Equity CEF Preferreds As Better Income Assets
- Sharp moves in asset prices have shined the light on the behavior of leveraged equity CEFs that have issued senior securities like preferred stock.
- In times of distress, these funds focus on protecting senior security holders at the expense of common shareholders.
- We compare common and preferred shares of leveraged equity CEFs from an income investment perspective using GUT as a case study.
- While there is nothing wrong with leveraged equity CEFs as a structure, income investors may prefer to hold their senior securities, which behave much more like income investments.
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The last few months have seen extreme moves in asset prices. This kind of outsized market volatility has underlined the fragility of certain asset classes and investment vehicles. In this article, we compare the behavior of common and preferred shares of leveraged equity CEFs, using the Gabelli Utility Trust (GUT) as a case study.
Our main takeaway is that investors should be careful about owning highly volatile assets in leveraged CEF wrappers. This is because of the likelihood of CEF deleveraging during periods of sharp drowns, potentially locking in permanent capital loss to investors. This is a consequence of the fact that fund managers will shift their focus on prioritizing protecting holders of senior securities at the expense of common shareholders.
This has two important implications for common holders. First, even if the asset prices fully recover, the NAV of the CEF will remain below its starting point. And secondly, because the deleveraging will tend to lower the earning capacity of the CEF, it is likely to be forced to cut its distributions. This can result in an odd situation where common holders end up holding a fund that generates a lower yield on their original cost basis than the yield of senior securities.
For this reason, we prefer holding exposure to volatile asset classes either through open-end funds that have no leverage or through senior securities of CEFs.
We maintain the following CEF preferreds on our Focus List:
Both series are investment-grade rated and have stripped yields of around 5% and asset coverage of over 500% in both cases.
Source: Systematic Income Focus List
CEF Leverage Recap
We often read comments here and elsewhere that say something like "CEFs must maintain their leverage below X". A quick glance at the 1940 Act shows that this is incorrect. There is nothing legally stopping a CEF from happily "breaching" its regulatory asset coverage, nor does it have to cure the coverage. All that happens is that the CEF is unable to carry out certain actions. The action matrix is fairly extensive, but for common shareholders, the key bits are that the fund will be unable to declare or pay a distribution or buy back common shares. Interestingly, the fund can continue to pay a distribution with its own shares.
These restrictions are fairly onerous, and no fund really wants to suspend distributions given the reputational risk involved. However, they can just carry on. In fact, it may be in the best interests of common shareholders that the fund continue with elevated leverage, particularly if the markets make a reversal.
Many leveraged funds holding volatile assets like equities, MLPs and CLO equity ended up deleveraging in March, which led to permanent capital losses because asset prices bounced back shortly after. Of course, not all funds can carry on with elevated leverage ratios, particularly those that have private credit facilities which carry hard leverage caps, but funds that finance themselves with senior securities can really just carry on for an extended period of time.
The chart below illustrates the risk of deleveraging. In this example, we have an asset price (blue line) that goes from 100 to 50 and then back to 100. The orange line tracks the NAV of a CEF that is leveraged 25% at the start and fully deleverages when its leverage hits 50%. Once that happens, asset prices come back gradually and the fund remains unleveraged. The end result is that while the asset price comes all the way back, the fund's NAV remains 27% below its start. This is clearly a toy example, but it does illustrate the risk that leverage can bring.
Source: Systematic Income
GUT Case Study
In this section, we take a look at a fund that has been trading for a long while and also has had senior securities outstanding for some time: the Gabelli Utility Trust and the associated GUT 5.625% Series A (GUT.PA). The fund also had Series B auction-rate preferreds outstanding during the period.
Through 2008 and early 2009, the fund's NAV dropped more than 50% before recovering in total return terms in 2011. In order to be able to make distributions, GUT had to repurchase and redeem its preferreds, as shown in the chart below. Series A were repurchased across mid-2008 to mid-2009, while Series B were redeemed in the second half of 2008. Series A shares were repurchased at a significant discount to market value, while Series B were redeemed at their liquidation preference.
Source: Systematic Income, Gabelli
In order to finance the retirement of both series of preferreds, the fund would have had to sell assets at what was in retrospect very depressed levels. And although the total level of preferred shares retired was not very large, the overall impact was still to lock in permanent losses for investors.
