Worries Mounting Over DMO Distribution + 20% Sale

Summary

• Welcome to another weekday blog post from Systematic Income.
• Possible CEF distribution changes are some of the more popular discussion topics at Systematic Income.
• A number of subscribers have expressed concerns over an upcoming distribution announcement and a possible cut which we explore here.
• Take advantage of a 20% discount until the end of the week and take a 2-week free trial of Systematic Income to explore our Income Portfolios and our Investor Tools.

Welcome to another weekday blog post from Systematic Income.

Many of our subscribers on the service follow upcoming distribution announcements and evaluate the likelihood of distribution hikes or cuts in order to maximize portfolio income and maintain strong total returns.

The Western Asset Mortgage Opportunity Fund (DMO) is a fund that announces quarterly and its next distribution announcement is coming up. A number of subscribers expressed concerns of a possible cut due to sub-par distribution coverage. We use three sources to gauge the fund's coverage: Section 19a disclosures, quarterly financial releases and shareholder reports. The message from all three is fairly clear - the fund's distributions are well in excess of its income. 

The second piece of evidence that has made investors nervous is the pattern of cuts after holds. To be fair, it's a small sample size but the fund has cut repeatedly after holding distributions fixed for one quarter. Since the fund also held distributions fixed in the last quarterly announcement the concern is that the next quarterly announcement will be a cut.

Our own view is that a cut is fairly likely this time around and investors who are highly sensitive to maintaining level distributions of their portfolios may very well reduce exposure here, particularly, in tax-efficient accounts. These investors should also consider fixed-coupon mortgage REIT preferreds with long call dates such as ARR.PC. Preferred stocks can't stop paying coupons unless they are in serious trouble which offers a measure of stability to income portfolios. This is one advantage of supplementing income portfolios with preferred stocks - something we practice at Systematic Income - as income portfolios built entirely out of ETFs and CEFs are much more susceptible to distribution and income volatility. 

Tactical investors may also want to pare back exposure due to a discount that has tightened meaningfully and is close to zero now.

For more strategic, buy-and-hold investors, however, it is not clear that reducing exposure is the right step here. Historically, the fund's discount has not always widened on a cut, particularly, when starting out at wider levels. Even if a cut happens, the fund's distribution rate will be relatively high in the CEF space so any discount widening is likely to be temporary. We also continue to like the legacy RMBS sector as a key diversifier in income portfolios. 

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