Many income investors hold both senior securities (i.e. preferreds and bonds) in their portfolios as well as funds, particularly, CEFs. In this article we take a look at the question of how investors can think about a top-down allocation between senior securities and CEFs based on changing market conditions.
It’s important to say three things upfront. First, this is a big topic so to keep it contained we highlight three key benefits of both types of income investments as well as a pair of metrics to guide the allocation process. Secondly, there’s no single right answer – different investors will take a different approach even when looking at the same set of data. We also don’t recommend investors shift their allocations in a binary fashion from 100% in CEFs to 100% in senior securities or vice versa.
And thirdly, investors should consider their own capacity for generating alpha in either CEFs or senior securities. Specifically, investors who are wizards at driving additional returns by trading CEFs (and actually have the numbers to show for it) should probably continue to tilt heavily to CEFs even in a less favorable market environment.
Three Key Benefits Of Senior Securities
In this section we highlight three benefits of senior securities.
One key benefit of senior securities is their structural resilience relative to CEFs. For bonds and preferreds with a set maturity, this resilience is obvious – unless the issuer defaults on the security, investors are going to get their principal back.
With preferreds, the resilience is less clear cut as most are perpetual with no guarantee of principal repayment. However, the key point is that cumulative preferreds have a set coupon which they have to pay or, at the very least, accrue on a particular “par” or “notional” amount – typically set to a $25 liquidation preference.
It’s true that the population of non-cumulative preferreds is fairly large, however, these are typically issued by higher-quality financial issuers for whom a suspension of a preferred dividend would be tantamount to a default so they would only do this as a last measure before a default. Investors who don’t like the profile of non-cumulative issuers can also simply avoid them in their allocation.
CEFs do not have a similar anchor and their “principal” can move around based on market gyrations, portfolio losses or gains and deleveraging. This last driver is often overlooked because it is not always obvious. For instance, as we have discussed earlier, Nuveen preferred CEFs, unlike the rest of the sector, deleveraged during the COVID crash – the summary of borrowings before and after are shown in the table below.
A deleveraging is not always a negative for a fund, however, in a reverting market environment such as the first half of 2020 it was a big negative. A deleveraging locks in permanent capital losses because there are fewer assets to take advantage of the bounceback, particularly, if the fund is slow to add assets back. It also reduces the fund’s income and often leads to a distribution cut or at least a drop in distribution coverage.
We can see how the deleveraging of the Nuveen preferred CEFs impacted their subsequent performance in the following chart where we compare the two perpetual Nuveen preferred CEFs (the other two funds are term funds and tend to run at lower leverage levels) to the rest of the sector. The chart clearly shows that Nuveen funds kept up very well with the sector into the drawdown and then sharply underperformed during the recovery phase since they now had fewer assets to drive the recovery in the NAV. It’s also not surprising that they quickly trimmed their distributions after the deleveraging as an acknowledgment of their fewer income-producing assets.
Another good example is obvious from the MLP CEF sector which had a large deleveraging during the COVID crash which has locked in permanent economic losses, causing it to underperform MLP open-end funds.
It’s tempting to think that investors can simply pick funds that won’t deleverage or find managers that “stick with it.” And it’s true that some funds are more or less likely to do so. However, as we highlighted above, sometimes a deleveraging can actually be beneficial to a fund, such as during a long drawdown rather than a sharp and swift one that we saw in 2020. So managers must always evaluate the likelihood of a drawdown to keep going in deciding whether to deleverage or not.
And secondly, there’s no fund that can simply ignore a drawdown – sooner or later a leveraged CEF will have to deleverage, either because of a forced unwinding of its credit facility or because its equity or net assets will threaten to go negative.
A second benefit of senior securities is that what we call a “WYSIWYG yield.” We don’t want to stretch this too far since no single yield metric is perfect at capturing the true yield of a senior security (though yield-to-worst comes pretty close). That said, it’s a lot easier to get a sense of yield of a typical senior security than it is for a CEF. This is because CEF distribution rates often have very little relationship to the true yields of their underlying assets.
We like to make a distinction between three types of CEF yields – current yield (i.e. distribution rate), net investment income NAV yield and portfolio yield. Most investors think that gauging the fund’s NII NAV yield (and by extension distribution coverage) is the end-all and be-all of CEF yield analysis. However, that view mistakes NII NAV yield for the actual yield earned on investor capital i.e. the portfolio yield.
A good example is the municipal sector. The table below shows the various metrics of the S&P Long Term National AMT-Free Municipal Index. An unleveraged CEF that held this index with 100% distribution coverage would have a current yield / distribution rate of 3.65% whereas the fund’s portfolio yield would actually be just 1.58%.
The point here is that yield-to-call / yield-to-worst is not adequately captured for callable assets such as preferreds, high-yield bonds, municipal bonds, and many other fixed-income assets. This means that gauging real CEF yields can be a guessing game and many investors assume that high CEF yields represent what they actually earn on their capital. However, even with 100% coverage the distribution rate of a given CEF can significantly overstate the true yield.
It’s also worth saying that the entire yield of senior securities go to investors while the CEF vehicle has management fees and operating expenses which are, in effect, paid by CEF shareholders.
Finally, investors who allocate to senior securities have full control over their holdings. A CEF can have hundreds of holdings and while many investors are comfortable giving fund managers full discretion over their positions, some investors like to pick and choose.
A good example here is the fact that investors in preferred CEFs will be significantly overweight financial issuers. For example, a popular fund like the Flaherty & Crumrine Preferred and Income Securities Fund (FFC) is 81% allocated to financial issuers. This is broadly in line with other preferred CEFs as well for the simple reason that 1) the preferred sector is overweight financials and 2) preferred CEFs tend to allocate to higher-quality rated preferreds, which excludes a lot of unrated issuers outside of the financial sector.
