With CEF valuations growing richer across the board we discuss how investors can think about allocating to CEFs versus other types of income securities in their income portfolios.
One For The Books
Before digging into different approaches of thinking about CEF allocations let’s have a look at recent CEF returns. To show what a crazy November we had, the chart below shows average CEF sector monthly total price return from the start of the century. Since then we have only had three months of double-digit positive returns for the average CEF sector. Two of them were coming out of the GFC both which were slightly higher than the November figure. A few other months came close such as this April and January of 2019 as well as a few dead-cat bounces in 2008 but all of those high returns were a result of sharp drawdowns in the immediately preceding months. Of course one reason why we had such a stand out month was that the most recent rally kicked off, as if on cue, on the first day of the month. However, this doesn’t fundamentally change the fact that November was really a unique month as the preceding months were not big drawdown months. October was a little weak but not out of the ordinary and the big drawdown month was more than half a year back.
Now, on to the main topic of how investors can think about allocating to CEFs in their income portfolios versus other types of income securities. We are the first to recognize that every investor has different needs and views and that the same prescriptive approach is bound to fail. This is why we have three different conceptual frameworks that we utilize and that may be helpful to other investors. Each is discussed in turn in the sections below.
1) 2-Dimensional Value Approach
One way to think about allocating to CEFs is to think of the process in terms of a 2-dimensional valuation space of underlying assets (the stuff that the CEFs hold like bonds, loans, etc.) and CEF discounts.
The most attractive time to invest in CEFs is when underlying valuations are attractive e.g. credit spreads are wide and when CEF discounts are wide as well. It is undoubtedly true that it is also a fairly difficult time to put capital to work because existing positions are likely to be severely underwater with volatility and uncertainty running at very high levels.
We can illustrate this two-dimension allocation approach with the following chart which shows how credit spreads and median CEF discounts have evolved over the last two years. Clearly, not every CEF holds corporate credit assets or fixed-income but this approach is broadly applicable to other CEF sectors though with their own asset-specific valuation metrics.
The chart below shows asset valuation, in this case high-yield credit spreads, on the x-axis and CEF discounts on the y-axis. The most attractive allocation period is in the lower right, when both credit spreads and CEF discounts are both wide and least attractive in the upper left when both are tight.
Starting in December of 2018 during the Fed communication fiasco both credit spreads and CEF discounts were relatively wide. Following that month we saw an extended period of tight credit spreads and tight CEF discounts. In March of this year, high-yield credit spreads blew out to above 10% and CEF discounts finished March more than 5% wider than where they started the year. In retrospect, March month end and the following months were terrific times to put capital to work as credit spreads continued to recover and discounts continued to tighten.
Where does this leave us now? Credit spreads are not far from where they started the year. Further tightening is certainly possible but the risk/reward looks asymmetric given we have retraced 80-90% of the drawdown. Discounts are still quite a bit wider than the start of the year so there is still some juice left on that front. Overall, while we are still not quite at the very expensive levels we saw at the start of 2020 the valuation situation is no longer as compelling as it was over the last few months
2). Checklist Approach
A checklist approach is less valuation focused and collates a number of broad metrics as a guide to CEF allocation. The key metrics to consider, in our view, are CEF discounts and underlying asset valuations already discussed as well as leverage costs, seasonality / technicals and market sentiment.
As highlighted above on the CEF discount front there is some more juice left to squeeze there. How much more is tough to say – different time horizons give us different guides. On a 7-year time horizon discounts are not far off their average levels. If we go further back, however, toward the start of this century then discounts are still quite a bit wider of their 20-year average levels.
If we break the sectors down across the equity vs fixed-income dimension we see that fixed-income CEF sector discounts are more fairly-valued now, at least versus the last 7 years or so in aggregate while equity CEFs still remain relatively wide, despite their sharp rally over the last month.
It’s also worth keeping in mind that CEF discounts, like other asset valuations, don’t typically stop at historic averages but tend to get overvalued and undervalued just like other financial assets. This means we would expect discounts to tighten through their historic averages if the macro recovery continues to gather pace.
Underlying valuations are, as we suggested above, not overly appealing. At the same time, asset valuations can spend a long time trading at unattractive levels. For instance high-yield credit spreads spent more than 3 years trading significantly below their average historic levels. Investors who derisked significantly or moved to cash paid a fairly high opportunity cost and missed out on a period of fairly decent returns.
Leverage costs – the third metric in this approach – remain at rockbottom levels which allow CEFs to maximize the amount of underlying yield that they can pass on to investors. This is particularly true of CEFs that use short-term borrowings like repos, credit facilities, TOBs, muni variable-rate preferreds and others.
The technicals picture is quite interesting given we have just gone over an election cycle. This election cycle has not behaved qualitatively different from the last few election cycles which tend to see outflows in September and October – at an average AUM reduction of 2.5%, according to Goldman Sachs which is then fully recovered in the two months following the election.
Apart from the roundtrip in discretionary positoning, systematic strategies like CTAs and risk parity funds have been adding capital to the market due to the reduction in volatility.
Those investors who may have been waiting out for any post-election volatility may have thrown in the towel and are coming back into the market as their strategy of waiting for another dip has been frustrated. Last week gold funds have seen their largest outflow on record. Pictet also calculates that around $1.2tn rushed into the relative safety of money market funds between March and May. Around 75 per cent of that is still sitting in low-risk funds.
End of year always presents an interesting seasonality picture for a couple of reasons. Tax-loss selling and the related January effect means the start of the year tends to be relatively strong. The sharp rally in November has reduced the number of funds trading with negative returns year-to-date however a few sectors remain in the red.
