3 Overvalued Closed-End Funds To Rotate Out Of If You Own Them

Summary

• CEFs are often inefficient, with prices diverging for no reason other than limited supply and demand.
• We present three CEF rotation opportunities that we highlighted to our members last week.
• One has already played out fully, but two are still in play. Don't let mean reversion catch you out!
• Looking for more stock ideas like this one? Get them exclusively at CEF/ETF Income Laboratory. Get started today »

Author's note: This article was initially released to CEF/ETF Income Laboratory members last week (April 28, 2020). An update of the numbers and situation are presented after each trade suggestion. One suggestion has already played out fully, but two are still in play.

3 More Quick Rotation Opportunities

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."

Here are three quick rotation opportunities that you may consider if you own the overvalued fund. After premium/discount reversion takes place, you can consider swapping back to the previously sold fund to gain "free shares" of the fund, no matter whether the markets has moved up, down or sideways in the meantime!

The main risk of this strategy is that the valuation difference can widen further, so sometimes patience is required! More active traders can consider shorting the overvalued fund, and possibly hedge by buying the undervalued fund.

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1. FGB --> BIZD

• Sell: First Trust Specialty Finance and Financial Opportunities Fund (FGB)
• Buy: VanEck Vectors BDC Income ETF (BIZD)

(Source: Stanford Chemist, CEFConnect, data from 4/27)

What's FGB doing at a +27.17% premium? Beats me! As of writing, FGB is up +5.26% while the benchmark ETF (BIZD) is about flat, putting the intraday premium at approximately +33%. The one-year z-score is +4.71, indicating extreme relative overvaluation.

The premium is highest since inception of the fund in 2007.

(Source: CEFConnect, data from 4/27)

There isn't another BDC CEF available, so the swap would be for BIZD.

Importantly, FGB is expected to announce its next quarterly distribution in around two weeks (the last announcement was on February 10). Given how much the NAV of the fund has fallen over the past several months, a distribution cut is quite likely, since the current NAV yield of 21.26% is too high. This is a similar setup to what we highlighted recently with EDF and EDI, which was an excellent short call as they suffered large price losses when they announced their distribution cut last week, allowing myself and members who followed this trade suggestion to reap 10%-plus profits in a single day (see EDF And EDI: The Hazards Of Chasing Yield).

Note that FGB's leverage of 41% as presented by CEFConnect (and which is shown in the table above) is stale. First Trust are one of the sponsors that reports daily leverage, and this has been decreased to 10.61% as the screenshot below shows. This would make it even more unlikely that the current distribution would be maintained.

(Source: FGB website, data from 4/27)

May 7, 2020, update:

Since the initial trade recommendation last week, BIZD has outperformed FGB nearly 600 bps. While this already is a very decent result, I still consider the trade to still be in play because FGB hasn't announced its next quarterly distribution yet. We continue to expect a cut, and with FGB still at a 21% premium (down from 27% last week), there's still considerable downside should a large cut materialize. However, the risk is that if the dividend were to be maintained, the price could shoot up higher.

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2. OXLC --> ECC/OCCI

• Sell: Oxford Lane Capital Corp (OXLC)
• Buy: Eagle Point Credit Company (ECC) or OFS Credit Company (OCCI)

	ECC	OXLC (est.)	OCCI (est.)
3/31 NAV	$ 6.12	$ 3.94	$ 8.69
4/27 price	$ 6.17	$ 4.85	$ 8.31
4/27 discount	0.82%	23.24%	-4.39%

Click to enlarge

Here we have a 20%-plus differential in premium/discount valuation between OXLC and ECC or OCCI. While NAV may not be the most useful metric to determine the intrinsic value of CLO funds, I still find it useful to help assess relative valuation within the peer group to execute our CLO rotation strategy.

Importantly, OXLC is about to announce its 3/31-end results in around a week's time (the last quarter's results were released on Feb. 4). We are anticipating a large decrease in NAV of around -40% to -50%, as well as a sizable distribution cut, based on what ECC reported earlier this month. It's possible that investors do not yet realize that OXLC's last reported NAV of $6.81 for 12/31 is wholly inaccurate (in fact CEFConnect is still showing the 9/30 NAV of $6.63 and a discount of -16.11%)!

Because of the above, sidestepping the announcement by moving into the more undervalued ECC and OCCI could be a profitable strategy. One thing to bear in mind that OCCI is due to announce its next three months of distributions very soon (the last announcement was on Jan. 29). Therefore, swapping to ECC may be the safer choice if one fears the reaction of a distribution cut from OCCI, which is likely to happen. Although as our CLO expert, Alpha Male, mentioned in the chat, there's a small off-chance that the distribution at OCCI could be maintained or cut only slightly just to give a positive impression of the fund.

May 7, 2020, update:

Wow! This was one of our best rotation suggestions that we have ever made in the Income Lab. OXLC's share price has slumped by over a third, while ECC and OCCI has fallen by much less (and possibly in sympathy). The profit differential from the pairs trade was around +30% in just over one week.

What happened? OXLC posted its Q4 results and reported a large NAV decline, to $3.58 on March 31, 2020, down from $6.81 the previous quarter. Moreover, management stated that "we believe that the Company’s Board of Directors will likely elect to reduce or suspend the Company’s distributions for those months (July, August, September)." Both the large NAV decline and the distribution cut were something that we predicted at the Income Lab, although apparently not known by the market as OXLC was still trading a hefty premium before the crash. CEF inefficiency at its finest! Thankfully, our members were alerted of this possibility in advance and saved countless dollars, while active traders who shorted OXLC would have been equally pleased.

As of writing, the pendulum appears to be swung the other way, with OXLC now being cheaper than ECC. Hence, this trade appears to have been fully played out. Those who swapped from OXLC to ECC or OCCI previously now have a chance to rotate back to OXLC to gain ~30% "free shares" of OXLC, or else maintain their previous share count but to retain the excess in cash.

	ECC	OXLC	OCCI (est.)
3/31 NAV	$ 6.12	$ 3.58	$ 8.69
5/7 price	$ 6.11	$ 3.33	$ 7.45
5/7 discount	-0.16%	-6.98%	-14.28%

Click to enlarge

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3. JHAA --> BSJN

• Sell: Nuveen High Income 2023 Target Term Fund (JHAA)
• Buy: Invesco BulletShares 2023 High Yield Corporate Bond ETF (BSJN)

(Source: Stanford Chemist, CEFConnect, data from 4/27)

JHAA's +11.06% premium is very puzzling given that it is a target term fund due to liquidate it under three years' time, giving a negative alpha of nearly -4% a year.

Instead, JHAA investors should consider switching to the corresponding ETF which has similar NAV performance (in fact it held up a bit better than JHAA in the crash because it is unleveraged), but which isn't trading at a high premium. If JHAA reverts back to near par one can always swap back to JHAA once again!

May 7, 2020 update:

JHAA's premium has fallen to +5.44%, causing it to underperform BSJN by around 300 bps since our initial trade suggestion. JHAA is still overvalued at this level so I consider this swap suggestion to be still in play.

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Summary

The current market volatility can create significant dislocations in the pricing of CEFs, which the nimble investor can take advantage of. There are probably other opportunities out there, one just has to look for them! We are constantly doing for our portfolios each day as well.

Remember, closed-end fund valuation matters!

Analyst’s Disclosure: I am/we are long ECC, OCCI. 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.

I am short FGB.