Operating with a margin-of-safety mindset, which takes advantage of asymmetric risk/reward, allows income investors to recognize and allocate to attractive opportunities. In this note we highlight 10 margin-of-safety strategies in CEF we use in our own portfolio construction process.
Given the rock-bottom level of underlying asset yields, many investors are worried about the sustainability of CEF distributions. And with short-term rates near zero, leverage costs are as low as they are going to get unless we see policy rates move below zero. With the exception of rotating to riskier holdings, this leaves growth in borrowings as the primary avenue in which funds can organically increase their income levels.
One fund worth highlighting here is the Nuveen Taxable Municipal Income Fund (NBB), trading at a 5.24% current yield and a 1.52% premium. The fund has added borrowings over the last couple of months.
NBB raised its distribution early this year which explains the dip in its coverage, however, since then, coverage has been stable and increased marginally along with UNII.
If this trend in raising borrowings continues, the fund will be well placed to further boost distributions. Two things worth highlighting are that the fund’s leverage is relatively elevated at close to 38% which is the highest level in the taxable muni sector. And secondly, further increases in interest rates will likely prevent the fund from adding borrowings since higher rates would pressure the NAV and cause the fund’s leverage to increase.
That said, the fund may also be attractive for investors who want to remain up-in-quality (with a 90%+ investment-grade allocation) as well as investors who may be somewhat bearish on risky assets. The fund’s long duration and quality focus should allow it to outperform shorter-duration and more credit-oriented assets in a risk-off environment, especially if interest rates fall.
The BlackRock MuniYield Quality Fund III (MYI), trading at a 4.24% current yield and 5.6% discount, raised its borrowings a couple of times in the past year. MYI also remains cheap relative to the broader sector.
This is despite posting sector-beating returns in NAV terms over different time horizons along with a very competitive current yield in the tax-exempt sector.
Relatively Low Distribution Rates
Much like pre-shrunk clothes, holders of funds whose distributions have already right-sized lower, don’t have to worry as much about nasty surprises. There are added advantages for funds with lower distribution rates as these funds often trade at cheaper valuations since many investors (incorrectly) interpret their lower distribution rates as a proxy for lower earnings levels.
For instance, the recently launched PIMCO Dynamic Income Opportunities Fund (PDO) has a much lower distribution rate than its sister funds. However, this does not reflect the fact that it behaves very much like the broader fixed-income CEF suite as the chart below shows for the period when the fund was fully leveraged up.
The fund’s lower distribution rate means its valuation will likely remain more attractive than that of other funds in the suite while also making it less vulnerable to a distribution cut than its sister funds. In effect, the fund provides a cheaper way for investors to access PIMCO “alpha” while decreasing their vulnerability to a cut.
Another fund that has this feature is the DoubleLine Income Solutions Fund (DSL), an EM-Debt focused fund, trading at a 7.24% current yield and 0.6% discount, which we highlighted earlier. The fund cut its distribution by more than a quarter late last year which we thought was more than required. Unless the fund radically cut its borrowing as well over the past 9 months (which it tends to do only during a sharp market correction) its distribution coverage should be relatively high. Although the fund’s discount has nearly closed since we added it to the High Income Portfolio at close to double-digits, it continues to trade well wider of the Multi-sector CEF space.
It is also worth highlighting the quartet of Nuveen preferred CEFs which share both of the features discussed so far. These funds cut their distribution rates about a year ago due to a deleveraging. However, since then, they have been steadily adding borrowings back while their distributions remain at the new lower levels. Within the suite we like the more defensive Preferred and Income Fund 2022 Term Fund (JPT) due to its lower leverage and term structure which should keep the discount well anchored into the likely termination next year. The fund should also serve as a good waiting point for more attractive valuations in a sector which is trading at very expensive levels at the moment.
Robust Leverage Structure
With asset valuations moving towards very expensive levels, many investors are starting to think about bullet-proofing their portfolios in case of another period of market weakness in the medium term.
One disadvantage of CEFs is their tendency to deleverage during market drops which, more often than not, locks in permanent capital losses for investors. One way to avoid this is to allocate to funds with more robust leverage structures such as those featuring preferreds over bank-facing instruments like repo or credit facilities. Unlike these instruments, preferreds cannot force a fund to deleverage during a market shock. Of course, there is no guarantee that CEFs will avoid some deleveraging (after all, fund managers can always do so for discretionary reasons such as market or risk management views), but not being forced to cut assets during a sell-off is a significant advantage.
