In a recent article we discussed CEF sector distribution profiles and why we were leaning to those sectors that are likely to boast more resilient earnings and hence distributions. In this article we take a more micro perspective and take a look at fund-level distribution and, more specifically, distribution coverage.
Income investors prize stable distributions with distribution coverage being one of the key tools allowing investors to gauge potential changes in distributions. Our main takeaway is that not all distribution coverage is created equal with some metrics being worse than others. Not all funds in the CEF space provide robust coverage figures and the information available on data portals like CEFConnect can be woefully out-of-date.
Our main takeaway is that rather than solely relying on the usual shareholder report coverage data, investors should firstly, use other sources of data which are timelier and more accurate such as monthly fund updates, quarterly earnings updates and Section 19 notices. Secondly, investors should evaluate coverage trajectory and not just the last data point. And thirdly, investors should take a more forward-looking perspective that anticipates the evolution of fund distribution coverage due to a given fund’s sensitivity to changes in interest rates, credit losses, leverage and others drivers.
We highlight a number of BlackRock municipal CEFs that boast attractive trends in distribution coverage such as the Municipal 2030 Target Term Fund (BTT) which holds a higher-quality portfolio with low call risk, strong drawdown profile and historic NAV returns.
Using Distribution Coverage
Gauging distribution coverage is an integral part of many CEF investor allocation decisions. Various screens are readily provided on this platform by various contributors making it easy to pick and choose among various funds. These screens tend to use data provided by CEFConnect because using CEFConnect provides the quickest and easiest way to gauge distribution coverage.
As we discuss below, however, indiscriminate use of CEFConnect for distribution coverage tends to go horribly wrong, particularly in the current market environment when many drivers of distribution coverage such as short-term rates, asset volatility and leverage, have all moved sharply. The end result is that “most attractive” funds provided by such screens will tend to be outliers whose coverage is actually very different.
This is not a fault of CEFConnect, as such, since it simply relies on semi-annual shareholder reports for its data. However, for many funds, other more reliable and recent data is available so there should be no excuse in using the right data for the right fund. In the sections below we discuss distribution coverage more generally, present some examples where lazy coverage calculations go awry, give some recommendations on using distribution coverage and highlight a few funds which currently look attractive.
The Meaning Of Distribution Coverage
At its most basic, distribution coverage is the ratio of the fund’s net investment income to the fund’s distribution amount per share. For example, a fund that “earns” $0.11 per share per month and distributes $0.10 per month has a distribution coverage of 110%.
Investors generally favor distribution coverage that is stable and above 100%. This has to do with the fact that funds with a falling distribution coverage typically find it necessary to eventually cut distributions. A distribution cut can be a double-whammy for income investors – the income of their position drops and they suffer a capital loss as funds that cut distributions often see their price fall and/or discount widen.
With a few notable exceptions, CEFs typically prefer not to massively overdistribute because doing so results in a falling level of net assets, all else equal, due to having to subsidize distributions out of fund capital. Falling asset levels entitles the fund to smaller management fees resulting in worse economies of scale. This often requires the fund to carry out repeated rights offerings which can be dilutive and cause the fund’s price to drop, further aggravating shareholders.
Although fund earnings and distribution coverage are key drivers of fund distributions they are not the only ones. The CEF market contains many “special cases” of funds that take a different approach to their distributions. First, funds with managed distribution policies typically make distributions that are linked to current level of price or NAV. Target term funds often cut distributions in order to conserve NAV or as a result of deleveraging into termination despite boasting high coverage. Some funds with very low distribution coverage such as equity funds, particularly Gabelli funds that finance their leverage with fairly expensive preferred stock, adopt a business model of converting capital gains into distributions which has worked well since the financial crisis. Whether it will continue to work well in a falling or stable market remains to be seen, however.
Distribution Coverage Issues And Complications
The definition of distribution coverage provided above looks simple enough, however this is where things get complicated. What are they key issues to be aware of?
First, the numerator of the calculation – earnings or, more precisely, net investment income – is a preliminary estimate. It depends on the precise accounting treatment which can be reclassified by the end of the reporting year.
Secondly, net investment income is a proxy for earnings and when we think about distribution coverage we are really after earnings not its proxy. This means that some sources of earnings such as assets that throw off ROC which we see in MLP or covered call funds will give us misleading coverage estimates.
Thirdly, earnings are calculated by using a rolling average – usually of three or six months. The reason we need to use a rolling average is because financial assets typically do not pay coupons or dividends on a monthly basis. Fixed-coupon bonds typically pay semi-annually, stocks and floating-rate assets typically pay quarterly. This means that the rolling average provides an imperfect approximation of the true earnings picture of a given fund. This suggests that we need to look at the historic trajectory of coverage as well as the most recent data point.
One example of when this timing difference between the numerator (earnings) and denominator (distribution amount) creates a misleading signal is when a fund cuts its distribution after deleveraging. Because the numerator contains months reflecting previously larger earnings, it will reduce at a slower rate towards the sustainable earnings value than the denominator which will fully reduce immediately.
This is what happened with the Nuveen preferreds funds which deleveraged to varying extent in March and cut distribution in April. When this happened, the distribution coverage spiked up. Over the following five months, however, we expect it to move slowly toward 100% as the previously higher earnings months roll off.