This episode illustrates the following investment implications.
First, when push comes to shove, so to speak, a leveraged CEF will pivot to support its senior securities at the expense of its common shareholders. GUT ended up financing the retirement of its preferred shares by selling its asset at depressed valuations. The corollary of this dynamic is that the repurchases of Series A also provided technical support for preferreds holders, while pushing down the value of the types of assets the fund actually held in its portfolio.
The second investment implication is that leveraged CEF preferreds behave a lot more like income assets than the fund's common shares. We can see this in the much lower drawdown of preferred shares than the common shares.
We can also see this in the underlying earnings profile of the fund. GUT, at its current price, has a very attractive current yield of 7.92%. Let's take a look at how the fund is generating its earnings. For the year ending December 19, the fund generated $10.52 million in total investment income, composed of dividends and interest on its total assets. Out of that figure, $3.7 million went to pay the fund's management fee with another $700k for additional expenses. An additional $5.14 million went to pay preferreds holders, leaving a bit less than $1 million in income for common shareholders.
Source: Systematic Income
So, less than 10% of GUT's actual income is going to its common shareholders. The actual earnings yield that the fund generates is 0.37% and its price yield after taking the discount into account is 0.20%. Preferreds shareholders, on the other hand, are receiving stripped yields in excess of 5%, while at the same time having common shareholders pay the fund's management fees. If the fund fails to generate capital gains during periods of falling or stable equity prices, it can end up in a curious situation where preferred dividends are paid out of its paid-in capital - creating an effective transfer of capital from common to preferreds holders.
Of course, we don't mean to compare common stocks to preferreds stocks - common stocks offer upside, which preferred stocks typically do not. Those investors who are looking for leveraged exposure on a basket of stocks have all the reason in the world to hold leveraged equity CEFs. However, these funds are also held by income investors, who view them as strictly income-producing assets, which they are demonstrably not. Rather, they are total return assets which behave like income assets by a kind of sleight of hand which converts capital gains into distributions for a sizable fee.
Investors who view leveraged equity CEFs as income assets are exposed to the risk that funds cut distributions, and many go to great lengths to seek out funds that have never cut distributions. This type of strategy can fail in a difficult market environment. This can be particularly painful because the price of the fund following the cut can remain at depressed levels not just because of a low NAV, but also because of significantly wider discounts caused by disappointed investors cutting their positions in the fund.
To illustrate this, let's take the Gabelli Go Anywhere Trust (GGO) as an example. Prior to the recent drawdown, the fund's price was trading a bit over $15 per share and it was distributing $0.20 per share quarterly, generating a decent-looking yield of about 5.3%. During the drawdown, GGO deleveraged somewhat and significantly cut its distribution to $0.05, which not only resulted in a sharp drop in its yield but also caused the discount to remain very wide at -18.5% currently - close to its historical wides. With the fund boasting a current yield of 2.23%, the discount is unlikely to recover. This presents a difficult dilemma for investors who bought into the fund prior to the drawdown. Either they continue holding the fund that with a 1.33% yield on their cost basis or they sell at current prices, locking in a 40% loss. All this is in contrast to the GGO Series A (GGO.PA), which has a yield of around 5% and is also puttable by holders back to the fund.
Investors should be careful in treating leveraged equity CEFs as income assets. This is because during sharp market drawdowns the interests of senior security holders, who have different incentives from common shareholders, will predominate. Fund managers will tend to repurchase or redeem senior securities in order to support the fund's asset coverage by selling down its assets at depressed valuations, locking in permanent capital loss. In addition, preferred shares of leveraged equity funds tend to have much higher true income levels, enjoy a subsidy by common shareholders who pay the fund's fees and can end up with much higher distribution yields if the fund ends up cutting the distribution on common shares.
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This article was written by
At Systematic Income our aim is to build robust Income Portfolios with mid-to-high single digit yields and provide investors with unique Interactive Tools to cut through the wealth of different investment options across BDCs, CEFs, ETFs, mutual funds, preferred stocks and more. Join us on our Marketplace service Systematic Income.
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Analyst’s Disclosure: I am/we are long GGN.PB, GNT.PA. 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.
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