JQC: Final Year Of The Capital Return Program
Summary
- The capital return program had a hiccup with 2020's volatile year.
- Winding down the fund's capital return program will see decreasing distribution throughout this third and final year.
- Overall, one would need to be optimistic on senior loans to consider getting involved with this investment at this point.
- This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Get started today »
Written by Nick Ackerman, co-produced by Stanford Chemist
Nuveen Credit Strategies Income Fund (NYSE:JQC) had initiated a "capital return program" on December 17th, 2018. The plan was to return 20% of assets to shareholders over a three-year period. It was via raised distributions over and above what the fund could actually sustain. However, 2020 certainly wasn't anticipated and I believe threw a wrench into its plan. It resulted in several cuts and is continuing to result in cuts.
The ultimate idea was to "enhance the Fund's competitiveness and investment returns for current and prospective common shareholders." This would have come through the fund's discount narrowing. Besides the higher distribution rate, it had also been buying back shares through a repurchase plan.
The basics of the fund are: "primary investment objective of high current income; and its secondary objective is total return." It will invest "at least 80% of its assets at the time of purchase, in loans or securities that are senior to its common equity in the issuing company's capital structure, including, but not limited to debt securities and preferred securities." It will "invest at least 70% of its assets in adjustable-rate senior secured or second lien loans, and up to 30% opportunistically in other types of securities across a company's capital structure..."
To put it in much simpler terms, it is a senior loan fund primarily with flexible exposure to other debt-related investments. These loans are floating rates typically and should benefit from an increase in interest rates. Now that rates are targeted to 0% by the Fed, the logical idea is that the only way they have to go is up. Barring the U.S. following other countries in a below zero interest rate world. The benefits aren't felt immediately; however, a "floor" must be breached first before benefits kick in. Stanford Chemist had covered that concept more in-depth for us.
(Source)
The fund is a rather fair size at almost $1.5 billion in total managed assets. Though it utilizes a massive amount of leverage through borrowings and reverse repurchase agreements. The current leverage is at 35.84% or $535 million in assets. The expense ratio for the fund comes to 1.39%, and when including the leverage expense comes to 2.31%.
Performance - 2020 Puts The Fund Back Down To Even Deeper Discounts
As a senior loan fund, I do tend to want to see how it compares to something like BlackRock's Floating Rate Income Trust (BGT). BGT is a rather plain senior loan fund with no frills or thrills - it just invests with leverage in a basket of senior loans. I believe it provides a good barometer.
Over the longer term, the total price return is significantly in favor of JQC over BGT. Though the actual underlying portfolio lagged BGT, as evidenced by the total NAV return basis.
The next I want to see is from when they initially started their capital return program to today.
We can see here once again that JQC came out on top on a price basis. Presumably on the reduction of a discount from then until now over BGT. We also see that the two funds were neck and neck throughout most of this time until 2020. The reason for a detraction from there would be the fund had to reduce leverage as it was running leverage high into the crash as well. BGT utilizes leverage but is more conservative in its approach. In 2020, it is those types of periods that really show the benefits of being modest.
(Source - Annual Report)
Overall, the borrowings were reduced, but they also show a reduction in the reverse repos they had reported too.
(Source - Annual Report)
The fund's current discount is nearly 9%. This can be compared with its one-year average at 12.13%, and its five-year average of 10.30%. When the fund implemented its strategy, it really didn't get the market excited. During the timing that it went into effect rate increases were paused as the market threw a tantrum in Q4 2018. Thus, the appeal of senior loans had waned right at the time they were trying to drum up attention.
Subsequently, it did start to reduce its discount and we noted as such in our previous JQC coverage. 2020 did have a different plan for the fund and brought the fund down to discount levels that it hasn't reached but a few times in its history.
(Source - CEFConnect)
Distribution - Heading Lower
As this plan continues to be implemented throughout the remainder of this year, it anticipates a lower monthly distribution every month. In the first two years, it intended to maintain a fixed-distribution at the beginning of the year and hold it throughout in both years one and two.
Now it intends to lower the distribution every month until the "supplemental" portion is reduced to zero. Or essentially, as I understand it until it matches up with what it is actually earning. As rates are held at 0% by the Fed - it isn't going to be nearly close to the ~12.6% that it is currently sporting.
