CEF Weekly Review: Just How Attractive Are Credit Valuations?

Jun. 04, 2022 6:28 AM ETEAD, ERC, EOD, CIK, EIC, ARDC, TCPC, FFC, FLC, DFP, PFD, PFO, XFLT, PCM, PDO, PGP, PTY, DMB, MMD6 Comments19 Likes

Summary

  • We review CEF market valuation and performance through the fourth week of May and highlight recent market action.
  • The CEF space had a V-shaped bounce this week, recovering most of the previous losses for the month. Reversing their previous underperformance, Munis did well.
  • We take a look at CEF credit valuations through various metrics to gauge how attractive they are historically.
  • And highlight a recent rotation in our Municipal Income Portfolio.
  • I do much more than just articles at Systematic Income: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

Financial stock market graph. Selective focus.

Diego Thomazini/iStock via Getty Images

This article was first released to Systematic Income subscribers and free trials on May 28.

Welcome to another installment of our CEF Market Weekly Review where we discuss CEF market activity from both the bottom-up - highlighting individual fund news and events - as well as top-down - providing an overview of the broader market. We also try to provide some historical context as well as the relevant themes that look to be driving markets or that investors ought to be mindful of.

This update covers the period through the fourth week of May. Be sure to check out our other weekly updates covering the BDC as well as the preferreds/baby bond markets for perspectives across the broader income space.

Market Action

It was a very strong week across the CEF space with all sectors seeing stronger NAVs and the majority seeing tighter discounts as well. This bounce erased most of the aggregate loss for the month of May though there is significant variability in sector returns.

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Systematic Income

Municipal sectors had a great May as the recent stabilization in Treasury yields helped the sector. Losers were Loans as well as some of the higher-beta sectors like Converts and REITs. It has been interesting to see the underperformance of Loans relative to High Yield corporate bonds - a theme we discussed last week, the key takeaway of which is that bonds have become increasingly more attractive relative to loans given the behavior of Treasury yields and the increasing likelihood of a recession.

The second interesting performance theme has been the outperformance of municipal sectors relative to credit sectors in the month of May. This aligns well with our earlier discussions this year where we highlighted that we wanted to wait for credit spreads to rise further before adding to lower quality sectors. This is why we, instead, favored adding to municipal allocations. And when the big move in credit spreads was well underway, we turned much more positive on credit as well.

Despite a very strong week, the bounce pushed the CEF space only marginally above water for May.

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Systematic Income

Year-to-date municipal sectors are no longer the worst performers though they remain in the lower half.

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Systematic Income

Discounts have tightened across both fixed-income and equity sectors; however, they remain in their range of the last few months.

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Systematic Income

Market Themes

Outside of a couple of weeks such as the last one, market action since the start of the year has been pretty grim for a wide swath of assets. The sheer size of the moves across different sectors has been disorienting. Here we try to take a big picture view and gauge valuations of the credit CEF space across multiple dimensions.

Our first port of call is very basic - to get a sense of high-yield corporate bond yields. The chart below captures the post-GFC 12-year period. We see that yields are about 0.8% above their average and median levels and that they have only been higher during periods of serious distress - the Euro crisis in 2011-2012 when a number of European governments were thought to be on the verge of default, the Energy crash of 2015 when 20% of the Energy / Natural Resource sector defaulted and, most recently, the COVID period.

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Systematic Income

What is also notable about the chart is the speed of the bounce from the recent high just last week. As of this writing, the data from FRED has not yet been updated for 27-May but, given the move in JNK, corporate credit yields fell further around 0.20%. This means that the retracement from the recent yield high is a full 1% - a big move by any count, especially to the downside in yields.

We don't know what yields are going to do going forward. But if 19-May marked the high in yields this year, the pattern will look pretty similar to all the previous peaks, all of which saw a very sharp rise in yields and a similarly sharp fall.

An arguably cleaner perspective is offered by credit spreads which strip out the impact of interest rates. Here we see that spreads are a touch below the median level. Credit spreads reached a peak of around 5% recently - a level which, in our view, was, perhaps paradoxically, attractive and well below the previous peaks. The reason is that the macro picture is still fairly robust, if weakening from its previously frothy level and that credit spreads don't actually spend a lot of time at their peaks, reversing fairly quickly to levels of 5-6% before grinding even tighter. If spreads continue to tighten to levels of 3.5-4%, we would consider the sector more fairly-valued and, hence, less appealing.

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Systematic Income

CEF investors are also interested in discounts. The chart below shows the historic median credit sector discount which is currently around 7% and is around 2% wider of the historic average this century.

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Systematic Income

For another perspective, let's consider the following chart. It shows how much of the total net portfolio yield (i.e. after leverage and fees on an NAV basis) that a typical high-yield bond CEF delivers goes to service its expenses. Our readers likely recall our lamenting the fact that in the second half of 2021, because of low bond yield, this figure crept up to 30% - a frankly, crazy amount for investors to dish out. It has now fallen back to a more sensible level of around 16%.

