Written by Nick Ackerman, co-produced by Stanford Chemist
RiverNorth/DoubleLine Strategic Opportunity Fund (OPP) is a unique approach that utilizes two investment managers. We have RiverNorth that manages a CEF portfolio as a well-known CEF sponsor. DoubleLine is known better, more broadly, as Jeffrey Gundlach's business operation.
These two investment advisors team up to manage OPP in a rather unique way. This isn't RiverNorth's only fund that utilizes a double investment advisor approach. DoubleLine manages the largest portfolio segment at any one time.
The fund also operates similarly to RiverNorth's Opportunities Fund (RIV) in how its distribution rate is handled. We covered RIV recently. They have distribution plans that target 12.5% distribution yields on the NAV. It is reset annually by taking the average of the last five trading days of the year. This guarantees a high payout for investors; however, that doesn't mean it is being earned, or that is the return an investor will be receiving.
What the approach does is mean that the distribution is entirely predictable. If the fund does well enough to earn or outearn 12.5%, investors will get a raise the following year. If the fund underperforms, that means we get a distribution cut. While the performance isn't predictable in any one year, it is predictable in what is to be anticipated.
The higher distribution tends to pull investors in and push the fund to trade at richer valuations. RIV has, on several occasions, traded at a premium. However, OPP didn't get the same love until 2021. That was the first time the fund began to trade at a premium. Despite that being the first year, they still have started up the rights offering machine in 2020.
This is the same thing that we explored with RIV. The fund pays a high distribution, gets investors to buy in, and then does a rights offering. This helps perpetuate the whole cycle over and over again.
As we explored with RIV in the last offering, OPP's 2021 rights offering was much more shareholder-friendly. It helped limit the dilution of the fund by adding a floor to the offering price being too far below NAV. Stanford Chemist had discussed this more in-depth in his previous article. We also touched on this subject more broadly in our RIV article - it is the same process, just a different underlying portfolio essentially.
For OPP, the rights offering ended up causing a $0.27 hit to NAV so far with their 2020 and 2021 ROs.
OPP's investment objective is "to provide current income and overall total return." To achieve this, they utilize an approach utilizing RiverNorth and DoubleLine investing in separate sleeves of the portfolio, as we touched on above.
They do this by "RiverNorth determining which portion of the Fund's assets is allocated to each strategy based on market conditions. The Fund may allocate between 10% and 35% of its Managed Assets to the Tactical CEF Income Strategy and 65% to 90% of its Managed Assets in the Opportunistic Income Strategy."
When investing in the tactical CEF Income Strategy, this can also include business development companies [BDCs] and exchange-traded funds [ETFs].
This fund has nearly $400 million in total managed assets. Though this was somewhat recently enlarged by the Series B Preferred Stock (OPP.PB) that they issued. That raised approximately $58.1 million for the fund. It pays a 4.75% dividend yield.
They also have Series A Preferred Stock (OPP.PA) that they issued back in 2020. That's still currently outstanding and carries a dividend rate of 4.375%. This is a more expensive form of leverage, although it also has its positives. For one, the rate is fixed in this case, which means when rates rise, it'll be one less factor to worry about.
In addition to that, the fund will also have greater flexibility during massive sell-offs in regard to being forced to deleverage. With preferred, the need to deleverage is drastically reduced when compared to borrowing terms through a credit facility from a bank.
They stated that this capital will be; "to use the net proceeds from the offering of the Series B Preferred Stock to repay borrowings under the Fund’s credit facility and for general working capital purposes."
They had borrowings of $75 million and were paying one-month LIBOR plus 0.95%. It has increased their borrowing costs exponentially but is a fixed rate. This could have been the right move if we see materially higher rates over the next few years. It just seems hard to imagine since it hasn't been since the great recession where the 4.75% would be cheaper in borrowings for CEFs.
The fund's expense ratio comes to 1.89%. When including leverage, it came to 2.10%. However, that was listed before they had issued this latest preferred. The leverage of 25.2% was also listed before the preferred issue, so the leverage ratio should also be higher.
Some of the underlying portfolio positions will have their own expenses as well. This would come in the CEF/BDC portion of their portfolio, which also has expense ratios. So expenses for the fund can be quite high. Since the minority of the portfolio is in a fund of funds approach, it won't be as meaningful as something like RIV's portfolio - but it is something to be aware of.
Over the years, one might have noticed that OPP and RIV have not followed similar performance. It seems there is one straightforward reason for this; it is that OPP is almost entirely invested in fixed-income investments. During a seemingly unstoppable equity market, the equity sleeve of RIV will benefit the fund and give us much more favorable returns.
Since they both implement the same 12.5% managed distribution plan, that means OPP will erode away at a faster clip. Unless, of course, fixed-income becomes in favor. However, that isn't likely to be the case any time soon when rates rise through 2022.
The above chart shows the total return performance between these funds. The below is price and NAV return only. That means it isn't factoring in any distributions. As a side note, these two funds help show why distributions need to be factored in for performance in closed-end funds. Without the distribution, it would have looked like investors had no return at all.
That doesn't make RIV better than OPP. This just helps tell us why the funds are different. There isn't a clear peer for OPP in all the funds I know. It's a bit of a unique offering. I would probably associate it more with multisectoral bond funds than anything else.
As we touched on above, the fund has become richly priced. For 2021, we have seen the first premium show up since the fund's launch. That being said, the fund's discount has never been too deep before either, aside from the COVID crash.
