(This report was issued to members of Yield Hunting on March 4th, 2020, with additional analysis for members only)
Well, we knew this was going to happen. Discounts were taking the escalator up for months reaching what has been historically tight levels. But as usual, panic selling sends those discounts down the elevator in quick fashion. This used to happen with more regularity but in the last several years, has become more infrequent. We used to tell members when we first started this service that you could expect some volatility in CEF pricing every few months or so. However, the last time we saw such discount widening volatility was in December 2018.
My, how things can change. On February 6th, we wrote:
The CEF market continues to be frothy though remains well below prior peak valuation periods. The only thing cheap right now are the funds that deserve to be cheap. In other words, funds we probably would not EVER own. We've been looking for alternative funds to add to the portfolio including BDCs, ETFs, and open-end mutual funds.
Just a couple of weeks later, in five trading days, we saw discounts blow out significantly. Why? Just like a traditional stock, the retail closed-end fund ("CEF") investor hates uncertainty. Remember, most CEF shares are held by retail investors - mom and pop do-it-yourself investors that tend to be emotional traders. Once fear and panic grip the markets, they tend to be very quick pulling the trigger and getting out. Given that CEFs have lower liquidity than other securities, that can send prices plummeting even if there is no rational reason for doing so.
A great example is one we highlighted recently in the March letter. BlackRock Build America Bond Trust (BBN) is a very high-quality municipal bond fund that is nearly all investment grade rated. There is no reason a fund like this should sell off the way that it did. In three days, the price fell from $25.91 to $24.50, a drop 5.5%. But at the same time, the NAV rose nearly $1 on the week or 4.7%. This led the discount to literally blow out from near par on February 21st to -9.63% on February 28th.
I can understand such widening in the current environment of low-quality junk bonds. CCC-rated debt trades a lot like equity and with the S&P 500 falling ~14% on five trading days, there is no doubt that junk bonds would get hit hard. But taxable munis are a flight to safety sub-sector as evidenced by the rise in the NAV.
This is irrational selling. Either investors are selling everything not bolted down or they are raising cash on their "winners" which in this case are the positions not down nearly as much, so that they can buy more stocks that have been crushed.
In the last 8 months, discounts had been on that slow tightening trend (as we noted, the escalator up). But in one week we gave it all up and then some (the elevator down). This is not as abnormal as many people think. You have to know when to allocate and this was one of those periods. The problem is that you never know when to sell.
So our strategy remains: clip coupons, manage risk, be positioned in the best funds from a fundamental standpoint, and pool cash for these events. The strategy rests on allocating to a 'safe bucket' that is invested in safer, mostly open-end mutual funds and ETFs to earn a targeted 3-3.5% yield. When these events occur we stand by ready to re-position into those CEFs.
For most of the last year, we had been raising cash and safe bucket levels as buying opportunities dried up. There were a few places that we invested but in the end, there were always far more cash-raising trades than cash-using. Our cash and safe bucket allocation reached an unprecedented 19% before the market decline. We began nibbling early last week - which in hindsight was of course too early.
This is the best strategy that we know of to capitalize on the volatility of CEFs while exploiting the extremely juicy yields of the wrapper. Buy low, locking in a high yield on cost, and then hold until circumstances change and the fund is no longer attractive from a fundamental standpoint or if the valuation gets totally out of whack and more compelling yield on (potential) costs exists compared to the current yield of the overvalued holding.
This chart is a fantastic one to gauge risk tolerance but also show the reward of holding. It shows PIMCO Corporate and Income Opp (PTY) since inception which was in late 2002. In the chart below, we assume you bought $1,000,000 worth of PTY at the initial price of $15 per share (NAV = $14.30) or 66,666 shares. The figures in blue show the amount of income produced in that given year between "normal distributions" and end-of-year special distributions. The blue horizontal line shows where the price is equal to the cost basis, $1,000,000.
Over the subsequent 16 years, the fund would have generated over $2.16M in aggregate income. Plus, you would have about $1.25M in your capital, while your Fidelity account would show a capital gain of just $250K over 16 years. However, the total return would be over 13.8% annually.
Look at the difference between the price return and the total return. In the first chart below, we show the price only return in which the S&P 500 returns over 10x that of PTY.
In the next panel, we show the total return on price since inception. Here, PTY demolishes that S&P 500 by a factor of 2x.
The problem with the stockchart image above is that the average investor cannot handle that type of volatility. They cannot sit tight and watch their initial $1,000,000 rise in value to $1,200,000 and then down to $330,000 before rising to $2,150,000. That is a massive amount of volatility thanks to the lack of institutional players in the CEF space which means that prices can move substantially without a basis of reality. You need to be able to handle that volatility to really be invested in the space.
Clearly, owning a basket of bond CEFs will help dampen that volatility but it won't reduce it entirely. The securities tend to trade together as retail investors tend to buy and sell at the same times. When you add in that these tend to have shallow order books (low liquidity), it means that price volatility can be artificially high.
Distribution Increase (>2%)
Royce Value Trust (RVT): Quarterly distribution increased by 7.7% to $0.28 from $0.26.
BlackRock MuniYield AZ (MZA): Distribution increased by 7% to $0.046 from $0.043.
BlackRock MuniHoldings CA Quality (MUC): Distribution increased by 5.75% to $0.046 from $0.0435.
BlackRock NY Muni Income (BNY): Distribution increased by 4.4% to $0.048 from $0.046.
BlackRock Invest Quality Muni (BKN): Distribution increased by 3.5% to $0.059 from $0.057.
BlackRock NY Muni Income II (BFY): Distribution increased by 3.1% to $0.0505 from $0.049.
BlackRock Muni Bond (BBK): Distribution increased by 2.75% to $0.056 from $0.0545.
