by following this trade. NRO (-3.18%) is still slightly more expensive than RNP (-4.15%), but most of the alpha from the trade has already been earned.]

Summary

As the CEF marketplace starts to get overheated, members should be vigilant in spotting rotation opportunities that could easily add significant returns to their portfolios. Hopefully, this quick note will help members understand the main factors that I look at when recommending a high-probability swap.

Remember, closed-end fund valuation matters!

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