With the election uncertainty mostly behind us, the markets are levitating higher as we expected. It was not the case to me that we would see it spike so fast - possibly because the outcome was not the base case (Dem sweep) and that split government is a positive market environment.
We wrote to members in our Yield Hunting Monthly Report (as well as many of the October Weekly Commentaries):
This election is most likely the most heated and contentious certainly that I can remember though I wasn't around in 1968. The market tends to trade sideways ahead of most presidential elections and then move higher following them. Remember, markets hate uncertainty. The certainty of the election being over tends to be a relief and allow the markets to levitate higher. Here is the S&P 500 path before and after the 2016 election with this year superimposed.
Our concluding thesis is that the opportunity in the CEF space is probably the best of the year - including the depths of the March lows. That is because we have a confluence of variables that are coming together: tax loss harvesting, market volatility, and stimulus all getting far in the background of the rearview mirror. That should allow a strong few months across the CEF space. Buying up wider discounted funds along with riskier NAVs should produce good results, all things being equal, through the end of January.
Lower leverage costs (and low probability of an increase in costs anytime soon) along with distribution hikes as tax loss harvesting pressures ease will combine to create a great environment for CEFs.
Nuveen GA Quality Muni (NKG), yield 4.34%, discount -13.3%
BlackRock MuniYield Quality II (MQT), yield 4.90%, discount -6.8%
Gladstone Investment Corp. (GAINL), 6.375% Series E Cum Term Pfd Stock
We've been discussing the opportunity that was available in the CEF market for a couple of months now such as this one: "The Falling Out Of Love With CEFs." Discounts, following their que from the VIX ("volatility index"), widened over the last two months. Essentially, the nadir for bond CEF discounts was the last day of August. Since then, discounts widened in a choppy fashion.
The VIX was near 40 the day before the election which is usually associated with a bear market (-20% from the highs). That was clearly not the case. At the same time, credit spreads were fairly tight and falling (not what is typical with a VIX that high) and interest rates were very stable.
(Source: Alpha Gen Capital)
In some areas of the bond CEF market, we are approaching the March 2020 wides for discounts (before last week's rally). In the equity CEF space, we are now wider than the March 2020 wides. The distribution analysis from below is very instructive. While discounts are tighter than they were in March, they are still on the far left tail of the distribution. In fact, 91% of observations were tighter than the current one.
Additionally, CEF corporate action activity remains very high. According to Georgeson, there have been 27 proxy fights this year, up from 16 last year. This is why we see increased tender offers to play. There are five going on right now to watch and participate, often juicing your returns. And we believe a few more will be coming soon in EFT, EFF, and MIE.
Saba is the main driver of these tenders as they put up strong performance in their CEFS ETF along with their private LP hedge fund. That drives more assets into both structures, giving them more ammo to conduct more activist activity which, again, helps to produce alpha. It's a virtuous cycle that individual investors can piggyback either through the ETF or by purchasing the underlying funds themselves.
In the month, we saw a lot of weakness in CEF prices in the equity side with the global dividend category faring the worst, down 6.4%. On the positive side, MLPs finally had a good month (there haven't been many of those) putting up a 3.3% price return and 2.6% NAV return.
The cheapest CEF sectors right now are convertibles and a bunch of pure equity CEFs. The more defensive sectors were the richest - tax free munis, utilities and government. But surprisingly, all CEF sectors have a negative z-score.
I cannot harp on this more. You want to play as many of the tailwinds as you can. However, just because you have a tailwind doesn't mean you're assured a positive outcome. The tailwind just gives you a bit more juice.
Tender offers are good examples of that. If you can buy a decent CEF at a 12% discount and can tender a portion of your shares (maybe 30%) back at a 0.5% discount just a month or two later, you get to capture an 11.5% capital gain, all else equal on nearly one-third of your position. This is why the activists do it.
Seasonality is another tailwind to play. Discounts historically widen in October and November thanks to tax loss harvesting but then rebound strongly in December and January. In the last several years, that seasonality has been far more pronounced. January, of course, sticks out. We have been stressing this service to use the current opportunities to get into positions ahead of that while being patient and picking your spots.
The article I linked above discusses this seasonality but also the broader cyclical trends that are apparent in the CEF space. Weak performance results in wider discounts while tight discounts tend to bring in newbies who buy regardless of valuations.
It's amazing the contrarian nature of the average CEF investor. We are able to see it first hand in our marketplace service. When members are joining in droves, it is typically not the best time to be entering the CEF space (although there're always opportunities available). When I get feedback that the now canceled member is "changing strategies" or "getting out of the CEF space" then it is often the best time to get in.
So we are optimistic on the market as both the top level CEF wrapper is trading at deep value levels (compared to historical data) and the underlying assets in many of the sub-sectors remain cheap although up significantly from where they were in March. In other words, the opportunity is still available.
So what do we think is the best area of focus for investors? Given the likely but not assured outcome of the election of split government (Biden as President, GOP senate, Dem house (but weakened)) then our thoughts that a reflation trade was here goes away. In fact, a deflationary environment appears more likely. In those environments, we want to be more heavily invested for slower growth and have duration in the portfolios as we think the yield curve will flatten.
The scenarios are laid out below.
So what works well in this type of outcome?
