Weekly CEF Market Report - May 2, 2021

Macro Picture

Equity indices hit new highs on Thursday before giving up those gains on Friday and ending the week mostly lower. Energy stocks proved to be the overall winner with oil reaching a six-week high. Communication services also did well thanks to strong earnings reports from Facebook and Google. Microsoft weighed down the tech sector despite a strong earnings report.

180 stocks of the 500 in the S&P 500 reported last week so we are now past the bulk of the earnings season.

We did have an FOMC meeting last week and Powell reiterated that he does not see any rate increases on the horizon. What he did note was there appeared to be froth in areas of the equity markets in his post-meeting press conference. Powell reiterated that the Fed would wait “some time” before raising rates, while also saying that policymakers were not ready to begin planning for a reduction in asset purchases.

Lastly, Covid numbers seem to be on the wane in most states with the "fourth wave" already petering out. This seemed to encourage investors though India's numbers and a possible new variant did add some concern. The US is sending 60m doses of stockpiled AstraZeneca vaccine to India and other countries that are having problems.

Commentary

Discounts tightened up a bit last week and remain near 8-year tights. Taxable CEFs are just under par (my adjustment for a few funds) and muni CEFs are now at -2.3%, their lowest in a couple of years.

It remains a market where you need to stick to your plan and resolve to the fact that nearly everything is overvalued (the everything bubble) and at any point the S* can hit the fan and unwind it all, a la' March 2020. No one knows what that catalyst will be. I hear a lot about the Taper Tantrum but I have a hard time believing it will be something so well known, and so well telegraphed by the Fed.

Instead, it is that unknown unknown ("UU") that will cause spreads to widen back out and discounts to crater. That UU can come tomorrow or not for several years. As I've noted, just because spreads are tight and discounts in taxables really tight, doesn't mean they have to widen. They can remain tight for long periods of time.

So the goal for you the investor is to minimize regret and focus on risk management. That includes building cash/safe buckets, reducing CEF exposure, reducing high yield/floating rate exposure, and of course, reducing equity exposure.

But remember, that does NOT mean get out of everything. It means slowly reducing risk. In my account, that means selling things that are extremely overvalued and when not finding a replacement swap, moving to an open-end mutual fund or ETF. Of course that means reducing your income production. It is a delicate balance and one without an easy answer.

As I noted many times, the goal is to minimize regret- so that means doing shifts and reductions in positions incrementally. What that looks like is instead of selling an entire position, doing so in thirds or quarters over time. You sell a third of your position at one level, and if it continues to rise, sell another third.

What this does it reduces that regret. If the shares continue higher after the first sale, you still have 2/3rds the position to participate in the gains. If it drops after the first sale, you are at least partially happy you sold some at a higher price.

I think it is important to note that while taxable bond CEF discounts are tight, they are not extreme with 17% of all observations being tighter than current levels going back to 1996.

In muni CEFs, that number is 37% which is why I think there is more value left in the muni space. While the threat from higher long-term interest rates is real (and likely), the real threat to a muni CEF, longer-term, is from rising short-term rates. The borrowing cost feature of a muni CEF is far more important than a likely temporary decline in the NAV from a rise in long-term rates. With the Fed staying put for at least another year, the threat is minimal.

And with the prospect of higher taxes near term, munis are going to get a lot more spotlight and demand. Supply constraints still abound so the technical setup is likely to be in favor of the muni CEF investor.

Obviously, the big news on the week was the PIMCO merger drama. I still regard this as a bit of cover. We tend to see a significant uptick in mergers and acquisitions happen late in the cycle. CEFs are seeing a strong number of mergers and liquidations lately. So much so that the number of CEFs in existence is about 100 fewer than it was five years ago.

The IPO market for a CEF is relatively strong but remember, the market can only handle a few CEFs coming out at the same time. CEF launches need to be timed for when there is little else to invest in (CEF-wise) so that they can maximize the assets garnered.

With fewer options in the space and more investors looking/turning to CEFs for yield, I expect the paradigm to be tighter discounts for the medium-term. I also think it will be harder to produce alpha by swapping "like" funds if those like funds merge together- obviously.

This past week I didn't do much in my accounts but sit on my hands. I continue to hunt for taxable bond funds that have wide discounts, higher yields (even if not earned) because they are likely to be targeted by novice CEF investors. These are short-term trades as eventually the market will rectify that valuation.

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