The CEF space is somewhat unusual, at least relative to the open-end fund (i.e. ETF + mutual fund) market in that the link between distributions and underlying asset yields (i.e. what the fund portfolio actually yields) is fairly weak. In other words, fund managers have wide leeway in the distribution rate of their fund. What this means in practice is that the distribution rate of the CEF can be well above the underlying yield of its portfolio.

In addition to the “yield” (i.e. distribution rate or current yield) of a given CEF, the other key dimension for most investors is its underlying “quality”. This is more relevant for credit CEFs i.e. those that hold assets like loans, corporate bonds, ABS, MBS, munis, etc.

The attitude that many CEF investors have is that – well, all I am after is a high “yield” (by which they mean CEF distribution rate, i.e. current yield) so I might as well get the highest quality portfolio I can get for a given yield. A typical strategy here is to find CEFs with the highest “yields” with mostly investment-grade holdings. After all, who wouldn’t go for a “safe” fund with a 7%+ “yield”?

The trouble with this strategy is that it can lead to disappointing returns on investor capital for the simple reason that higher-quality assets don’t actually generate particularly high yields – at least not anywhere close to the current yields of these funds.

To illustrate this point let’s take a look at CEFs with a higher than 50% investment-grade allocation (“IG” on the y-axis) and an above 6% current yield (on the x-axis) in the chart below. The key point is that funds in the upper-right quadrant, i.e. those with both a very high quality allocation and high current yield will likely struggle to deliver returns anywhere near their current yields.

Source: Systematic Income

To illustrate how this works let’s pick out a number of funds towards the upper right quadrant and compare the 5-year total NAV returns to their current yields. We used 5-year returns for 2 reasons. First, 10-year Treasury yields were about what they are now 5 years ago which controls for any large duration impact. And secondly, it’s a decent balance between the short and long-end returns, capturing enough of a historic track record without being so long as to be irrelevant for current discussion.

The chart below shows how the current yields (orange bars) of these funds stack up to their 5-year total NAV returns (blue bars). It is clear from the chart that the actual NAV returns generated by these funds are well below their “yields”. This is not particularly surprising for the simple reason mentioned above that the higher quality allocation of these funds makes it difficult for them to generate high NAV returns since high-quality assets also tend to have low yields.

Source: Systematic Income

More broadly, there are significant challenges to the high-quality CEF model in the current market environment. First, high management fees are starting to take a big chunk of underlying yields. With AA-rated taxable bond yields at around 2% and CEF fund fees in the range of 0.8-1% it means fees will eat up close to half of the underlying yield.

And secondly, leverage is not going to save the day here since the cost of leverage for taxable credit CEFs is around 1%, which after management fees, is bumping right against the 2% yield of AA bonds, leaving little if anything to investors.

Investors who are betting on high-quality portfolios having low volatility / drawdowns may be disappointed since discounts will typically widen significantly even for high-quality portfolio CEFs. The chart below shows that price drawdowns in 2020 were well above the NAV drawdowns of these funds.

Source: Systematic Income

Are there good reasons for holding high-quality portfolio CEFs? Sure, particularly for investors who think that Treasury yields will move lower or those who believe a given management team will deliver significant alpha or where a given fund is trading at an unusually cheap valuation. However, in most situations, investors should think twice before going for the “free lunch” offered by CEFs with high current yields and high-quality portfolios.

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