Coronavirus Roundtable - The Closed-End Funds Opportunity Persists
Summary
- We gather a panel of authors to discuss closed-end funds and their set-up heading into June.
- While distributions have been cut in some places, other areas have held up nicely.
- Combined with still wider discounts to NAVs, nimble investors may find opportunities.
Markets have settled and recovered from the initial shock of the coronavirus spread and the response of governments around the US and the world to lock down the economy. But while the major US indices have approached, if not quite matched, the fabled v-shaped recovery, there are still plenty of questions left for investors.
The disconnect between the markets and the economy has become a cliche, which doesn't change its validity. The size of stimulus in the US has been unprecedented. As governments start to reopen, it's to be seen whether we will see a second wave of cases. And we don't yet know how quickly people will go back to spending, and what the engine of the economy will be in this uncertain period.
To suss out all these uncertainties, we're doing a second round of our coronavirus roundtable series. We'll be looking at some of the major sectors of the market that are in the market, overall market and macro outlooks, and niches that may deserve investors' attention.
Today, on reader request but also given it's a lesser followed part of the market, we're covering Closed-End Funds, or CEFs. Attractive for income or as a way to get a discount on highly liquid assets, they are also a different way to add diversification to one's portfolio. As they're less known, we've asked a panel of Marketplace authors who follows them closely to shed light on the topic. Our panel:
- ADS Analytics, author of Systematic Income
- Alpha Gen Capital, author of Yield Hunting: Alt Inc Opps
- Blue Harbinger, author of Big Dividends PLUS
How have closed end funds held up in the current environment, and are you surprised by the volatility in the sector or has it played out as expected?
ADS Analytics: The performance of CEFs is largely a function of the performance of their underlying assets, the leverage carried by the funds and the procyclical discount dynamic. This means that, as expected, different sectors reacted differently. Higher quality sectors like Agencies and Investment Grade saw relatively shallow drawdowns of 20-30% while higher-octane sectors like MLPs, CLO equity and REITs saw catastrophic price drops of 60-80%.
This divergence was not a surprise. What surprised us instead was how well discounts held in over the first few weeks of the sell-off with only modest widening of a few percentage points. While it was tempting to put cash to work after more than a year of low yields our message during those early weeks of the sell-off was to hold tight. In our view the CEF market could not sustain such strong performance in light of poor price action in the underlying assets alongside a lack of visibility on the bend in the infection curve. It only took a couple of more weeks before CEF discounts blew out from low single digits to an average of around 25% - not quite reaching the levels we saw during the financial crisis but wide enough to be extremely attractive for both tactical and long-term investors.
Alpha Gen Capital: Well, we entered this crisis at a slightly rich valuation meaning that funds were trading tighter than average to their NAVs. From July of 2019 to February of 2020, discounts slowly tightened from -5% to -2.5% on average. But by the third week of March, those discounts were in the low -teens. So we had a hit to NAVs as underlying prices fell, and we had an additional drag as discounts widened out. Add in the leverage of these structures and you had a perfect storm. So they have not held up very well.
However, we do think this is the time to be getting into these funds, especially on the fixed income side. We could be on the precipice of a new golden era of CEFs as leverage costs plummet and bond swaps allow for earnings to increase, and thus distribution yields to increase for the first time in a long time. You can get 8-12%+ yields today in what we think is a value space. The S&P 500 has recovered most of its loss since mid-February. Bond CEFs have not and have some nice upside optionality.
Blue Harbinger: Predictably, many CEFs got doubly slaughtered by pandemic fears, thereby creating some extraordinarily attractive buying opportunities. For example, we highlighted the attractiveness of PIMCO’s Dynamic Income Fund (PDI) in this article back on March 20th, and it’s up over 23% since then and has paid two additional big monthly dividends. CEFs are a unique investment vehicle, and one of the few places in the public markets where obvious price inefficiencies can arise. CEFs vary with regards to the types of asset they hold (e.g. stocks, bonds), and those assets can occasionally provide attractive investment opportunities in their own right. However, it’s the wide premiums and discounts to NAV (a characteristic that is almost unique to CEFs among daily priced vehicles with level 1 assets) that can provide for the most extraordinary investment opportunities. For example, if you buy an income-producing bond CEF when it’s trading at a discount to NAV, you get access to the income stream of those bonds at a discounted price. And PDI was just one example.
What do you look for when investing in closed end funds, and which type of funds do you look to invest in?
ADS Analytics: The overall risk stance on our Income Focus List has been cautious and selective.