Two funds that look strong on this front are the pair of Virtus AllianzGI Convertible & Income Funds (NCV) and (NCZ). NCV is funded 92% with preferreds and NCZ is funded 100% with preferreds. One disadvantage of preferreds is that they tend to be much more expensive than bank leverage instruments and this is true of these two funds also which are paying 5.625% and 5.5% respectively on their retail preferreds. However, this is balanced by their auction-rate preferreds on which they pay less than 0.10%. And although on a net basis the funds’ leverage cost is still above those financed entirely by bank instruments, in our view, this is a cost well worth paying as we saw last March. Despite NAV drawdowns of more than 40%, the funds’ borrowings remained intact. In fact, NCZ had to suspend its common distributions temporarily because its preferred asset coverage fell below the regulatory levels. This may seem a terrible outcome for common shareholders but was, actually, a much better outcome than a deleveraging in retrospect as the fund was fully able to take advantage of the bounce back in assets unlike many other CEFs.
These funds also look attractive on a valuation basis, trading well wider of the average CEF in the Multi-sector space.
Potential Activist Tailwind
The CEF market features a number of activist investors who pressure CEF managers to tighten the discounts on their funds by initiating proxy battles. To state the obvious, one risk of tagging alongside activist funds is that the activists fail and withdraw from their strategy. This can deliver a double whammy to investors. First, the likely unwind of the activist’s holdings will pressure the fund’s price since the activist will, presumably, not want to carry a sizable ownership of the fund for any extended period and would rather use their capital elsewhere. And secondly, additional pressure will come from the unwind of the market’s expectation of success. What this means is that, unless investors have a firm view of the activist’s likely success, it makes sense to seek out funds that already are attractive for other reasons and that have limited downside in case of activist failure.
Let’s now take a look at what’s going on with a number of Eaton Vance funds where Saba has been building a position over the last few months with substantial current holdings.
This is how Saba ownership has evolved for the Eaton Vance Floating-Rate Income Trust (EFT).
EFR holdings by Saba have continued to grow as well – their allocation increased substantially on the last day of the year.
We can gauge how much of the activist’s strategy is already priced in by looking at how the fund’s discounts have moved. The key date in question was 8-October when the planned acquisition was announced, which started the clock on the eventual proxy battle.
On that date (marked by a red line in the chart below) we saw a tightening in discounts across most of the five Eaton Vance loan CEFs which suggested that the market expected some chance of shareholder-friendly event such as a tender offer. The more the market is pricing in success the less upside is left in case of a shareholder-friendly tactic and the more downside there is if the activist fails.
It’s tempting to gauge this likelihood strictly on the behavior of prices or even discounts, however, that isn’t the best way. This is because the price action of these funds should be viewed relative to the behavior of the broader sector. For example, imagine the discounts of these funds all went from 10% to 5% on announcement of the acquisition. It’s tempting to look at these numbers and say that the market is pricing in some shareholder-friendly action at around 50%. At 50% the downside would be quite sizable.
However, if the broader sector discounts also tightened from 10% to 5% over this time then the right probability is actually closer to zero and the funds would look attractive as there would be little if any downside in case of activist failure since the funds’ valuations have not richened at all.
So, rather than look at the behavior of absolute discounts, let’s look at how the discounts have moved relative to the sector. By this metric the tightening in discounts is not as stark as it is in absolute discounts, suggesting that the market is pricing in a small likelihood of success meaning there is little downside if Saba fails.
EFL is a special case here as it’s a term CEF and does not appear to be part of the proxy battle. Apart from EFL, EFR looks attractive here since it outpeformed the sector by only about 1% since the acquisition was announced.
This is how the overall fund discounts moved relative to the sector. The chart shows that EFF has priced in a lot more of success here than a fund like EFR or EVF which have only very marginally outperformed the sector in its discount. The discount behavior of these funds is roughly in line with the Saba holding levels, which makes a lot of sense as Saba is more likely to succeed in funds where it has a larger stake. For example, EFF is its largest holding among the four funds and it’s the fund whose discount outperformed the most. EFR is its smallest holding and it is the fund, outside of EFL which Saba does not hold, that has outperformed the least.
In our view, both EVF and EFR are attractive here, though our own preference is for EFR due to its lower cost base, higher-quality portfolio and stronger historic absolute and risk-adjusted NAV performance.