Still, OPP is trading well above its average discount, with a range that seemed clearly defined before 2021. This puts the fund in a position where an investor should probably just put it on the watchlist. I don't think investing at this time makes sense.
In 2021, RIV almost covered its distribution and earned 12.5%. RIV would have had a minor trim if they had followed their policy down to a T. OPP didn't have the same fate for the reason we discussed above. That saw their distribution take a cut of 6.8%, from a monthly distribution of $0.1586 to now $0.1478 for 2022.
That significant jump in the distribution in 2019 resulted from the plan going into effect at the 12.5% target. Previous to that, they had just a managed plan of paying out $0.15 to shareholders.
The Board approved the implementation of the level distribution policy to make monthly cash distributions to common shareholders, stated in terms of a rate equal to 12.5 % of the average of the Fund’s NAV per share for the final five trading days of 2018, which amounted to $17.60. The Fund makes monthly distributions to common shareholders set at a level monthly rate of $0.18 per common share.
Previously the Board approved the adoption of a managed distribution plan in accordance with a Section 19(b) exemptive order whereby the Fund made monthly distributions to common shareholders set at a fixed monthly rate of $0.15 per common share.
The amount of the Fund’s distributions pursuant to the managed distribution plan are not related to the Fund’s performance and, therefore, investors should not make any conclusions about the Fund’s investment performance from the amount of the Fund’s distributions or from the terms of the Fund’s managed distribution plan. The Board may amend, suspend or terminate the managed distribution plan at any time without notice to shareholders.
Since the fund implemented this policy, it has only been downward in the following years.
Being a fixed-income fund, we often want to see net investment income [NII] covering the distribution. We know that they aren't earning the distribution as the fund decreases its distribution every year. On the other hand, we know it's going to be reset to 12.5% every year so looking at earnings also doesn't mean a lot in this case.
The fund hasn't been covering its distribution through NII. Further, it comes in even lower after factoring in the preferred dividends. Since they issued more preferred, their NII should rise but so will their dividends to another preferred series. Since the latest preferred were offered at 4.75%, everything they earn above that will be a net benefit.
Though the expense ratio also has to be put on top of that 4.75% - meaning they'll have to earn roughly 6.64% to benefit common shareholders. Not an impossible task, but certainly not going to be a huge benefit to common shareholders. The biggest beneficiaries with that latest raise were primarily management - and those holding the preferred, in my opinion. I'll touch on this more when we go over their portfolio.
With earnings looking like that, it comes to little surprise that the large amounts of the payouts for OPP are going to be classified as return of capital.
Above I mentioned that the latest preferred raise was best for management. Though the actual preferred holdings are getting quite a good deal, too, at a fixed 4.75%, there are worse things out there. It is incredibly safe because of all the regulations and restrictions the CEFs have when they issue debt.
All that being said, I say this because if you glance through their portfolio holdings, most of the assets are paying less than this. The last holdings list I can find was from their Annual Report for the period ending June 30th, 2021.
Here are some of their non-agency CMOs that was the largest portion of their portfolio at that time.
At this time, none of these holdings would cover the 6.64% required to pay the new preferred dividend plus the expense ratio. Going through their portfolio holdings, some would cover those expenses, but they seem to be in the minority. Higher rates also tend to mean higher risks. There's a reason they are paying higher rates in the first place; it isn't because they want to.
As I said, it isn't impossible for them to put it to work in something in the 10 to 12% yield range, but that is if it goes to riskier investments.
The heaviest sector allocations are shown as non-agency MBS, agency MBS and bank loans. These can be fairly attractive investments that offer pros and cons to each. This is from their latest Fact Sheet that was as of September 2021.
The bank loans are often floating rates, so they can benefit from the increase when higher rates come. Their non-agency and agency MBS seems to be split between fixed and variable rates. Though a large portion is in the floating rate when you start looking closer - at least when they reported their holdings at the end of June 30th, 2021. Their portfolio turnover last reported was 54%, so the fund can be fairly active. All these floating rates keep the fund's effective duration relatively low. The fund last reported an estimated duration of 2.52 years.
We can also take a quick look at their top 5 positions. It is quite interesting because it is mostly in cash or cash equivalent.
We have U.S. Treasuries yielding 1.625% - which may as well be a cash equivalent. Then we have actual cash and cash equivalent that are likely earning nothing too. Given the inflation level at this time, a lot of their portfolio isn't earning positive returns.
OPP is an interesting and unique fund. I'm a big fan of RiverNorth when you can get a good deal on their funds. DoubleLine is also a well-respected fixed-income manager. However, neither OPP nor RIV are offering an enticing opportunity at this time. The 12.5% distribution yields are certainly tempting, but I have some serious concerns about OPP at this time.
If you must invest in one and just want the 12.5% regardless of positioning or earning it, I'd defer to RIV at this time. Between the two, RIV has a better chance to earn its distribution. OPP seems set to lose investors' capital and/or buying power at this time. Yields are too low and aren't likely to cover the fund's expenses of the capital that they just raised through the Series B preferred. That is unless, of course, they go further down the quality spectrum and invest in riskier holdings. Add to that the premium that it's trading at, and it is a pass.
If we could get OPP at a 5 or 10% discount, then we could see some opportunity open up for mean reversion. At that type of valuation, we would be compensated for the greater risks that are being presented.
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Additional disclosure: This article was originally published to members of the CEF/ETF Income Laboratory on January 9th, 2022.