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Systematic Income

Another way to look at the question of CEF valuations is to ask the question - how much additional yield can CEFs generate over and above their unleveraged portfolios? The lower this number is, the less attractive it is for an investor to take the leveraged exposure and discount risk of CEFs. This number fell to around 0.5% in the second half of 2021, meaning that for all their huffing-and-puffing, a typical High-Yield bond CEF could only add a measly 0.5% above its asset portfolio. This number has now risen to a more respectable 2.1%.

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Systematic Income

Obviously, the big difference between now and then is that while the macro picture still looks OK, inflation is obviously very high, which is the primary reason why yields are high also. Clearly, it would be a better investing environment if everything were the same and inflation were lower - however, that's not realistic.

In our view, having an environment of attractive valuations, decent macro and high but peaking inflation is a better one than one with a poor macro picture and low inflation. In short, corporate credit yields north of 7% in an environment of sub-1% default rates and peaking 6.2% year-on-year core CPI is preferable to one of 4% default rates and 1% year-on-year core CPI.

All of the metrics discussed above point to the fact that the credit environment is fairly attractive, if not as attractive as it was at the end of last week.

Market Commentary

Three Wells Fargo / Allspring CEFs trimmed their distributions. These funds use a 12-month average NAV lookback managed distribution policy, i.e. MDP. So if the NAV starts to trend lower as it has for obvious reasons in the last few months, they will reflect this in lower distributions. This worked well on the upside as NAVs recovered through 2020 and 2021 but has obviously reversed. A programmatic MDP that these funds have is a good way to forecast / anticipate distribution changes. It’s worth watching these funds - EAD, ERC, EOD - in case their discounts get really cheap which they can as some investors will invariably interpret their distribution cuts as linked to poor performance. We have previously trimmed out allocation to EAD in favor of CIK.

CLO Debt / Equity fund Eagle Point Income Co (EIC) reported results which were fine. GAAP income ticked up by a penny in Q1 and has moved higher each quarter in the last 5 quarters. Higher Libor has been feeding through income from day-1 unlike the majority of loan funds because CLO Debt securities have no Libor floors. The company lucked out on fixing about 2/3 of its liability profile in 2021 at 5%. It would probably have to pay something like 7.5% if it wanted to issue a preferred today. With CLO Debt yields at 9-10% (and moving higher) and CLO Equity north of that, the fund offers a strong income generating capacity even if its cost liability cost is above that of the average credit fund. That said, it has the lowest leverage cost of all CLO funds.

In April, we trimmed our EIC allocation (timing shown by vertical red line below) given its high premium and reallocated the capital evenly into ARDC and TCPC, both of which have outperformed the fund in total return terms since then.

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Systematic Income

The fund's valuation is tricky to gauge – the discount is around 8% off the April NAV but credit spreads have moved significantly wider in May, so the discount is probably actually pretty flat in reality. For example, the NAV of XFLT has fallen around 12% so far in May, so the NAV of EIC is also obviously quite a bit lower than its last stated April figure.

We didn't discuss the latest cuts in the Flaherty preferred suite (FFC, FLC, DFP, PFD, PFO) when they were made in April, so it's worth saying a few words now. We had an article out in February on FFC that said that the entire suite was looking at substantial drops in income which will likely require significant distribution cuts. The reason for that is that the Flaherty suite don’t hedge leverage costs, so their income will drop by the most in the preferreds sector. FFC distribution is now $0.119 which is still above the $0.112 pre-COVID level. With short-term rates heading above their pre-COVID level, we should, in theory, see the distribution cut back to below the $11.20 level which is at least another 7% from here or around 14% from the peak.

CEF distribution coverage for April was updated for PIMCO and Nuveen CEFs. Numbers mostly rose for the PIMCO taxable funds except for PCM and PGP. PDO is at a very high 172% coverage with over 5 months of UNII (i.e. UNII equal to 5+ months' worth of regular distributions).

Some investors love PTY for its apparently high yield but once you look through to covered yield, i.e. net income yield on price (which takes into account both the net income and the valuation), PDO is at 15.7% vs. 12.9% for PTY. There is very likely going to be another PDO special distribution at the end of the year – perhaps bigger than the last one.

Stance And Takeaways

We had a rotation in the Municipal Income Portfolio this week. Two-thirds of the MMD position was moved to DMB – a BNY Mellon revenue-focused bond with a higher unrated bond focus. DMB has decent historic returns – about 0.7% above the sector average in the last 5 years in total NAV terms and is trading at a 6.7% discount, which is 2% wider than the sector average - fairly unusual for it - and a 5.33% current yield. MMD has outperformed the sector in the short life it’s had in the portfolio. It was added at a 3% premium valuation to the sector and moved out to a 9% premium valuation relative to the sector (now at a more modest 8% premium valuation).

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Disclosure: I/we have a beneficial long position in the shares of TCPC, PDO, CIK either through stock ownership, options, or other derivatives. 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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