CEF Market Distribution Update

Summary

• We discuss CEF distribution changes declared in June.
• Previous trends have extended into June. Loan, MLP and equity funds have continued to cut distributions while municipal funds have continued to raise distributions.
• Our focus has remained on higher-quality assets, low call exposure and short-term leverage instruments.
• We highlight two funds that feature these characteristics: MVT and GDO.
• Looking for a helping hand in the market? Members of Systematic Income get exclusive ideas and guidance to navigate any climate. Get started today »

Since the start of the drawdown, the CEF market has experienced a wave of distribution cuts driven by deleveraging and falls in asset prices. With most of the June distribution announcements in the bag, we take a look at how various sectors have fared since the end of the drawdown.

The main takeaway is that the previous trends have extended into June. Loan, MLP and equity funds have continued to cut distributions while municipal funds have continued to raise distributions.

Our recent sector and fund focus has taken advantage of these trends and remains on higher-quality assets, low call exposure and short-term leverage instruments. These features should support investor portfolio valuations and earnings over the medium term.

We highlight two funds that should enjoy these trends:

• Western Asset Global Corporate Defined Opportunity Fund (GDO)
• BlackRock MuniVest Fund II (MVT)

CEF Distribution Dynamics

In the fund distribution announcement database available on our service which drives this analysis, for the three months since April, we count 206 CEF distribution changes with 155 of them cuts. By far, the biggest month has been April with 66 cuts and 5 rises. May and June showed both lower cuts and higher raises. This pattern makes sense. The sharp drop in asset prices in March caused some funds to deleverage, prompting cuts while funds with managed distribution policies cut due to the drop in NAVs. The following two months saw a recovery in NAVs which allowed some of the funds that cut in April to partially or wholly reverse the cuts in the following months.

Source: Systematic Income

If we look over actual distribution cuts and rises across sectors, we see significant divergence both in the number of distribution changes as well as the composition of changes in terms of cuts versus rises. In order to make an apples-to-apples comparison, we need to adjust the number of distribution changes by the number of funds in the CEF sector.

Source: Systematic Income

In the chart below we show the net distribution cuts in the sector (negative numbers mean the sector had more distribution rises than cuts) as a percentage of the number of funds in the sector. Figures above 100% mean that the sector saw more distribution cuts than the number of funds - in other words, several funds have cut more than once.

Source: Systematic Income

The most affected sectors have been loans, MLPs and equity sectors, primarily for different reasons in our view. Loans were hurt by the sharp drop in Libor - the base rate that underpins loan coupons. The MLP sector suffered across-the-board deleveraging due to catastrophic falls in asset prices. The equity sector made cuts for three reasons: cuts in dividends in their underlying portfolios, a right-sizing of the distribution profile to the fund's NAV as well as deleveraging for some funds.

Let's take a look at net distribution cuts (cuts less rises) across the last three months. Interestingly, we don't see much of a let-up across some sectors such as loans, equity and hybrid. The behavior of the loan sector makes sense given the tightening of the Libor/Fed Funds basis due to the improvement of liquidity across fixed-income markets. The continued cuts in the other two sectors is harder to explain.

Source: Systematic Income

We are also seeing more rises than cuts in the municipal bond sectors over the last two months. This is a function of three main drivers: the overall quality and resilience of municipal bond prices, reduced leverage costs due to the drop in short-term rates and its impact on tender-option bond floating rate notes and variable-rate preferreds and the reduction in call activity given the temporary dislocation in bond markets.

Sector Positioning

How have these developments informed out sector positioning in the CEF as well as the broader fund space?

First, we have shied away from floating-rate exposure, and loans in particular, over the last few months. This was due to our continued view that as market liquidity got back on track, Libor would continue moving lower and the loans sector would continue right-sizing its distribution profile. This has played out as we expected. One exception that we have made in the floating-rate sector has been in non-agency RMBS in which we maintain an overweight in our Sector Rating Framework. This is due to our view that the legacy part of the market should prove resilient owing to high LTVs, decent household balance sheets and a housing market that still features good fundamentals.

