CEF Market Update: V-Shape Discount Recovery Leaves Fewer Bargains

Summary

• CEF discounts have staged an impressive recovery despite continued weakness in markets, supported by attractive yield differentials to Treasuries.
• We take a look at the corporate credit sector and view high-yield as more appealing to loans as we expect sharply lower rates to pressure loan payouts more.
• As discounts remain tight overall, high-yield open-end funds deserve a look where we like ANGL and JPHY.
• This idea was discussed in more depth with members of my private investing community, Systematic Income. Get started today »

Despite good jobs numbers and central bank action, broader risk markets remain nervous about an extended supply shock that may hit the global economy. CEF discounts, however, remain surprisingly sanguine and not at all reflective of sharply lower stocks, wider credit spreads and higher volatility readings.

Although we find overall CEF discounts disappointingly tight, sharply lower interest rates suggest that this could very well be the new normal. That said, at these levels, we think open-end funds deserve a look. In the high-yield sector, which we touch upon in this article, we like the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) and the JPMorgan Disciplined High Yield ETF (JPHY).

Teflon CEF Discounts

Breaking down total price returns since the start of the sell-off across CEF sectors, we can see that most sector discounts have widened just a few percentage points with some even tightening in the period. This is in contrast to much sharper drops in NAVs.

Source: ADS Analytics LLC, Tiingo

If we look at the discount time-series since the drawdown began, we can see two distinct periods - widening during the first week, followed by gradual but steady tightening. All in all, the average sector discount is only about 1% wider since the sell-off began, hardly bargain territory. And this is despite a reversal in equity performance.

Source: ADS Analytics LLC, Tiingo

So, despite multi-year highs in volatility and credit spreads, current CEF discounts are around middle-of-the-pack values over the last six years.

Source: Systematic Income Investor CEF Tool

To see whether this is unusual, let's check how discounts performed during the December 2018 episode. Interestingly that episode looks a lot similar to our current one.

Source: ADS Analytics LLC, Tiingo

We would highlight three similarities:

1. Discounts stopped widening well before the end of the equity drawdown period.
2. Discounts started to reverse at around a 10% drop in stocks.
3. Discounts bottomed at a level around 4-5% wider from the pre-drawdown level.

None of this suggests that discounts can't widen from here, particularly if the broader economy and earnings start turning lower, but the similarities are striking. It appears to us that yield-starved CEF investors who have been patiently waiting in the wings have started to move into the market. This is because on some metrics the CEF space is undeniably attractive. For example, the difference between the trailing twelve-month yield of the high-yield CEF sector and 10-year Treasury yield stands at the highest level since 2016. This yield pickup should support discounts from here on, particularly if we avoid a further negative feedback loop between sentiment and macro activity.

Source: Systematic Income Investor CEF Tool

High Yield or Loans?

One interesting question at this juncture is what to do in the corporate credit space. The high-yield credit spread has reached a similar level that we saw in December 2018. We are still well below 2016 levels; however, that was largely driven by a blowout in the energy sector which is arguably somewhat stronger now as the weakest links are now long gone.

Source: Systematic Income Investor CEF Tool

Taking a look at sector discount valuations and yields across the credit sectors, all the sectors look uniformly expensive on the five-year z-score metric apart from loans. On a discount percentile metric, calculated since 2000, most sectors are at around 50% or higher indicating fair-value or expensive levels, again except for loans. The loans sector is also trading at the highest covered yield as well as the widest discount.

Source: Systematic Income Investor CEF Tool

Does this mean that loans are the place to be in the current environment? One argument for loans is that the sector is higher up in the capital structure. And although many issuers have loans as their only form of debt, suggesting that future recoveries will be lower than historical averages, the recoveries in the sector are still expected to be well above high-yield.

However, we see a few arguments against the sector as well. First, the recent widening in the loan sector discount has been on par with high-yield, so the more attractive current discount valuation of the sector is not a recent phenomenon.

Source: ADS Analytics LLC, Tiingo

Secondly, the steady move lower in the short-term rates since the end of 2018 and particularly over the last couple of weeks translates much quicker into lower loan sector earnings than it does for the high-yield sector. This is because loan coupons are tied directly to the Libor rate, particularly as we are only now getting close to Libor floors in loan payouts. The earnings of the high-yield sector should be a bit stickier as calls and maturities take a longer time to flow through fund earnings.

For this reason we have a preference of high-yield funds or mixed-allocation funds over loan-only funds, at least until we see a much more pronounced weakness in the loan CEF sector. However, given the historically expensive discount valuation of the high-yield sector, we find it difficult to jump in full-heartedly into high-yield CEFs at these levels.

For this reason, we think ETFs may be a better beta play. We like the passive VanEck Vectors Fallen Angel High Yield Bond ETF with a 4.58% current yield which allocates to funds that have been downgraded from investment-grade - a strategy that has delivered sector-beating returns. We also like the active JPMorgan Disciplined High Yield ETF with a 4.93% current yield for its wide mandate and strong returns. Both funds feature below-average fees.

Conclusion

CEF discounts have proved surprisingly resilient despite broad-based and continued weakness in the markets, supported by lower interest rates and a wide yield differential to Treasuries. In the corporate credit space, we favor the high-yield sector over loans despite historically more expensive discount valuations. Loan fund earnings will adjust more quickly to lower interest rates which should pressure distributions more quickly than would be the case for high-yield funds. And since overall discount valuations remain historically tight, we think open-end funds deserve a look. Among high-yield open-end funds we like ANGL and JPHY that have attractive strategies at relatively low fees.

Analyst’s Disclosure: I am/we are long ANGL, JPHY. 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.