We have focused on higher-quality sectors with attractive valuations for the underlying risk. Our higher-yielding allocations have been informed by a three-pronged approach. First, we have increased allocations to higher-yielding munis which we see as offering an attractive balance of yield vs. quality. Secondly, we have added to non-corporate credit assets such as non-agency RMBS which offer relatively robust fundamentals such as low LTVs. And thirdly, we have maintained holdings in term high-yield and loan CEFs on the view they would take advantage of a further rally in risk assets and also offer some downside protection in case of a retracement.
In terms of individual fund characteristics, we have spent a lot of time looking at leverage mandates and cost structure. Our research shows that some funds, particularly those with strict leverage caps have been more likely to deleverage in a drawdown which can impair long-term returns and income levels. We have also tilted to funds with unhedged floating-rate leverage facilities since the drop in short-term rates will increase fund earning levels.
Alpha Gen Capital: When investing in CEFs, most of the investors are looking for a couple of simple variables: discount and yield. The space is dominated by retail investors who own approximately 80% of all CEF shares. CEFs are far more complex than a traditional mutual fund. I’ve been analyzing these things for more than 20 years and it has only become more complex since the Financial Crisis. When we invest in a CEF, we are looking for an opening in Core funds primarily. Core funds are the funds we know well and are managed by good managers/sponsors. These are also funds that we believe have good underlying assets and not crazy risky stuff like MLPs or equity tranche CLOs, which is owned in ECC for example. Today, we like muni CEFs, both taxable and tax-free, preferred CEFs, mortgage CEFs, and some high-quality corporates and multisector funds. Each week we look at what has happened in the prior week and look for opportunities – both to buy and sell.
Blue Harbinger: We invest in CEFs for high income and price appreciation, and we invest opportunistically across CEF types (as long as the opportunity is consistent with our long-term income-focused investment goals). And in addition to looking at asset classes and discounts/premiums to NAV (as mentioned earlier), we also pay attention to leverage (borrowed money can magnify gains/losses), sources of income (dividends/interest, long-term/short-term gains, return of capital), management teams (do we trust them) and expenses (CEFs often have higher expenses than ETFs with similar investment exposures, so investors need to make sure a CEF is giving them enough extra value to warrant the higher expenses). For example, one CEF we like is the Adams Diversified Equity Fund (ADX). It’s been paying attractive dividends for over 80 years, it uses essentially zero risky leverage, and it’s overweight tech stocks (a sector that has been dramatically outperforming this year), especially considering ADX pays a larger fourth quarter distribution based mostly on price gains (which will likely be relatively strong this year based on its sector exposures). ADX also currently trades at an attractive discount to NAV, it has relatively low expenses, and it can provide important sector diversification compared to more typical high-income investments.
What are you seeing as far as available discounts to net asset value and changes to net asset value year to date?
ADS Analytics: CEF sector NAV returns , apart from a few outliers, has generally been on the order of -20% to -5%. Higher-quality sectors like Munis, Investment Grade and Agencies are at the upper part of this range and equity-linked and lower-quality fixed-income sectors are at the lower end. A few outliers like MLPs and CLO Equity funds have returned on the order of -50% year-to-date in NAV terms.
As far as discounts, some sectors like preferreds, taxable Munis, Utilities and Investment Grade have largely retraced their discount widening. Other sectors like tax-free Munis, REITs, CMBS, MLPs still feature relatively wide discounts. This kind of dynamic largely makes sense since it is these sectors that have been hit particularly hard by the current shock. That said, we are still finding value in the Muni space, for example, with some high-quality funds priced at very attractive discount levels.
Alpha Gen Capital: Discounts are still relatively wide compared to early February but have already tightened up nicely since the third week of March. Like equities, CEF discounts reached their nadir at roughly the same time that the S&P 500 troughed. As is typical, the initial few trading days after that bottom was when a significant amount of money was made. Since then, discounts have bounced around with a slight tendency towards closing. In just the last two weeks, discounts tightened by over 2%. That’s a nice tailwind to what we are seeing on the NAV side which have started to rise in earnest lately. We have been buying well managed funds by high quality sponsors with yields above 8% and discounts that were wider than normal. NAVs are still down YTD but are recovering.
We think the upside from here is far better in bond CEFs rather than the S&P 500, especially on a per unit of risk basis. As NAVs continue to inch higher, some funds can lever up more and replenish what they took off in March which helps accelerate the NAV recovery. We really like non-agency mortgage focused CEFs today as the underlying assets remain “money good” and at wide discounts to par.