Beginning with the Fund’s January 2019 distribution, the Fund expects to include a supplemental amount in its regular monthly distribution. For the Plan’s first two years, subject to Board oversight and approval, the Fund expects to establish at the start of each year a fixed supplemental amount that would then be paid monthly throughout the year along with the Fund’s net investment income. Because the supplemental distributions in that first year will tend, all other things held equal, to cause the Fund’s net assets and net asset value per share to decline by a commensurate amount, the Fund expects that the supplemental amount in the second year would be reduced in order to maintain a roughly comparable average incremental distribution yield on net asset value, attributable to the supplemental distribution amount, in years one and two. In the Plan’s third and final year, the Fund expects that the supplemental amount will be reduced ratably each month to zero by December 31, 2021.
2020 had other ideas for the fund though, and they had to cut the distribution a couple of times throughout the year two period. Looking at the chart and we see just how much they had propped up the distribution in 2019 for this program. Though it also highlights how far it is likely to fall as we head through the year as well.
(Source - CEFConnect)
For a better understanding of the numbers, we can take a look at how much they actually earned for their 2020 report.
(Source - Annual Report)
They report for the period ending July 31st, 2020. We can see that over the year they had net investment income [NII] of $0.39. This worked out to NII coverage of 34.4%. This is around what should be anticipated due to their plan.
The other issue here is that we are still seeing results from a period where rates hadn't been cut to 0% by the Fed. Meaning that earnings will likely decline even further from this point - so, in other words, that $0.39 might still be too high. Even if we take that figure, it looks like they could support a $0.0325 distribution per month. This actually makes sense as before this cut they had been paying around a ~$0.038 distribution amount. Now rates have declined from that period, as well as their assets via the return program. Therefore, a much lower rate could be anticipated if they are going to set it at an amount around what they are earning.
Ultimately, it wouldn't be surprising if after the return program JQC pays around a 5 to 6% rate. This would put it around its peers anyway and would be based on what the fund can earn. Of course, CEFs can pay out what they want, when they want and however much they want.
Holdings - Watch Rates
The bottom line on their holdings is to watch where the Fed is heading with its rates. As touched on, it seems the most common sense that rates can only go higher from here - if the U.S. doesn't go down the failed path of below zero rates.
This is because senior loans make up over 80% of the fund's assets. Again, as touched on above, these are primarily floating rate in nature so any increase could result in increased earnings after the floor is broken through.
(Source - Fund Website)
Senior loans are primarily issued by lower credit quality companies. So it is natural that most of JQC's portfolio is comprised of below investment grade rated "junk."
(Source - Fund Website)
Of course, as an income investor - junk doesn't mean it isn't investible. It just comes with more risks. Senior loans and high yield are also notable as debt securities that are more sensitive to economic conditions and typically have shorter maturities. The effective maturity of JQC's portfolio is rather low at 4.5 years. Additionally, the effective duration is 0.55 years.
The top issuers of the fund can be seen below.
(Source - Fund Website)
I believe the most notable here would be United Airlines Holdings (UAL). Considering there is a significant risk to if individuals will be traveling as much as they did pre-pandemic. The main benefit here for JQC, and its shareholders, is being "senior" in line in the event of bankruptcy.
Conclusion
As JQC enters the final year of its capital return program, we can expect distributions to go lower every month. Not just because coverage is rather poor, but as this is exactly their plan from the beginning. This means that 13%+ distribution isn't likely to be here for too much longer. If we are looking at current earnings and environment, a distribution rate in the 5-6% range could be more feasible.
The fund's current discount isn't necessarily a screaming buy or a screaming sell - rather a more neutral valuation if we are going to compare to several other senior loan funds.
Ultimately, JQC could be a great senior loan investment if an investor is looking for that type of exposure. An investor would need to be more optimistic about interest rates rising to benefit the underlying portfolio's earnings, which could then see the result of distributions heading higher. 2020 had a different idea for their capital return program, and the result was something I don't believe they exactly were planning for.
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This article was written by
Nick Ackerman is a former financial advisor using his experience to provide coverage on closed-end funds and exchange-traded funds. Nick has previously held Series 7 and Series 66 licenses and has been investing personally for over 14 years.
He contributes to the investing group Learn more.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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Comments (32)
12/20 stopped out of jqc as the jqc/bkln pair is below multimonth low and it appears we will close below 6.28
