This is historic analysis and may no longer be current
Despite a couple of bumps on the road, the last couple of decades have been very friendly to CEF investors. On the fixed-income side, CEF investors enjoyed the combination of high starting yields that generated strong coupon income and a lower yield tailwind that boosted bond prices. However, the situation now is very different. Bond yield levels are at or near historical lows and a lower yield tailwind is unlikely to materialize given 10-year Treasury yields at 1.20% and very tight credit spreads. In this article we take a look at how investors can keep returns ticking along at a healthy clip by tilting to funds with strong historic alpha.
The article is premised on two basic facts about the state of the fixed-income market. First, asset yields are historically low. The chart below captures the yield of the high-yield corporate bond index – a decent proxy for “credit”, broadly speaking – which is currently trading at just around 4%.
The second key fact relevant to this article is that NAV return dispersion within CEF sectors has been and remains high. The chart below shows the difference between the 5-year NAV returns of top quartile and bottom quartile funds in each CEF sector. Fixed-income funds in the top quartile have generated an annual return of 2-4% above those in the bottom quartile.
The key takeaway here is that in a world of low baseline returns due to low yields and lack of a lower yield tailwind, even a 1-2% additional alpha annual return can compound quickly into decent outperformance. In the following sections we take a look at different ways to proxy alpha and highlight funds with a history of delivering it. It goes without saying that gauging historic alpha is not the same as predicting which funds are going to exhibit it in the future. However, the key point about CEFs is that their outperformance is not just due to high-wire macro tilts or security selection but also due to the more staid fund features such as management fee levels, leverage cost, leverage mandates and other drivers which are fairly “sticky” and can reliably deliver outperformance.
A Brief Survey Of CEF Alpha
In this section we take a look at the different ways to quantify alpha in the CEF space.
Risk-adjusted performance tends to be the default way to calculate alpha, and it is intuitive because funds with higher alpha are those that are able to provide a larger return per unit of volatility – a proxy for the amount of “risk-taking”. This is a useful metric but it has some limitations. First, you can’t pay your bills with alpha, i.e., a fund with amazing alpha but a 2% CAGR is not all that attractive.
Secondly, mathematically, a leveraged fund that is identical to an unleveraged fund except for the leverage element will always have a lower alpha since the leverage cost will take away from the total return. Does this mean that a leveraged fund is always less appealing than an unleveraged fund, all else equal? Not really – leverage cost (unless it’s excessive) is the cost of getting the leverage in the first place and leverage can generate additional returns (though it has some downsides as well).
Thirdly, this metric doesn’t take into account any structural tilts in a fund’s allocation. So, for example, funds with a naturally longer duration stance, e.g., investment-grade or taxable munis will show a higher alpha, all else equal, for the simple fact that yields have moved lower over the past few decades. This is not due to the funds’ clever allocation but a dumb windfall from this trend. And unless yields go negative, we certainly shouldn’t expect a similar type of returns from these sectors over the next decade.
This risk-adjusted version of alpha is a very useful one despite its drawbacks because it can capture a number of fund features that can generate sustainable outperformance. These can be as simple as lower fees or cheaper leverage as well as the more obvious ability to generate returns via superior security selection skills. This is a metric that we rely on often in our analysis.
A quick note for the geeks in the audience. Alpha is typically calculated as the differential in the return of a given security over the risk-free rate that is not explained by its beta to the benchmark. Since CEFs typically don’t have a benchmark, we address this issue by calculating a pairwise alpha of a given fund versus all the other funds in the sector and averaging the result. This is how the numbers look for the Preferreds CEF sector.
Another proxy for alpha is the consistency of outperformance. The idea here is that you want funds that can perform well in different types of environment rather than picking a fund that posted the strongest return from point A to point B. A fund that got lucky or took advantage of a non-repeatable market dislocation a long while ago can still show a very strong 10-15 year return but could have delivered middling performance more recently.
The chart below captures this metric for the preferreds CEF sector. Each fund has two bars – an orange bar shows the number of years of available NAV returns and the blue bar shows the number of years it outperformed its sector in absolute terms. The chart is sorted in the ratio of the two so the funds that have outperformed in more of their years are on the right, i.e., funds on the right-hand side of the chart have a higher alpha according to this definition.
The last metric we like is performance in a stable yield period. This metric aims to control for any duration or credit tilts in a fund’s performance. The reason is that one reason a fund can show high alpha is because of a structural tilt to higher duration which was a huge tailwind in retrospect. However, the same structural tilt could very well be a liability going forward since it is extremely unlikely that yields will fall as much as they did over the last couple of decades (unless risk-free rates go negative).
The main difficulty here is how to define the “stable yield period” when funds’ allocation profiles don’t always look exactly like those in the available indices, not to mention the fact that funds have significant portfolio turnover. Separately, not all sectors have easily available indices such as preferreds. If we try to use a single window period for both lower-quality and higher-quality fixed-income then we have to go with something like 8-Sep-2016 : 25-Sep-2020 where the high-yield corporate bond and municipal bond index starting and ending yields were both broadly similar. The obvious concern here is that the end date is about a year away from today’s date so it misses some of the more recent performance. However, because yields have continued to push lower (due to both lower Treasury yields and tighter credit spreads) there is no way around this. The NAV CAGRs over this period in the Preferreds CEF sector are shown below.
And Some Results
In this section we walk through some of the CEF sectors and highlight fund with strong historic alpha metrics. To present the results we use two alpha metrics – the risk-adjusted figure on the x-axis and the stable-yield figure on the y-axis. In this visualization the top-right quadrant will be the most attractive.
The results of the High-Yield sector will not be too surprising to our readers. We have continually highlighted many of these funds in the past. In the sector we like the Credit Suisse pair of funds, particularly the CSAM Income Fund (NYSE:CIK), trading at a 2% discount and a 7.89% current yield. The fund’s low fee, decent valuation and strong absolute and risk-adjusted returns make it appealing.
The fund’s valuation has recently reverted back to being wider of the sector average which makes for an attractive entry point.
In the Loans sector, we like the Apollo Tactical Income Fund (NYSE:AIF), trading at a 8.9% discount and a 6.7% current yield.
The fund’s valuation remains attractive, likely a function of its lack of brand-name cache in the fund management space. The fund is likely to merge with its other sister credit fund though it should retain its cross-sector credit mandate.
In the Municipal sector we like the Nuveen Municipal Credit Income Fund (NYSE:NZF), trading at a 0.3% discount and a 4.54% current yield. The MainStay Defined Term Municipal Opportunities Fund (NYSE:MMD) as well as the Invesco Municipal Income Opportunities Trust (NYSE:OIA) are also appealing, however, patience may be rewarded with a more attractive valuation.
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