Blue Harbinger: Many discounts were at their widest, and many NAVs were at their lowest, around late March when market fear was at its highest. That was a great time to buy. Conditions have since been improving, but a variety of attractive opportunities still remain, particularly among bond CEFs (which we will discuss in more detail later in this report). One sector where net asset values have been relatively strong, and discounts have been smaller than usual, is healthcare (healthcare often performs relatively well when market volatility is high because it is considered defensive/essential, and that effect was magnified this year by increased interest in healthcare and pharmaceuticals thanks to coronavirus fears). We took advantage of these conditions by selling out of our position in the Tekla World Healthcare CEF (THW), and we did so at a significant gain considering the NAV was higher, and the discount to NAV was smaller, than when we bought it several years ago. We were sad to let go of the big 9.7% dividend yield, but it was time to move on to newer better opportunities.
How have distributions held up as we're now more than two full months into this downturn?
ADS Analytics: The CEF market has seen deep and broad distribution cuts. Across the months of April and May we count over 150 distribution changes, 90% of them cuts. This nearly unprecedented distribution cut wave has been driven by a few factors. First, funds with managed distribution policies have sharply cut distributions due to falling NAVs and prices. Secondly, dozens of funds, such as those in the MLP sector, have had to deleverage as a response to falls in their assets. Thirdly, lower short-term rates have decreased earnings in sectors with floating-rate assets such as loans and securitized products.
We have been recommending sectors with the following profiles: fixed coupon, longer maturity, lower call risk and higher-quality underlying assets. These sectors will be able to hold up better in distribution terms. On the fund side, we look for three criteria in order to gauge distribution stability and strength: 1) strong distribution coverage profile, 2) unhedged floating-rate leverage instruments, 3) no leverage caps or leverage that is not overly high.
Alpha Gen Capital: Good managers have been able to increase distributions in the last two months by refinancing their leverage and reducing their interest expense while conducting bond swaps. On the former, they can reduce the costs to shareholders which accretes to EPS allowing the fund, all else equal, to increase distributions. On the latter, bond swaps are replacing short-term, lower-yielding paper for higher-yielding longer-term paper increasing the general yield of the portfolio. Muni CEFs have realized this in a big way in the last month with the SIFMA index (a proxy for leverage costs for muni CEFs) falling to nearly 4-year lows. We really like high quality (meaning high % of investment grade) portfolios that are yielding in excess of 5% tax-free yields. For someone in the top brackets, that is over a 10% tax equivalent yield for some states. When analyzing muni CEFs which have been the area of the CEF market most susceptible to distribution cuts, there are a lot of fundamental factors to watch to make sure the distribution is covered. We look for strong coverage ratios but also high UNII levels which are trending up. We have a proprietary screening process that looks for these funds and what their fair value is for us to create a warranted “buy under” threshold.
Blue Harbinger: The strength of distributions varies widely across CEFs types, but one thing investors need to watch out for is when distributions are funded with a return of investor capital. We prefer distributions be funded with dividends or interest payments first, and then by long-term capital gains second. However, when conditions become tight (as they have this year) CEF managers can be tempted to maintain dividends (to create the illusion of strength and health) by funding them with short-term capital gains or a return of capital. These are often not preferred because of potential tax impacts, but it can also be a signal of even more trouble ahead for a CEF if conditions don’t improve. One interesting CEF that we wrote about recently in this article is Cohen & Steers Quality Income Realty CEF (RQI). It’s been funding its big 8.9% distributions yield with entirely income and long-term gains over the last year, and it also trades at an attractive discount to its attractive NAV.
How much of your strategy is focused on exposure to underlying sectors, and how much is focused on the managers involved? Why?
ADS Analytics: Our allocation strategy is both top-down and bottom-up. In our experience without a proper allocation framework income investors are likely to end up with a hodgepodge of funds that reflects yield-chasing rather than any specific sector views and risk/reward.
The first layer of our allocation framework is focused on tilting to sectors that have attractive valuations for their fundamental risk and that should do well across a range of macro and market scenarios. This has allowed us to completely bypass fragile sector like CLO equity that have seen both massive price losses as well as large distribution cuts.
The second layer of our framework focuses on fund selection. Here we rely on bespoke metrics that have worked very well in practice such as the discount sector spread and fund alpha. Our database of fund portfolio metrics such as credit ratings, call exposure and timely leverage figures allow us to spot attractive funds. We are manager-agnostic in our approach. We do recognize that some managers are able to add more alpha than others, however, in the end it's the complete package that matters to us.