Munis are back in the fold with the new environment. We are passing the bulk of the new issuance calendar which should remove an overhang to the sector. We also have a possibility of higher taxes (though less likely from split government) but just the fear of an increase in tax rates can drive higher demand for tax-free municipal bonds.
The current muni average discount is approximately -6% which is about double the long-term average. And with the overhang from higher leverage costs gone, and a possible deflationary environment, we think the discount could get closer to NAV.
Nuveen GA Quality Muni, yield 4.34%, discount -13.3%
This fund is one of the best of the best meeting all the quantitative factors that we hunt for. NKG boasts a strong coverage ratio (+100.1%). Now that is down from 113.8% the month before but the decline was because they increased the distribution for November from $0.04 to $0.045 (+12.5%). So the distribution is well covered and Nuveen feels confident enough to raise the payment. That is the second increase in the last six months.
The fund also has positively trending UNII and the highest state specific Nuveen UNII balance at +3.3 cents. In September, that UNII balance was up 18%. That is a very strong fundamental number and ensures that the distribution is safe, all else equal, for some time.
Lastly, and probably most importantly, we estimate near-term redemption exposure (the percentage of the portfolio that is callable or will mature in the next 24 months) is the lowest of the Nuveen state funds at just 13.4%.
While fundamentals look spectacular, it is all for naught if the valuation of the fund is rich. However, that is not the case for NKG. The current discount is -13.3% which is wider than the average -12.7% discount with a one-year z-score of -0.33.
The yield is also very compelling at 4.40%.
BlackRock MuniYield Quality II, yield 4.90%, discount -6.8%
This is one of the best buy-and-hold types of funds that one can buy today. In our traditional analysis, the fund scores one of the highest values with continued strong coverage (101.5% after the recent distribution increase) and very positive UNII trends. UNII balance has grown month over month for 12 straight months, increasing by +7.9% in the last reported period, to the current 5.3 cents/share. Lastly, the fund has a really benign call schedule. We estimate near-term redemption exposure (the percentage of the portfolio that is callable or will mature in the next 24 months) at just 17.2%. The fund has one of the best long-term NAV performance track records as well.
While the discount isn't overly wide at the moment, it is very close to our buy threshold. We have removed the buy cushion from our muni core model as it was no longer needed for the current expected macro scenario (disinflationary).
High quality preferreds and baby bonds that are backed by assets of some sort of fund structure are very attractive here. These would include the baby bonds of BDCs or CEFs.
RiverNorth/DoubleLine Strategic Opp A (OPP-A), 4.38% Series A Pfd Stock
This is a high-quality recently launched preferred stock that is the leverage mechanism for the 40 Act fund, OPP. The fund pays $1.09375 per annum for a coupon rate of 4.38%. With the price currently under par, the current yield of the fund is 4.44%. While that is low, this is an investment grade issue that is not callable for five years. Today, the investment grade bond ETF, iShares iBoxx Investment Grade Corp Bond (LQD) currently pays just 2.04% (2.89% ttm). So OPP-A pays double for similar quality (without the diversification).
The Series A Preferred may be subject to an early call in 2021 if the fund converts to an open-end management investment company. In regard to the payment of dividends and upon liquidation, the preferred shares rank junior to the company's senior debt, equally with other preferreds of the company, and senior to the common shares of the company.
So the issue may be called next year if the underlying CEF, OPP, gets converted to an open-end fund. But as long as you purchase below par ($25) the result would be a capital gain, and some reinvestment risk as it's hard to find a similar yield of similar quality. In the meantime, you collect a handsome investment grade income stream.
Gladstone Investment Corp. 6.375% Series E Cum Term Pfd Stock (GAINL)
This is one of the monthly payers for preferred stock from Gladstone Investment Corp. (GAIN), a business development company. This one is on the safer end of the risk spectrum in terms of BDCs plus we are investing in the preferred stock of the BDC, not the common shares, which further reduces our risk.
The firm simply makes private investments into small and medium-sized businesses either with a first or sometimes second lien loan or through the equity of the company. Gladstone is one of the more well-managed with lower leverage and a higher percentage of equity investments.
The preferreds trade below par currently and offer a 6.43% yield. It just became callable in August at $25 plus accrued interest and is mandatorily redeemable at $25 in August 2025. So an investor can think of GAINL as buying a slightly discounted individual 5-year bond with a yield-to-maturity of 6.5% and a yield-to-worst of 1.8% should they be called right away. Use limit orders on this one only.
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This article was written by
Plus: Muni CEF Shopping List.
Our team includes:
1) Alpha Gen Capital - I am a former financial advisor and investor. Not someone from another career doing this on the side. My analysis is meant to provide safe and actionable insight without the fluff or risky ideas of most other letters. My goal is to provide a relatively safer income stream with CEFs and mutual funds. We also help investors learn about investing and how to properly construct a portfolio.2) George Spritzer - Another career financial guru who runs a registered investment advisor with a specialization in closed-end funds for individuals. George uses the following investment strategies:1) Opportunistic Closed-end fund investing: Buy CEFs at larger than normal discounts to NAV and sell them when the discounts narrow. 2) Exploit special situations: tender offers, fund terminations, fund activism, rights offerings etc.
Disclosure: I am/we are long NKG, MQT, OPP, OPP-A, GAINL, LQD. 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.