CEF investors may be thinking of ways to bulletproof their portfolio in case the market hits another speed bump. Because CEFs tend to boast some of the highest yields across the investment space, many investors tend to allocate primarily or exclusively to these products. However, this misses out on the advantages that other investment products have over CEFs that do not necessarily require significant yield sacrifice. In this article, we discuss some of the advantages of senior securities such as preferred stocks and baby bonds over closed-end funds.
These advantages overall make senior securities more defensive and resilient over CEFs, all else equal. This is why our income portfolios have significant allocations to preferreds and baby bonds. Of course, this does not mean that preferreds are always better options than CEFs – far from it. Rather, investors should consider allocating across both sectors, depending on their risk appetite and investment goals.
The range of CEF management fees is very wide from levels comparable to those of passive ETFs to 4-5% such as those of CLO equity funds. CEF fee structure can be quite complex and non-transparent. The advantage of CEF senior securities is that their holders, in effect, have common shareholders to pay the fee for running the fund. There is no confusion about whether the income stream kicked off by preferreds and baby bonds is gross or net of fees or whether the income stream is covered by earnings or not. This makes senior securities a bit easier to think about.
CEF investors worry a great deal about potential distribution cuts. This makes sense – after all distribution cuts act as a kind of double whammy. First, they lower the yield on the fund holding and secondly, they often lead to a discount widening of the fund. Holders of senior securities do face a risk of dividend suspension, however, that would happen in a fairly distressed environment for highly cyclical and market-sensitive issuers such as REITs and mREITs that suspended dividends this year. The upside here is that non-bank preferreds are typically cumulative and so would have to be fully repaid before the issuer is able to pay common dividends.
CEFs have three sources of volatility – their underlying asset allocation, the leverage typically embedded in the fund and the fund’s discount. The chart below shows that price drawdowns of PIMCO CEFs, for instance, were significantly larger than their NAV drawdowns.
Drawdowns can present two major problems for income investors. First, they make it more difficult to manage the behavioral impulses that can push investors to sell at the trough and miss the upside during the inevitable recovery phase. And secondly, they limit how much capital is available to reallocate to attractive opportunities in a period of low asset prices.
Of course, this is not to say that senior securities don’t have large drawdowns which they often do. But the main difference is that senior securities don’t have an additional procyclical discount component which further pushes prices down during downturns in excess of NAVs.
Deleveraging is a considerable risk for CEF investors. A forced deleveraging by a CEF is typically caused by excessive asset volatility that pushes the fund’s leverage levels close to or above their contractual levels or simply levels in excess of what the manager feels comfortable with.
The trouble with a forced deleveraging is that it can lock in permanent capital losses if asset prices recover after the deleveraging. This is because the fund controls fewer assets on the move higher than it did on the move lower. The chart below can illustrate how this can happen.
Senior securities, because they are not pools of assets, are not liable to deleveraging and so can recover in price back to pre-drawdown levels quicker, all else equal.
One thing that makes CEF allocations risky is the high premium levels of some funds. This is particularly true of funds that have high distribution rates, whether those rates reflect actual fund earning yields or not. A high premium makes the fund’s price level highly dependent on its continued high distribution rate and when this changes, it can lead to a sharp collapse in premium and hence price.
We have seen this dynamic play out across a number of PIMCO funds through the years as well as more recently. Another poster child for this dynamic is the pair of Stone Harbor EM Funds shown in the chart below. These funds boasted extremely high distribution rates which attracted a lot of investor demand and when the distribution was cut the premiums quickly deflated, leading to heavy losses.
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