This article was first released for Systematic Income subscribers and free trials on December 18th.
Welcome to another installment of our weekly CEF Market review, where we discuss closed-end fund (“CEF”) market activity both from the bottom up and highlighting individual fund news. and events as well as top-down, providing an overview of the wider market. We also try to provide some historical context as well as relevant themes that appear to be driving markets or that investors should pay attention to.
This update covers the period from the third week of December. Be sure to check out our other weekly updates covering the business development company (“BDC”) sector as well as the preferred/junior bond markets for perspectives on the broader income space.
This will be our last CEF Weekly for the year. happy holidays to our readers.
CEFs were mixed this week. However, most sector discounts have moved wider. This is a trend that has been in place for about a month now, as the following chart shows. This widening of discounts at fairly stable NAVs indicates that investors may be exiting CEFs either to collect tax losses or for other reasons.
This discount weakness is particularly evident in the fixed income sector, where the average discount for the sector is not far from this year’s low of 10%.
Year-over-year underperformers are higher-beta or longer-duration sectors such as REITs, Converts and Taxable Munis. MLPs were the only sector that advanced, and Utilities rounded out the sectors that did better than the 10% decline. EM Equities is the only sector whose discount has moved in the opposite direction to its NAV, which is otherwise a common pattern for large NAV movements.
There was a discussion of the concept return on cost on the service, which is something many investors look to when deciding how to allocate their capital. This concept comes into play especially when comparing investment opportunities today to when prices were lower.
For example, suppose a fund is trading at a 10% yield today, but an investor bought it when it was trading at a 12% yield, ie, when its price was significantly lower than it is now (for simplicity, assume the distribution is unchanged). The opinion of many investors is that well. I can’t afford to redeploy the capital tied up in this fund because I (mostly) can no longer find 12% returns anywhere else.
This way of looking at a portfolio then locks investors into certain positions that they have acquired at much lower prices. Our opinion is that this approach is not correct. A fund’s 12% return may have been true when the position was acquired, but it is no longer true. The capital allocated to the fund now earns the 10% return it has today. The capital allocated to the fund at any given time gives everyone exactly the same return – the return where it is currently trading.
The price increase, which raised the fund’s yield from 12% to 10%, increased the amount of capital allocated to the position. In other words, to generate the same return on the fund as when it was purchased, the investor must now commit more of his capital to the position, and this lowers the yield from 12% to 10% in the example. Many investors act as if the capital gain and capital appreciation dedicated to that position does not exist, but there is a lot, built into the original position.
This also means that it is much easier to analyze what your capital is doing in any asset; there is no need to return to the basis of cost. just look at the return on the asset today and there’s your answer.
Note that this does not take into account tax considerations. Rotation out of a large capital gain position may have tax implications and this consequence should be considered. This is what is called a capital gains bracelet. a large gain in a taxable account makes it more difficult to sell the position because it will incur a large tax expense, not accounting for capital losses. This year, this situation is less likely and, naturally, it does not exist in a tax-free account.
Blackstone credit CEFs Blackstone Senior Floating Rate Term Fund Fund ( BSL ), Blackstone Strategic Credit Fund ( BGB ) and Blackstone Long-Short Credit Income Fund ( BGX ) raised their allocations by 10-20% higher on BSL. BSL’s higher growth had much more to do with its oddly low distribution ratio of just 6.3% to NAV, compared to about 8.9% for the credit sector, a disparity we’ve highlighted before.
BSL has a higher proportion of floating rate assets at around 95% compared to around 80% for the other two funds, which helps boost its returns compared to the other two funds. Interestingly, BGX and BGB offset this to some extent by having higher levels of leverage, as well as having fixed-rate preferences as part of their overall leverage, which helps boost returns as short-term rates rise. It’s the third increase this year for the trio, though the first increase only offset the odd reduction in cash distributions in the first quarter. Overall, BSL is a reasonable loan option in the CEF space and one that makes sense for a tax loss rotation. Guggenheim Taxable Municipal Bond & Investment Grade Debt Trust (GBAB) appears to have released a semi-annual report. however, it was only a modification of what was previously published. GBAB is the only one of the three taxable muni funds that does not appear to disclose income on a monthly basis, making tracking difficult. It is also the only fund in the sector that has not cut its distribution this year. However, just because it didn’t cut its distribution doesn’t mean we don’t know what happened to its earnings.
Even before looking at the report, we can say with almost 100% certainty that his net income is down this year for two reasons. deleverage due to sharp drop in NAV.
These two drivers of net income, combined with fixed income assets, mean that net income should fall. Clearly, not all CEFs have fallen victim to this dynamic; The Western Asset Mortgage Opportunity Fund (DMO) is one that is straightforward in two respects, as previously discussed, but almost all other leveraged funds have become.
We’ll know more when the actual report comes out, but we have the GBAB monthly Section 19s showing how much ROC is being distributed. The ROC rate has risen from 20% to more than 30% this year, which is quite a contrast to what is happening with the other two taxable community CEFs. GBAB has the highest rating in the industry. in fact, it’s the only fund that trades at a premium that should change when it’s shorted.
Positioning and Takeaways
We see quite a bit of weakness in CEF discounts versus stable or higher NAVs. Over the past few weeks, discounts have increased by around 2%. This could be due to tax loss selling, but assuming the money is just floating around the CEF market, we shouldn’t see much discount weakness overall. This suggests that it is likely that investors are pulling money out of the area. Individual funds worth watching are MFS High Yield Municipal Trust (CMU), Western Asset Mortgage Opportunity Fund (DMO), Angel Oak Financial Strategies Income Term Trust (FINS), and PGIM Global High Yield Fund (GHY).
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these shares.