Distribution Decrease (>2%)
JH Income Securities (JHS): Distribution decreased by 36.2% to $0.1401 from $0.2197.
Nuveen Mort and Income Fund (JLS): Distribution decreased by 19.8% to $0.091 from $0.1135.
Nuveen PA Muni Val (NPN): Distribution decreased by 19.7% to $0.0305 from $0.038.
Nuveen NY Muni Val 2 (NYV): Distribution decreased 19.1% to $0.0275 from $0.034.
Nuveen NJ Muni Val (NJV): Distribution decreased by 17.3% to $0.031 from $0.0375.
Nuveen Muni 2021 Target (NHA): Distribution decreased by 13.3% to $0.013 from $0.015.
Blackrock Energy & Resources (BGR): Distribution decreased by 12.3% to $0.068 from $0.0776.
Nuveen CA Muni Val 2 (NCB): Distribution decreased by 11.5% to $0.0345 from $0.039.
Nuveen MO Quality Muni Income (NOM): Distribution decreased by 11.1% to $0.036 from $0.0405.
Nuveen High Income 2021 (JHB): Distribution decreased by 10.8% to $0.037 from $0.0415.
EV National Muni Opp (EOT): Distribution decreased by 10.46% to $0.0642 from $0.0717.
Delaware Enhanced Global Div (DEX): Distribution decreased by 10.3% to $0.0831 from $0.0926.
Nuveen Multi-Mkt Income (JMM): Distribution decreased by 10% to $0.027 from $0.03.
JH Income Investors (JHI): Distribution decreased by 9.7% to $0.2956 from $0.3274.
Nuveen MN Quality Muni (NMS): Distribution decreased by 9.2% to $0.0445 from $0.049.
Nuveen Muni Income (NMI): Distribution decreased by 8.3% to $0.033 from $0.036.
EV Sr Income (EVF): Distribution decreased by 7.9% to $0.035 from $0.038.
Nuveen High Income 2023 (JHAA): Distribution decreased by 7.7% to $0.048 from $0.052.
EV Sr Floating Rate (EFR): Distribution decreased by 7.1% to $0.078 from $0.084.
Nuveen CA Muni Val (NCA): Distribution decreased by 7.02% to $0.0265 from $0.0285.
EV Floating Rate Income (EFT): Distribution decreased by 5.95% to $0.079 from $0.084.
Templeton Global Income (GIM): Distribution decreased by 5.78% to $0.0277 from $0.0294.
Voya Prime Rate (PPR): Distribution decreased by 5.24% to $0.0217 from $0.0229.
EV Floating Rate Income Plus (EFF): Distribution decreased by 4.7% to $0.081 from $0.085.
Templeton Emerging Market Income (TEI): Distribution decreased by 2.13% to $0.0597 from $0.061.
Monthly Statistics - Commentary
All sectors took a beating in February but the equity-oriented areas obviously were hit harder. The sectors you would guess would be down the most, were - and the sectors you would have thought would do best, did. The area of the market we are most interested in are the bottom z-scores adjusted for risk. What we mean by that are sectors that are cheap but are defensive in nature and provide some degree of downside protection.
The cheapest sector on the list are taxable munis with a one-year z-score of -3.4. That is a very cheap value. Now, there are only 3 funds left in the space, so it is susceptible to wild swings thanks to large movements by just a couple of funds. The three funds in the space are:
- Guggenheim Build America Bonds Managed Duration Trust (GBAB)
- BlackRock Build America Bond Trust
- Nuveen Taxable Muni (NBB)
All three are solid defensive choices offering distribution yields between 5% and 6.5% today. The discounts recently had been non-existent as investors bid up these shares over the last year to, in the case of GBAB, premium levels. But in the last week of February, these shares were hit just like others are as investors raised cash by selling winners.
You can see in the chart below the steadiness of the discount/premium over the prior three months and then a steep drop-off recently. There has been a small rebound but these funds remain cheap and good options for qualified accounts which shouldn't house tax-free munis.
CEF Universe Analysis:
We saw a significant amount of change in the last week with many funds dropping by 15% or more compared to NAV. Amazingly, we saw many MLP funds actually become more expensive. Not because their price went up but because their price did not fall as much as the NAV was falling. Goldman Sachs MLP Income Opps (NYSE:GMZ) is a good example of that. The price was down -22% but the NAV was down -27.5%, meaning that the discount closed during the week.
High premium funds saw the most valuation change. PIMCO funds were hit extremely hard with PIMCO Corporate & income Strategy (PCN) seeing a 22.2% valuation change (premium decline) in a week. At the current 14% premium, it still isn't cheap but it is no longer the risky, expensive fund it was at a 35% premium.
PIMCO Dynamic Income (PDI) also was hit hard falling from a 22% premium down to 9% before rebounding slightly. The z-scores are now firmly negative but again, using relative valuation, the fund is not overly cheap, just no longer expensive. Of course, an investor should be assessing the valuation based on the macro picture. For example, an 8%+ yielding fund with a fairly stable yield is now significantly more attractive in the current 1% interest rate environment. When comparing PDI to other income investments, the fund looks highly compelling.
Preferred funds look interesting (as do some individual preferred. See the Landlord Investor tab on the Google Sheets). The fund we had been pushing was First Trust Inter Duration Pfd Inc. (FPF) but that opportunity has now passed as the discount tightened back to -2.8%. Another option would be Nuveen Preferred and Income Term (JPI), a self-liquidating fund (in theory) in August 2024. At the current -5.5% discount, you gain an extra 1.1% per year in total return on top of the 6.84% distribution yield. We also think that once calm returns to the market, the NAV will recover and individual preferred shares will migrate back towards par. These are the best times to purchase shares in preferred stocks.
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