Historically, January tends to be a strong month for discounts with a median tightening across sectors of nearly 1.5% over the past two decades.
Discounts don’t tighten every January and more recently the pattern has been more mixed, however, market history is on the side of a long position here.
Market sentiment – the last metric in the basket – is very elevated. The AAII Bullish indicator has been above 40% for 3 consecutive weeks – the first time in nearly 3 years. The CNN Fear & Greed Index as as high as it was in January of this year. Quite a comeback from a reading of just 2 this March.
Source: Systematic Income
The level of euphoria should make investors somewhat more cautious. That said, there are plenty of reasons to remain long CEFs. Collating these indicators gives roughly the following overall picture of the CEF investing environment.
3). Excess Yield Approach
Another way investors can gauge the broad attractiveness of the CEF market is through something we call CEF excess yield. This approach may be particularly relevant for income investors who view the income investment landscape in terms of income versus risk.
To illustrate what we mean here consider the popular high-yield bond and loan CEF sectors. The allocation sweet spot of these sectors tends to be around single-B rated assets, the yield of which at the moment is around 5%. This is our starting point in the chart below as the left-most bar we call “Unleveraged Yield”. The chart shows how a typical CEF structure can generate income in excess of this base level of yields. The figures in the chart assume fairly standard levels of 32% leverage, 1% leverage cost, 0.85% management fee on total assets and a 5% discount – the current average discount of the high-yield CEF sector. There is clearly some variation in these figures across the CEF space but they broadly reflect levels at which CEFs tend to cluster around.
The chart shows that typical CEFs that allocate to assets like B-rated corporate credit securities will tend to add a bit less than 1% on top of the yield of their portfolios. This 0.93% is the CEF excess yield.
This is how the excess yield varies for different levels of the underlying asset yield. For example, this year B-rated credit yields ranged from 12% to 5% (on the x-axis). At a yield of 10% the CEF wrapper adds more than 3.5% on top of this yield (keeping discounts fixed) and if B-rated yields were to fall to 4% the CEF would add less than 0.5% of excess yield.
How does the current excess yield compare to the previous decade? Let’s take a longer term perspective on excess yield and see how it’s behaved through time and whether the current figure of 1% is attractive.
What the chart shows is that apart from late 2019 and early 2020, excess yield has not tended to move significantly below 1%. It also shows how unattractive the early 2020 environment was when the CEF excess yield was very close to zero. This meant that investors were taking on the additional risks of CEFs with no compensation for those risks and any additional yield generated by the CEFs went right to the fund’s management, leaving investors with very little in additional income beyond the portfolio yield. That said, as the chart shows, excess yield can spend a long time trading at depressed levels although spikes do happen fairly regularly, offering much better entry points along the way.
What does the current environment mean for excess yield going forward? If risk-free rates remain at current low levels and discounts remain on the tighter side it means that we should probably recalibrate our expectation of excess yield. Going forward, particularly as memories of the pandemic volatility fade, 1% may be all investors could hope to achieve in credit CEFs on average and that will look attractive relative to other investment alternatives.
What is also interesting is that the excess yield may explain the puzzle of why CEF discounts have remained on the wider side despite strong underlying asset valuations. If discounts were to tighten even more, the excess yield would completely vanish and it’s quite likely that given the memories of capital destruction in CEFs we saw this March investors are simply not excited putting it to work for such thin additional compensation.
An obvious question is why not allocate to CEFs so long as excess yield is positive? There is no right or wrong answer here. Some investors are happy to hold CEFs through all market environments. Our long-time readers, however, will know our view that investors may be able to increase both their income levels as well as total portfolio wealth by behaving counter-cyclically, that is, by decreasing exposure to CEFs when valuation is unattractive and increasing exposure when it is attractive. This might sound like “trading” but it is nothing more than the traditional value investing approach applied to CEFs.
One big reason to consider allocating towards other types of investment vehicles is that CEFs do present a number of additional risks to investors. Most obviously is the additional volatility and drawdowns of CEFs which are a function of not just their embedded leverage but also the discount dynamic.
For example, the Angel Oak Financial Strategies Income Term Trust (FINS), which is one of the higher-quality credit CEFs with a majority investment-grade profile had an enormous price dislocation this March, far in excess of its NAV. It is also worth noting that the fund’s price never recovered back to its original starting point as the discount has remained sticky near a double-digit level – well below the premium it traded earlier in the year.
This price behavior shows that the CEF structure can be fairly fragile due to the discount dynamic as well as the potential for a forced deleveraging – something we saw a lot of in the second quarter this year.
This kind of behavior has a number of knock-on effects. First it presents some potentially challenging behavioral issues – as larger drawdowns may cause investors to lose conviction in their holdings and lead them to sell in the midst of a drawdown, locking in permanent capital losses.
Sharp drawdowns also prevent investors from being able to reallocate capital to attractive opportunities since there is simply less capital left to play with after a 30-50% portfolio drawdown.
Where does all this leave us?
It is fair to say that the excess yield approach to CEF allocation does suggest that CEFs are offering much less additional reward for their additional risk over and above other types of securities such as open-end funds, preferreds, baby bonds and others. While there is still some juice left in underlying valuations and CEF discounts, the risk reward picture is going to worsen further if we keep on the trajectory that we have travelled since March.
None of this means that investors should batten down the hatches and move into cash, particularly since cash has a 2% real drag versus inflation. What it does mean is that investors should consider approaching the CEF space with a margin of safety approach. They should also be selective in sectors that are still offering decent value such as high-yield munis. They should start to look outside of CEFs into assets and investment vehicles that have proven to be very resilient this year. They should also broaden their fund perspective for a full-spectrum approach.
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