This is an extract from an earlier article at Systematic Income Premium.
Income investors rarely see eye to eye on the best sectors, securities and investment strategies. However, one thing that unites them is that they don’t like seeing their portfolio income drop over time. In this article we highlight some of the key income stability risks as well as strategies to manage them.
Factors Behind Income Instability
Most CEF investors have become more familiar with a number of factors that cause income instability as these became more apparent over 2022. Here we touch on 2 primary factors investors ought to keep in mind to avoid surprises.
The most important factor driving net income weakness since the start of 2022 is the rise in leverage costs. Most CEFs use floating-rate instruments for their leverage. We can see this dynamic in the chart below which shows the leverage cost profile of a typical tax-exempt Muni CEF. As short-term rates increase, funds have to pay more to maintain their leveraged assets which, typically, compresses their net income CEFs, particularly for CEFs that are overweight fixed-coupon securities.
An important issue is the magnitude of net income compression for various types of CEFs. A typical leveraged CEF running at around 35% leverage (i.e. total assets are 154% of net assets) will have about a third of its total assets (the 54% out of 154%) financed with leverage (with the remaining two-thirds – or the 100% – financed with equity). The following toy balance sheet shows these key figures.
This means that the rise in leverage cost will impact only a third of the fund’s total assets (the $54m of leveraged assets relative to $154m of total assets). From an NAV perspective, however, every 1% rise in leverage cost will cause net income (i.e. NAV income) to fall by about 0.5%. This is because the fund’s leveraged assets make up around half of its net assets ($54m of leveraged assets vs. $100m of net assets). For the typical bond CEF this means that the rise in leverage cost from around 1% at the start of 2022 to about 6% today has lowered net income by around 2.5%, all else equal.
The other important issue to consider here is that CEFs with different allocation profiles will fare differently from a rise in leverage cost. The toy balance sheet above implies that if a CEF has more than $54m of floating-rate assets, its net income would actually increase, all else equal, since this number of floating-rate assets will exceed its floating-rate liabilities, resulting in an increase in net income.
This discussion suggests a number of ways investors can position to avoid a drop in net income across their CEF holdings in a period of rising rates. One is to increase the allocation to funds with a significant floating-rate footprint. This includes CEFs with holdings of bank loans, securitized assets and CLOs, most of which are floating-rate.
Second is to allocate to unleveraged CEFs or open-end funds which, by definition, don’t face rising leverage costs. The chart below shows the net income profile of two unleveraged tax-exempt CEFs NUW and NIM vs. a typical leveraged CEF NAD. The starting point here doesn’t matter – what matters is the trajectory.
Finally, investors can tilt to funds that use fixed-rate leverage instruments. Admittedly, the pool of these funds is fairly small. It includes funds that allocate to CLO Equity such as XFLT as well as credit CEFs such as ARDC and FINS. BDCs also tend to boast a significant amount of fixed-rate borrowing – around half of total borrowing.
Across our own allocation we have used all three strategies for dealing with rising leverage costs – by holding unleveraged tax-exempt open funds such as the Nuveen Short Duration High Yield Municipal Bond Fund (NVHAX), increasing our allocation to BDCs such as BXSL as well as the fund Ares Dynamic Credit Allocation Fund (ARDC) mentioned above which has more than half of its liabilities in fixed-rate preferreds.
The final takeaway here is that it’s important for investors not to allocate with a rear-view mirror. The risk to short-term rates going forward is very different than it was in 2022. As the market consensus and the Fed both expect, there is much more downside to short-term rates over the medium term. Once short-term rates start to drop, leverage costs of most CEFs will start to fall which can allow them to partially reverse their distribution cuts. This is why we recently increased our allocation to a fund like NAD whose net income has fallen over the past year.
A final point on CEFs is to highlight funds with managed distribution policies or MDPs. There are different kinds of MDPs but some are linked either explicitly or implicitly to the fund’s NAV. Funds like MCR or MMT, which have distributions linked to the previous months’ NAV will see monthly changes to their distributions so when the NAV drops, the distribution will drop as well. And since many of these funds also overdistribute, the NAV will tend to move lower over time (because it is used to partly finance the distribution) bringing the distribution lower as well.
Outside of CEFs there are a few other things to keep in mind. Just like floating-rate assets can drive fast-moving changes in CEF net income, they can drive dividend changes in securities like floating-rate preferreds and BDCs.
For these income assets, however, there are two factors to consider. One is that the coupons of preferreds (both fixed and floating-rate) are contractual so investors are not going to be surprised by changes in preferreds dividends because they are driven by a coupon formula. This can provide investors more control in planning their portfolio income. Specifically, investors can sell the floating-rate security if its dividend is expected to decrease over time and move into a fixed-rate alternative. We continue to allocate to the floating-rate mREIT Annaly Capital Management Series F (NLY.PF), trading at a yield north of 10%.
And as far as BDCs, many BDCs carry very high levels of distribution coverage – in the region of 120-140%, meaning there is a lot of cushion if base rates start to fall. These coverage figures tend to be significantly higher than coverage of floating-rate CEFs. This can allow them to maintain their current dividends even if the Fed starts to reverse its previous hikes. This is one reason why we continue to hold BDCs such as Ares Capital Corp (ARCC) and Sixth Street Specialty Lending (TSLX) as we don’t expect them to cut the dividend once short-term rates start to fall.
Another risk that doesn’t always come up on investor radars is reinvestment risk. Many investors hold cash or short-dated bonds in their portfolios for the purpose of ballast or liquidity, particularly since the yield curve remains inverted. However, short-dated assets will need to be reinvested soon enough and if yields fall, investors may be left reinvesting the capital at much lower rates. Of course, this doesn’t make these allocations unattractive but it’s something to keep in mind as interest rates have fallen across the curve over the last month or so.
A final income stability risk factor, which unfortunately recently reared its head, is dividend suspension for preferred securities. Investors in equities are already familiar with this risk, if not total suspension, then in the form of dividend cuts. First Republic Bank recently suspended its preferreds dividends, though this did not come as a shock given the preferreds were trading not far from $5 (vs. a $25 “par” amount). Our strategy here has been to allocate to larger systemically important institutions that operate under a stricter regulatory regime.
In our recent articles we highlighted the value of allocating to larger too-big-to-fail banks which face stricter supervision and tend to run at higher levels of capital than regional or community banks. These banks may even benefit from a deposit reshuffle in the banks sector. In the sector we continue to like US Bancorp Series A (USB.PA) and Wells Fargo Series Q (WFC.PQ), trading at 8% and 6.2% yields.
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