It’s important to stress, however, that by themselves these funds are not necessarily worth holding “as a punt” on the Saba proxy fight. Rather, investors who already want loan exposure may find the potential tailwind of the Eaton Vance funds attractive.
It’s also fair to say that this is not a traditional margin of safety opportunity where the downside is more limited than that of similar funds. The downside for EFR and EVF is actually somewhat higher than in other loan funds if Saba doesn’t succeed, however the upside, in our view is significantly greater than in the other funds in the sector over the near-term.
Share Repurchase Programs
Share repurchase programs are a way for funds to manage their discounts and to deliver NAV gains to their shareholders. Not all CEFs have these programs in place and those that do may not always take advantage of them when discounts are attractive. However, all else equal, it’s worth holding funds with the program in place as it does provide the potential for discount outperformance and NAV accretion due to share buybacks.
If we take a look at the Municipal CEF sector – by far the biggest and one with a significant number of funds with and without repurchase programs – we notice that the differential in discounts between the two groups compressed this year. In other words, funds with repurchase programs outperformed those without in discount terms. There’s not enough information to definitively attribute this dynamic to the funds’ repurchase program but it is certainly tempting to do so.
A fund with a live repurchase program is one we recently discussed – the Blackstone Senior Floating Rate Term Fund (BSL). Unfortunately, CEFConnect does not highlight which funds have this feature which can make it difficult for investors, however, other CEF data aggregators may be able to do so, such as our own Systematic Income CEF Tool.
Expecting a Rise In Distributions
A few months ago we discussed a number of funds with managed distribution policies and how investors can forecast their distributions. Since fund discounts often react to distribution cuts and raises, investors can position to take advantage of the expected changes in distributions and, consequently, potential shifts in discounts that reflect those changes in distributions. If the CEF market were entirely efficient, discounts would anticipate changes in distributions for funds with managed distribution policies, but, it appears that they don’t.
A group of funds that we highlighted in the article linked above that looked poised for outperformance was a set of Wells-Fargo CEFs with a 12-month rolling managed distribution policy. This policy will allow the funds to raise distributions once March is kicked out of the 12-month rolling window in a few months. As the chart below shows EAD – a fund that we added to our High Income Portfolio shortly after – saw its discount widen in line with the drop in distribution. However, since the fund’s distribution is based on the rolling NAV average the drop in distributions would be slowly expected to reverse which would subsequently allow the discount to outperform the sector.
The opportunity played out quite a bit faster than expected, however. The timing of the original article that discussed the opportunity was almost comically good as it appears to have caught the bottom in the relative discount. Since then the fund’s discount outperformed the sector by about 2.5%. That said, we expect further relative tightening once actual distribution rises start kicking in Q2 of this year.
At current valuations the fund’s discount is still wider than the sector average which doesn’t make a ton of sense, in our view, as the fund’s fee is very low, its current yield is above the sector average as are its historic absolute and risk-adjusted NAV performance.
Discount Asymmetry CEFs
Term CEFs have been a favorite of ours because they provide additional risk control and discount visibility to investors. This is because while perpetual CEFs can see their discounts move wider permanently, the discounts of term CEFs are expected to amortize to zero into the termination date. The challenge of term CEFs has been the fact that they tend to trade at relatively tight discounts versus their sectors which is not surprising because it, in effect, prices in the fact that the fund’s discount is expected to tighten into termination. One risk, however, is that the fund holds a shareholder vote to extend or cancel the termination date, turning the fund into a perpetual fund. This may cause the fund’s discount to widen back out towards the sector average.
A number of term CEFs, however, are currently trading at discounts near the sector average. This reduces the risk of potential discount correction in case the fund turns into a perpetual CEF. This creates an attractive asymmetric payoff for investors. Either the fund terminates and its discount compresses to zero or the fund turns into a perpetual fund in which case its discount should not move a whole lot since it is already around the sector average.
One such fund is the BNY Mellon Alcentra Global Credit Income 2024 Target Term Fund. The fund’s discount has tended to trade tighter than the sector average but has now moved out to trade right around the sector average. This may be because the fund cut its distribution earlier in the year due to a small drop in borrowings and a fall in short-term rates which caused its loan coupons to drop. That said, the fund’s covered or earnings yield appears to be right at the sector average, suggesting that the discount fair-value is not significantly wider of the sector average.