Source: Systematic Income CEF Tool
Fourthly, distribution coverage is necessarily backward looking and will not immediately reflect changing market conditions such as changes in short-term rates, calls, portfolio rebalancing, defaults and other factors.
Drivers of Distribution Coverage
What are the key drivers of fund distribution coverage?
One of the biggest drivers that we have witnessed over the last few months is the drop in short-term rates. This has led to decreased distributions from floating-rate sectors such as loans, non-agency MBS and mezzanine CLOs. Preferreds will be only marginally affected as the percentage of floating-rate retail stocks is in the single digits, and there are few 2021 first calls.
We can see the impact of changes in Libor on the benchmark loan ETF Invesco Senior Loan ETF (BKLN) in the chart below.
Other drivers such as changes in borrowings which we have seen across PIMCO funds in the last couple of months as well as any sub-sector rebalancing will drive shifts in earnings as well.
Historically, calls were a significant driver of high-yield, municipal and preferreds sector earnings. The chart below shows a steady drop in earnings for the iShares Preferred and Income Securities ETF (PFF). This passive fund holds preferred stocks regardless of their yield-to-call and has steadily lost small amounts of capital due to call action.
Source: Systematic Income
Calls will likely be less of a driver of lower earnings in the near-term for the higher-yielding securities in these sectors as the jump in credit spreads has pushed many prices below “par” making it uneconomical for the issuers to exercise the call. For example, most of the retail preferreds market is trading below “par”.
Source: Systematic Income Preferreds Tool
When Distribution Coverage Goes Awry
In this section we take a look at the differences in distribution coverage provided by CEFConnect versus higher-frequency figures provided by many CEFs.
In the chart below we show CEFs with the biggest differences between the figures calculated via CEFConnect and figures provided by the funds themselves. The obvious takeaway from the chart is that the differences are massive and, apart from a few cases, actually lower than what we see via CEFConnect.
Source: Systematic Income, Tiingo
Let’s take the PIMCO Dynamic Income Fund (PDI) for example. CEFConnect shows earnings per share / net investment income of $1.6779 which covers a six-month period to end of 2019 (the actual figure is $1.70 from the shareholder report but it’s close enough). Turning it into a monthly figure and then dividing by the standard distribution of $0.2205 we get the 126% figure that is shown in the chart below under the “CEFConnect” label. That looks pretty good but let’s dig into it a bit more.
As it happens PIMCO provide three flavors of distribution coverage: 3-month rolling, 6-month rolling and fiscal year-to-date. The difference between these is the earnings period that is used. Let’s now take a look these figures (with March-end the last available figures – April should be available in the next few days). We can see that both the 6-month rolling and fiscal year-to-date figures were around 120% at the end of 2019 so that’s pretty close to the 126% figure – so far so good. Since then, however, all three coverage figures have moved lower. So making an investment decision based on the 126% figure would miss important developments since the end of the year.
Source: Systematic Income, PIMCO
The Nuveen Taxable Municipal Income Fund (NBB) is arguably even more of an extreme case. Its last shareholder report net investment income figure from Sep-2019 of $0.37 works out to a distribution coverage of 67%. However, if we look at the monthly figures provided by Nuveen we can see that coverage has moved around 100%.
Source: Systematic Income CEF Tool
It’s not clear what to make of the $0.37 semi-annual net investment income figure. This translates to a $0.062 monthly income whereas it has been running 50% higher than that over the last nine months as well as prior to the 2019. It’s possible that the fund had more “paid-rate” hedges in place for the that semi-annual period which caused a drop in income due to the fall in Libor, however this is speculation on our part.
Source: Systematic Income CEF Tool
Dealing With Unreliable Distribution Coverage
So, what are investors to do given that figures provided by CEFConnect can be significantly divorced from reality. Below we list four different information sources for distribution coverage in order of quality – with the highest at the top.
- Monthly rolling coverage updates
- Periodic, typically quarterly, earnings updates
- Section 19 updates
- Semi-annual shareholder reports
Monthly fund updates are the highest-quality source in our view, however, few fund groups provide them. Currently, only PIMCO, BlackRock and Nuveen publish them with a few-week delay. Eaton Vance appear to have stopped publishing updates since January – they have not replied to our email requests on this.
Quarterly earnings updates are provided by some fund groups like John Hancock and Western Asset.
Section 19 reports don’t have to be filed if the distribution is fully covered by net investment income so they are not always available.
Finally, semi-annual shareholder reports are a kind of “backstop” to distribution coverage in the sense that all funds have to provide this information, however, as we have seen above it may be seriously out of date (NBB being more than 7 months out of date) by the time it comes out.
Following all this information is probably outside of all but the most active and research-oriented investors, however, at the very least investors can check the fund website for the relevant information prior to making their allocation decision. This doesn’t solve the problem of actually screening funds for distribution coverage unless investors rely on a capable third-party platform. The key point here is that investors should not accept the kind of lazy screens that rely solely on CEFConnect figures and should question the source and reliability of the information put in front of them.
Despite its apparent conceptual simplicity, measuring fund distribution coverage can be a fraught exercise. Investors should be aware of various shortcuts used by lazy screens, particularly when better data is available for many CEFs. Apart from using better data investors should also consider the historic trend of distribution coverage rather than the last data point and use forward-looking estimates based on the coverage sensitivity of various funds.
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