Alpha Gen Capital: As we noted above, strong managers and sector allocation play a HUGE role in the selection of underlying funds. Knowing which sponsors that are sub-par and which are premier is imperative to avoiding bad outcomes. The lower quality managers like NexPoint slap investors in their funds with countless rights offerings and poor corporate governance. But retail investors still buy the funds because they place a high distribution yield on those funds. The yield is like a siren song for the retail investor and tends to lure them into bad funds. In terms of sectors, we have avoided and pressed our members to avoid several areas including MLPs and CLOs (among others). These are bad areas of the market to be invested in if you are looking for safer income streams. We have favored high quality areas including taxable munis, preferreds, mortgages, and investment grade corporates. We have even been cutting our exposure to non-investment grade (high yield and floating rate loans) to reduce overall risk. If we invest in those sectors, we want an upside option usually gained through piggybacking on activism. Look for our upcoming article on First Trust Floating Rate II (FCT) as a good example.
Blue Harbinger: Focusing on the right sectors and quality managers is very important. For example, as contrarians, we like the real estate sector focus of RQI (mentioned previously). Further, selecting the right manager is also very important, but probably not in the way many people think. Specifically, when selecting the right manager, it is less about the manager’s security selection ability because many CEFs are so broadly diversified within their prospectus-mandated sectors that security-selection isn’t statistically/mathematically able to make a large performance difference relative to a particular CEF’s index/benchmark. Rather, we want to select a manager that has the administrative and operational support to implement the strategy without making errors, and we also want to trust that the manager won’t make unsustainable decisions (such as funding the distributions with a return of capital just to artificially prob up the distribution yield).
The sector seems like it would have been hit hard by the liquidity fears of mid March and helped by the subsequent Fed buying. Has this period changed your thinking about how to position in CEFs at all?
ADS Analytics: Prior to the drawdown we have made the case that across many asset classes the marginal yield that CEFs were adding above open-end funds was close to historic lows. This meant that the risk/reward was stacked against CEFs, an in particular, leveraged perpetual CEFs. For this reason tilting toward low-leverage CEFs, term CEFs and open-end funds made a lot of sense and these products have indeed held up much better in this current drawdown.
Given the volatility and historic drawdown levels of CEFs our approach is to allocate carefully across the available risk spectrum from open-end funds, to low leverage CEFs, term CEFs and leveraged perpetual CEFs. There is no one right answer for everyone however the recent market environment has only validated this approach.
Alpha Gen Capital: The advantage of the CEF structure is that they do not have to meet shareholder redemptions. However, that is offset by the fact that CEF trading itself tends to be less liquid on average than most ETFs and open-end mutual funds. Looking at the daily average volume that a CEF has is imperative if you are committing a decent amount of capital to the fund. Additionally, funds invested in less liquid holdings (level 2 or level 3), while they don’t have to sell to meet client redemptions owing to the closed-nature of the fund, are susceptible to open end fund selling. We saw that with AlphaCentric Income Opp (IOFIX) and mortgage funds like PIMCO Dynamic Credit and Mortgage (PCI). While PCI didn’t have to sell their non-agency mortgage bonds, IOFIX did thanks to a mass of redemptions by their shareholders. That forces down the prices of those bonds and PCI is then forced to mark down the prices in their portfolio to the market. This reduces the NAV. So, investors need to watch for fund liquidity (daily volume) as well as portfolio liquidity.
Blue Harbinger: The liquidity fears of mid-March were an issue for bond CEFs, not stock CEFs (even though stock CEFs sold off hard, there was still plenty of liquidity). For bonds CEFs, the drying up of liquidity caused many of their underlying holdings to trade at inappropriately low prices just because there were too few buyers relative to sellers (i.e. people were trying to sell bonds to raise liquidity to meet margin calls). For example, US government agency securities (such as those issued by Freddie and Fannie) were never at any real risk of default, but because there was no liquidity, people were forced to sell at ridiculously low and inappropriate prices. This created some very attractive buying opportunities, many of which still exist today (to some extent), even though the Fed has pledge unlimited support for bond markets (and they’ve been backing that up with unprecedented bond purchases just to ensure liquidity is available thereby allowing the ordinary functioning of bond markets). This has created some very interesting buying opportunities in bond CEFs, as well as in their distant cousins, mortgage REITs (which hold many of the exact same agency securities) as we wrote about in great detail here.
What sort of changes have you been making at the portfolio level? Sectors you are seeking more or less exposure to, and why?
ADS Analytics: In our sector rating framework which serves as the first step in our allocation framework we have been overweight Munis, particularly high-yield and taxable Munis, as well as Preferreds, non-agency RMBS, high yield and EM external debt. These sectors still feature attractive risk / reward as well as a distribution profile that should be relatively stable over the medium term.