Source: Systematic Income

Secondly, we have tilted away from using CEF wrappers for highly volatile sectors such as CLO equity, MLPs and equities more broadly. The high volatility of the underlying assets makes leveraged funds particularly vulnerable to deleveraging, permanent capital loss resulting in low-yielding investments. For example, the Eagle Point Credit Company (ECC) is currently yielding around 6.4% at the pre-drawdown cost basis of around $15 per share given its new distribution profile - a figure that is not a million miles away from current yields on taxable municipal CEFs. This combination of a leveraged CEF wrapper with a highly volatile asset class makes for a fragile investment vehicle. This doesn't mean that investors shouldn't own these asset classes - however, they need to think carefully what type of investment vehicle is the right one for a given asset class.

Thirdly, we have tilted to relatively high-quality sectors that use floating-rate leverage instruments like tender option bonds, credit facilities and repos. The fact that municipal CEFs, which tend to own higher-quality assets and use floating-rate leverage instruments, have seen more distribution raises than cuts is not a coincidence.

Fourthly, we have also tilted to term CEFs as our higher-yielding options, particularly those with attractive pull-to-NAV yields. These funds tend to boast lower leverage profiles and performance tailwinds due to discount compression into termination.

Fund Highlights

A fund that is on our Focus List is the BlackRock MuniVest Fund II (MVT). MVT closed on Wednesday at a 7.58% discount and a 4.92% current yield. The fund has a below-average fee in the sector and a slightly higher than average leverage.

The fund boasts a solid distribution coverage profile that has improved further over the last few months alongside a positive UNII. The fund has been adding to its borrowings over April and May, taking advantage of wider credit spreads. This, alongside, lower leverage costs has strengthened its earnings picture.

Source: Systematic Income

Over the last 10 years, the fund has bested the sector in NAV terms by 0.6% per annum though it has lagged more recently, likely due to its larger high-yield bucket.

The fund's discount is quite attractive currently, trading at the 8th percentile over the last 5 years and a 0% discount sector spread percentile. We can see from the chart below that the fund used to trade at a premium to the sector but is now trading at a wider discount. This is in the context of a current yield that is a full 0.5% higher than the sector average.

Source: Systematic Income

The fund has a 21% non-investment grade allocation with a below average not-rated bucket. The call exposure of the fund is in line with the sector average.

Source: Systematic Income

A term fund that provides an attractive combination of quality and discount valuation is the Western Asset Global Corporate Defined Opportunity Fund (GDO). The fund is 62% allocated to investment-grade bonds with an additional quarter in BB-rated assets. The fund closed Wednesday at a 6.75% discount and a 7.31% current yield which is about 85% covered.

GDO is a term fund with a scheduled termination date at the end of 2024. The current discount means the fund is expected to generate a tailwind of about 1.5% into its termination net of any portfolio unwind costs which should be minimal. The current pull-to-NAV yield is attractive relative to the fund's history.

Source: Systematic Income

GDO has outperformed its sector in NAV terms over the last 5 years though it has lagged somewhat over the past year. Its discount valuation is relatively attractive currently with the discount spread to the sector close to the wides over the last 5 years despite it being a term fund. And finally, the activist campaign against the Legg Mason (LM) and Templeton (BEN) merger could very well result in an earlier wind-up of the fund and generate a quick dose of alpha.

Source: Systematic Income

Conclusion

The high market volatility over the last few months has caused wide divergences across the CEF market, most notably in distribution outcomes. For this reason, we remain overweight those sectors and funds that should prove more resilient across varying market scenarios. Our focus has remained on higher-quality assets, low call exposure and floating-rate leverage instruments. These features should support fund valuations and earnings over the medium term.

Analyst’s Disclosure: I am/we are long MVT. 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.