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MORL Vs. CEFL: Which Is The Better Choice Currently?

In the comments section of an excellent article done by Professor Brofman: the question was posed, "whether you think CEFL is a safer bet than MORL when the Fed ends ZIRP? My answer ended up being a much longer than I intended comparison of MORL and CEFL so I thought I would repost it here.

Hi dannyboy2,

Neither CEFL nor MORL is a good choice if you believe interest rates are going up sharply, both would lose lots of money.

CEFL currently is basically a covered call fund. All of the top 10 components are covered call / buy-write CEF's. You could buy SPY, leverage and sell covered calls on it to get essentially the same thing. If you are using a regular account at Interactive Brokers or some other provider with very low margin rates, you could even do this at a cheaper overall cost than CEFL and benefit from the majority of the returns being tax advantaged call premiums (returns on capital). Because the majority of CEFL currently is in covered-call CEF's, it also does not have as much diversity as one would hope. While the CEF's in it do trade at a discount, that discount is not significantly greater than average, and the combined fee's are fairly high (≈2.5%). So I would not call the underlying CEF's in CEFL cheap right now either. Overall, there are better choices available out there right now.

Covered call funds generally outperform when the market rises gradually and do ok when the market declines gradually. This is because the call premiums make up the majority of the return. When the market rises sharply they make money but under perform the market as the majority of the upside has been sold away via the covered calls (e.g. the market goes up 40% you make roughly 15-20%, half from stock appreciation half from selling the premium). When the market declines sharply, you still get all the decline but it is offset somewhat by the covered call premiums (e.g. market goes down 40% you lose 40% in the stocks but make 10% on the premiums for a net 30% loss).

Covered calls can really under perform when you get a sharp decline which bounces and is followed by a sharp rise. You take the majority of the ride down, but do not get the majority of the ride back up (e.g. 2008 -2010 period). Covered calls can be a good choice for someone trying to dampen volatility and produce tax advantaged income if they also have the contrary discipline and fortitude to sell them after the market has tanked (despite significant losses) and move into something riskier. Thus they work best as part of a more diversified portfolio, with a written policy on what to do when the market crashes and a little hand holding to make sure you actually do it. It is not easy increasing risk when the market has just dropped 40%+. You have to ask yourself, would you really do it?

Back to the original question, if ZIRP ending results in sharply rising rates (which I think is unlikely), stocks would likely see a significant drop (low rates having propped them up for years) causing CEFL to also drop significantly. It would also increase the cost of the leverage, hurting returns further. I do not consider CEFL a compelling investment right now and think the index criteria utilized needs to be changed to produce greater diversification, CEF's trading below average discount and no CEF's trading at premium's.

MORL would also be hurt significantly if ZIRP ending causes a sharp rise in rates or a significant flattening of the interest rate curve (short term rates up but not long term rates). I don't think the sharp rise in rates is likely but the flat curve could happen. That would hurt both the underlying spread business (borrow short, lend long) as well as making the leverage more expensive. If that happens, TSWHTF (The Sh!t Will Hit The Fan), MORL will see a significant loss (SPY probably won't be a safe haven either).

I think the most likely rate scenario is one small rise in short term rates taking us above 0 then a stop or very long cautious pause. If that doesn't happen and short term rates go up 100 basis points or more in a relatively short period of time while long term rates are held down by poor worldwide economics (aging of population, low oil prices, EU, Japan, China rate cuts effectively imported to the US) you could see a very flat curve or even an inversion. Again in this situation, look out.

MORL however can handle a muddle along economy just fine (what we have been in since 2009), and declining rates or even a gradual increase in rates ok (provided the rise is both long and short so the curve doesn't flatten further). MORL has a few components which hold MSR's that actually benefit from higher rates (e.g. NRZ, TWO), some which are more credit, commercial paper or special situation focused than rate focused (e.g. CIM, NCT), some which hold significant amounts of actual real estate (e.g NRF, HOT), and some who heavily hedge the agency portions of their portfolio's against interest rate increases (e.g. AI, EFC). So while MORL's largest components are agency paper holding NLY and AGNC, it's more diversified than many seem to realize. All you have to do to see this is compare what happened to MORL vs. NLY or AGNC during the taper tantrum. Essentially, MORL provides twice the yield of it's average component but with less than twice the risk. It is a well constructed ETF that actually adds value. Furthermore, many of the underlying components of MORL are currently trading at significant discounts to book. So in my opinion MORL is cheap right now (as is BDCL). Last MORL has a very low correlation to SPY, so for many people adding an reasonable allocation to it would actually lower overall portfolio risk.

Note if the above comment didn't already bore you to tears, here is an article I wrote on the YMBC (You Must Be Crazy) portfolio which utilizes UBS 2x ETN's such as MORL, CEFL, BDCL, DVHL, SMHD, SDYL to come up with a fairly well diversified very high yield portfolio:

Disclosure: The author is long MORL, BDCL, SDYL, DVHL.

Additional disclosure: The author may buy or sell any position mentioned in the next 72 hours without notice. This post is not meant as personal advice as I don't know your personal situation and therefore cannot make a recommendation. The post is intended for educational purposes only.