The preferreds sector has a relatively strong credit profile with CEFs in the sector featuring majority investment-grade portfolios. Although some investors are uncomfortable with exposure to banks and financials given their experience during the financial crisis, our view is that first, banks came into this crisis in much stronger shape and secondly, this crisis is not at its heart a financial crisis but a combination of a supply and demand shock. Unlike in the previous crisis banks stand to do relatively well given their central role in addressing the macro slowdown. We continue to like Munis because the sector has entered the drawdown in very strong shape. Unlike the corporate sector, the total amount of Muni issuance has not increased very much over the past decade. Plus the aggregate rainy day cushion of the sector has grown to record levels. Within the sector we have tilted to funds with a low number of unrated bonds and low call exposure over the next few years.
Alpha Gen Capital: In early March we made some changes to the portfolio to reduce risk but should have made more. We trimmed some high yield corporate exposure including floating rate. Like many, we were caught off guard by the swiftness and severity of the downturn. We still have an overweight to quality in the Core Portfolio favoring munis, preferreds, and mortgage focused funds. That includes funds like PCI (mentioned previously) but others like Nuveen Mortgage Opps (JLS) and Western Asset Mortgage Opps (DMO). We think these non-agency MBS funds remain the best area of the bond market as the liquidity crunch in mid-March sent prices on these securities plummeting. That was primarily a liquidity issue and not a credit risk issue (as of now).
The Fed is not helping this area of the bond market, so the prices remain depressed but have been slowly recovering. We see some nascent signs that the recovery is gaining steam lately. Thus, we continue to keep our overweight to it and even increase it on occasion. We added to DMO on Friday as the price reached NAV when the fund typically trades at a large premium. New financials on the fund also showed it increasing its earnings in the last quarter nicely.
Blue Harbinger: Since mid-March, we’ve been beating the drum (i.e. releasing lots of free and members-only articles) about the attractiveness of bond CEFs (as well as mortgage REITs that hold many of the same underlying bonds), and we have been strategically adding exposure to our prudently-diversified income-focused portfolios. We also reduced our exposure to healthcare CEFs (as mentioned earlier) for the exact opposite reasons (i.e. NAVs were getting too frothy and discounts to NAV were shrinking). Basically, as the market sold off, fear created attractive investment opportunities, as it almost always does.
Any funds that you have added to your portfolio or increased your position in over the recent months, and why?
ADS Analytics: Our core CEF allocations at the moment feature a number of municipal and investment grade funds that feature good quality profile, low call exposure and attractive discount valuations. This includes funds like NID and VBF.
Our higher-yielding allocations are in the preferred, high-yield and RMBS sectors featuring a a number of term funds like JPT and FIV that will take advantage of a further rally in risk assets and also offer some downside protection in case of a retracement.
Alpha Gen Capital: As we discussed in the last question, we have been adding to muni CEFs and mortgage CEFs primarily. But we will use this opportunity to discuss some great other options that we have been seeing lately. We had a public article on Western Asset Global High Income (EHI) a couple of weeks ago highlighting the activism in the fund plus the corporate action that shareholders should participate in. Western Asset is owned by Legg Mason which is being acquired by Franklin Resources. The fund needs shareholder approval on the new investment advisory agreement. But Saba, an activist hedge fund, along with other activist institutional investors own a significant portion of the fund. They are unlikely to vote for the new investment advisory agreement which means that the fund will not have a quorum. We think they will try a few times to get the necessary votes and then give up allowing the fund to liquidate which is done at NAV. The shareholder then generates a capital gain in the form of the discount. We see a few others that we have just alerted members to that are also likely to liquidate and have juicier discount spreads.
Blue Harbinger: We added exposure to funds with agency-backed securities because they remain dramatically undervalued from an NAV standpoint. We believe as coronavirus fears recede, and the world adapts to the post-pandemic realities, these bonds (and the funds that own them) will continue to rise. Not to mention the big attractive income payments they continue to kick off to investors.
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Thanks to our authors for chiming in on closed-end funds. Check out their work at the links provided at the top of the article.
We plan to continue this next week with a look at the trader's mindset amidst this market, so watch out for that. If you have any other subject requests, please let us know - after all, this topic came from a reader comment.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
ADS Analytics is long JPT, FIV, and NID
Alpha Gen Capital is long PCI, EHI, DMO, JLS, and FCT.
Blue Harbinger is long ADX.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given that any particular security, portfolio, transaction or investment strategy is suitable for any specific person. The author is not advising you personally concerning the nature, potential, value or suitability of any particular security or other matter. You alone are solely responsible for determining whether any investment, security or strategy, or any product or service, is appropriate or suitable for you based on your investment objectives and personal and financial situation. The author is an employee of Seeking Alpha. Any views or opinions expressed herein may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank.
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