Investors who pick and choose among individual senior securities can underweight financials or avoid them altogether and tilt to sectors or individual securities they find attractive.
Three Key Benefits of CEFs
CEFs have their own benefits and in this section we discuss three of the ones we find most compelling.
First, CEFs are common shares of actively managed investment vehicles and can therefore benefit from alpha, or the additional return generated by its managers over and above a static portfolio of securities. For example, if the managers generate an additional 1% annual return, this flows directly to the bottom line of common shareholders either in a NAV increase or additional distributions. Tilting to funds with a consistent level of alpha generation has been one of our strategies for CEF allocation.
The second benefit of CEFs is instant diversification. Many CEFs are well diversified with many running a three-digit number of positions across multiple subsectors. Building such an extensive portfolio can be a tall order for investors in senior securities, potentially leaving them overexposed to a few issuers. One way to manage this risk for senior security investors is by holding what we call systematic securities which are wrappers of other securities such as mREIT preferreds or BDC bonds.
Finally, an advantage of CEFs is they can provide direct access to niche subsectors allowing investors to fully capture a high conviction view. For example, through the past year we have highlighted sectors such as CLO debt via (EIC), non-agency RMBS via (DMO) and CMBS via (IHIT) and (IHTA). DMO, IHIT and IHTA significantly outperformed all the PIMCO taxable fixed-income funds this year in total NAV terms while EIC kept pace with the PIMCO crowd while also trading at a wider discount and delivering a higher yield. Preferred securities can only offer indirect access to these sectors via the handful of CEF preferreds (i.e. preferred shares issued by CEFs) and cannot capture nearly as much upside as they don’t offer direct exposure to many fixed-income sectors.
So what metrics can investors use to guide their allocation between senior securities and CEFs in an income portfolio?
One metric we like to use is what we call CEF excess yield which is simply how much CEFs are adding above and beyond the yield of their underlying securities i.e. the portfolio yield. For example, a CEF holding a portfolio roughly approximating the high-yield corporate bond index will have an unleveraged (i.e. total asset) portfolio yield of 4.36%. The question is then what’s the resulting yield investors earn on their capital once fund fees and leverage is taken into account? Recall that this number will differ from the fund’s distribution rate or net investment income yield as they don’t accurately capture yields-to-call.
To provide some intuition about how the 4.36% yield will flow through the “CEF sausage factory” we can have a look at the following chart. We start with the 4.36% yield, add to it the additional 2.35% yield generated by the fund’s leverage (using 35% as the average figure), take away average management fees and leverage costs, add in the impact of the broader CEF market valuation (of around 1% discount) and come out with a yield of 4.86% on net assets.
All in all, a fund that starts with assets yielding 4.36% ends up providing a CEF excess yield of 0.55% on net assets. Obviously, different CEFs will have different inputs to this “sausage factory” but the point is to provide an intuition about the broader CEF market.
If we calculate this number for the High Yield CEF sector (which we can use as a proxy for the broader credit CEF market) we get the following chart. The excess yield calculation is based off the weighted-average rating profile of the sector and current average yields for a given rating.
The chart shows that the current excess yield offered by high yield is relatively low historically despite rock-bottom leverage costs. Once CEF leverage costs begin to rise with the expected Fed hikes next year, the CEF excess yield will fall further, unless credit yields rise to compensate (with the side-effect of lower fund NAVs).
Obviously, not all credit CEFs share the same excess yield – higher-quality funds have a lower excess yield than lower-quality funds, all else equal, while funds trading at sizable discounts can also sport attractive excess yield levels. However, the point here is to highlight the broader credit CEF investment environment.
It should be noted that this approach is less useful for equity CEFs which don’t lend themselves to a yield based approach since their business model is not to leverage the underlying yield but to turn capital gains (or ROC in the absence of capital gains) into distributions.
The key point here is that, ultimately, investors are taking explicit leverage risk by allocating to CEFs as opposed to open-end funds or senior securities for which they should be compensated. Leverage risk not only increases downside exposure but also carries the risk of deleveraging, potentially locking in permanent capital losses. The current aggregate level of excess yield is relatively low historically which suggests that current compensation for taking on leverage risk is also relatively low.
Our second approach is to gauge the broader market environment by looking at 1) CEF valuation i.e. discounts and 2) credit valuation i.e. credit spreads. An environment of wide CEF discounts and wide underlying credit spreads is particularly attractive for CEFs as they can deliver excess returns by the tightening of discounts and by leveraged exposure to rallying assets.
The chart below shows a monthly picture of these two metrics over the last 10 years with the red dot – Dec-21 – showing the current environment. The current market environment is well inside the red circle which, in this approach, suggests that the current environment is relatively unattractive historically. More attractive environments have been during the commodity crash in 2015-16 as well as, obviously, during the COVID crash period and some months after it.
These two approaches both suggest that the current environment for CEFs is less attractive than it has been historically. This doesn’t mean, of course, that CEFs can’t keep performing, particularly if the markets hold up. Plus, there are always more and less attractive individual opportunities in the CEF market.
The big picture is that by allocating to CEFs vs. senior securities, investors are taking on both leverage risk and the additional risk of discount widening. Both of these can lead to permanent loss of capital via a deleveraging or by the discount moving to a wider (i.e. more negative) plateau, perhaps because of a distribution cut (either due to a deleveraging, a rotation into lower-yielding portfolio securities, a rise in leverage cost or a myriad of other possible drivers).
The key question for investors is whether a given CEF provides sufficient compensation for these two risks through either excess yield or alpha to make it earn a position in the portfolio. Hopefully, the three benefits of each investment vehicle and the two related approaches discussed above can provide a mental framework for a top-down allocation between these two types of investment vehicles in income portfolios.
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