The volatility and heavy drawdowns across various assets of the past few months have caused many income investors to revisit the construction of their CEF portfolios. In this article we take a look at a number of strategies that investors can use to make their portfolios more resilient. These strategies are particularly relevant for a barbell approach to portfolio construction that allocates across a spectrum of assets.

Higher-Quality CEF Sectors

One obvious way to make a CEF portfolio more resilient is to tilt to higher credit-quality and lower volatility sectors. For instance investment-grade, limited duration and municipal sectors saw much lower NAV drawdowns earlier this year than the average sector.

Source: Systematic Income

MVT is a municipal fund with about 80% investment-grade holdings and JMM is a multi-sector fund overweight Agencies that is about 70% investment-grade. Both funds boast good distribution coverage. The MVT discount has compressed somewhat since we added it to our Focus List however the fund remains attractive versus the broader sector.

Source: Systematic Income

Our repeated refrain over the last few months has been that highly volatile asset classes are not compatible with the leveraged CEF structure. This is because they are more liable to a forced deleveraging and a lock-in of permanent income loss. This can leave investors with a difficult dilemma of remaining with a low-yielding asset on their cost basis or selling the fund and locking in significant capital losses due to sharp price and NAV drops.

Low/No-Leverage CEFs

The main benefit of no-leverage CEFs, which we covered in more depth earlier, is that they are at no risk of deleveraging and locking in of losses during drawdown periods. The chart below illustrates how a forced deleveraging can happen.

Source: Systematic Income

If this chart is too abstract consider a real-life example of the two popular PIMCO CEFs. The Dynamic Credit and Mortgage Income Fund (PCI) entered the drawdown period at a significantly higher leverage than its counterpart and consequently had to deleverage to a greater degree. This meant that it was unable to claw back losses to the same degree. 

Source: Systematic Income

No-leverage CEFs are not going to knock anyone’s socks off with their yields. Comparing them to leveraged CEFs isn’t the point however. A better comparison would be open-end funds which by-and-large don’t use leverage. Relative to open-end funds no-leverage CEFs can boast three advantages. First, they tend to have higher yields due to their ability to hold a greater variety of assets, regardless of liquidity. Secondly, they can boast lower effective fees (the discount effectively gives investors a rebate on the CEF fee). And thirdly, they offer active management whereas open-end funds tend to be passively managed.

A trio of Nuveen funds to watch here are:

  • Select Tax-Free Income Portfolio (NXP)
  • Select Tax-Free Income Portfolio 2 (NXQ)
  • Select Tax-Free Income Portfolio 3 (NXR)

These funds offer rockbottom fees with the bulk of the portfolios rated A and above. The discounts of these funds are trading on the tighter side so we would wait for better entry points.

CEFs With Resilient Leverage 

The market action of the last few months has shown which types of leverage structures are more or less robust. A less robust leverage structure is more likely to force a fund to deleverage and lock in permanent capital and income losses. There are two key drivers of leverage structure robustness: leverage mandates and leverage instruments. 

Those funds that have strict leverage mandates, capping leverage at a certain level, are more likely to hit them in a drawdown. In our view, this is what primarily explains the deleveraging of the Nuveen preferreds CEFs in March in comparison to the Flaherty & Crumrine funds which have no leverage caps and which did not deleverage.

Source: Systematic Income

The second element of this is the nature of leverage instruments. Some are more robust than others. For example, tender option bonds give lenders the right to get their cash back on a weekly basis which we saw happen in March across the sector. 

For example, all of the deleveraging that we saw across the PIMCO national muni funds was in tender option bonds rather than the more robust term preferreds. Because tender option bonds tend to have a lower interest rate funds are tempted to use them to minimize their leverage cost however this lower cost does not come without risks.

For this reason we would tilt to funds that underweight these instruments versus other more robust options. This is one reason why we have preferred the PIMCO Municipal Income Fund (PMF) relative to its two national counterparts. 

Source: Systematic Income

Term CEFs

We have written previously why term CEFs are useful additions to income portfolios. From a risk perspective these funds have three advantages. First, they tend to run at a lower leverage and reduce leverage into termination. Secondly, they tend to hold assets with lower durations which limit their volatility and drawdowns. And thirdly, they tend to have less volatile discounts since the termination date acts as an anchor which ensures convergence between price and NAV. 

Reasons why some investors avoid term CEFs are that they tend to see lower earnings and low current yields in the last years of their lives. The low current yields hide the fact that all-in yields (covered yield plus pull-to-NAV yield) are often significantly higher. There is also some possibility that the termination date may be extended though funds typically give investors an option to tender back at NAV.

Source: Systematic Income

JHB has begun to reduce its leverage this year though it still has $27m of borrowings outstanding down from $192m, equating to about 4% of leverage. The fund has cut its distibution by about a quarter since the start of the year to reflect this and currently maintains above 100% distribution coverage. We would estimate the all-in yield i.e. covered (or earnings) yield of about 4% plus pull-to-NAV yield of 3.2% resulting in an expected yield of around 7.2% which is pretty good for slightly longer than 1-year asset. The discount of the fund has recently widened which has made its pull-to-NAV yield historically attractive.

Source: Systematic Income

CEFs With Resilient NAVs

CEF sectors boast funds with different investment mandate, sub-sector exposure, leverage levels, alpha capacity and other factors. This is why their resilience to market drawdowns can be very different. The chart below shows that in the high-yield sector 1-year total NAV returns have ranged from -10% to 4%. Investors can choose to tilt to those funds that have displayed an ability to conserve capital during difficult periods.

Source: Systematic Income

CEFs With Attractive Discount Valuations

Solid discount valuations act as a kind of margin of safety in the CEF space. Funds trading at historically wide discounts, unless there is an obvious reason for it, will tend to be more resilient and less fragile in light of adverse events such as distribution cuts or market drawdowns. 

One of our favorite discount metrics is the discount sector spread percentile, which measures whether the fund’s discount is historically rich or cheap to its sector. We like to pair this metric with other ones such as the 1-year NAV return mentioned above for a more composite picture such as the chart below which highlights funds with resilient NAV returns and attractive discount valuations.

Source: Systematic Income

Rotate From CEFs into CEF Preferreds

Another strategy to increase resilience of income portfolios is to rotate from CEFs into CEF preferreds. This is not an option in all sectors but a good one in equity and CLO sectors. Preferreds in these higher volatility sectors have a more robust distribution and risk profile. For example, investors in the Oxford Lane Capital (OXLC) preferreds have flat 1-year returns while investors in the commons shares are sitting on losses of half of their invested capital.

Takeaways

In previous articles we have suggested that income portfolios can benefit from a barbell structure or an allocation that spans both defensive and higher-yielding assets. This type of portfolio structure has a number of advantages such as diversification and a store of dry powder to spend in an event of a drawdown.

There are many strategies that investors can pursue in their CEF allocations. As our last strategy suggests however, investors should also look beyond CEFs in building income-generating portfolios into products such as individual preferreds, baby bonds and open-end funds. Though most of these instruments tend to boast lower yields, their risk-adjusted income tends to be higher than that of CEFs of the same asset class due to their lower volatility. 

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