The MLP sector has gone through a tumultuous year, to say the least. Overall, it’s a difficult sector to own for income investors for a few reasons, not least its terrible historic performance and waves of periodic forced deleveraging which cause the sector to underperform open-end fund alternatives. It’s no surprise, therefore, that the sector’s discount has jumped sharply wider of its previous trading pattern.
This is not, in itself, a good reason to pile into MLPs, however. A more compelling strategy is to hold funds that enjoy the wider discount of MLPs but are not true MLP funds. One such fund is the Tortoise Power & Energy Infrastructure Fund. Unlike the rest of the MLP sector TPZ holds nearly 2/3 of its portfolio in fixed-income securities, mostly pipeline corporate bonds.
This may not seem like an important feature but what it means is that the fund’s risk profile is significantly reduced relative to the average pure MLP fund. For example, the fund’s 1-year total NAV return is 24% higher than the average MLP CEF return and its NAV drawdown this year was 21% smaller (in absolute terms) than the average MLP CEF drawdown.
The key dynamic for the purpose of this discussion is the discount valuation of TPZ which is trading at a 28.7% discount – wider of the average discount of the MLP sector of 25.5%. From a historic relative value perspective this might make sense – TPZ has tended to trade at a wider discount relative to the sector. But from a big picture perspective it doesn’t make a whole lot of sense. Our intuition here is that TPZ is a 2/3 bond fund (admittedly, in the energy sector though with what looks like a majority investment-grade profile) and a 1/3 MLP fund. If we spun out the fixed-income portion of the portfolio into a separate fund, it’s unlikely to trade much wider than a discount of 15%. However, because TPZ sits in the MLP sector on CEFConnect, it is very much tarred with the same wide discount broad brush. Our view here is that it is quite possible for TPZ to continue trading at this wide discount in the medium term so we wouldn’t necessarily bet on the tightening. However, from a broader risk/reward perspective, a nearly 30% discount on a majority fixed-income allocation looks reasonably attractive relative to where hybrid sector CEFs are trading which is at the low double digit discount average.
Another margin of safety element for TPZ is the recently announced share repurchase program by Tortoise which intends to repurchase $5m of the outstanding shares if they are trading above a discount of 10%. This amounts to around 8% of the fund’s market cap. The management company has announced and actually delivered in large part on repurchasing shares of its other funds that are trading at similarly wide discounts. So far, the market has ignored this and the discount has actually widened since the announcement by about 2%.
Discount Control via Tender Offers
It seems like tender offers have been coming at a solid pace over the last few weeks. The table highlights recent tender offers among the different SEC filings we track on the service.
As we discussed in an earlier article on CEF tender offers, there are two ways in which they can be attractive. First, they can deliver gains for investors who choose to participate in the offer. And secondly, and less obviously, they can be attractive for investors who choose not to participate but sell their shares ahead of the tender offer. This is because the discount of the fund undergoing the tender offer is likely to remain better anchored than other funds in the same sectors in case of a sell-off. This potential stability in the discount through the tender offer period can reduce the likelihood of discount widening and make the fund an attractive hold over other funds in the same sector.
We will ignore the NexPoint Strategic Opportunities Fund (NHF) as it is not the traditional “shares for cash” tender offer and focus on the other four in the table below. The way we evaluate the relative attractiveness of tender offers is through the concept of breakeven which is the estimated drop in the shares not accepted into the tender offer for the profit & loss on the overall position to be zero.
A fund that stands out on this metric is the Western Asset Global High Income Fund. We see that assuming a 75% of total shares tendered (a conservative assumption) we can sustain a loss of over 9% on the residual shares and still make out even on the position. This is due to the fairly generous tender offer details of this fund.
The fund also looks attractive even if investors choose not to participate in the tender offer. The tender offer expires on 16-November, taking us through the election period which could deliver some additional volatility so it might make sense to swap out other high-yield / EM sovereign CEFs for EHI over this timeframe.
Distribution Sustainability Screen
Our starting point is a set of mostly four-star rated funds across a number of fixed-income sectors. A four-star rating is the highest rating in our CEF Tool and is derived from collating a dozen or so different metrics.
Within this basket of funds we calculate two metrics:
- The average change in net investment income or “EPS” from the last shareholder report versus the two preceding annual reports.
- Distribution coverage – defined as the net investment income in the last shareholder report divided by the current annualized distribution
The EPS change metric gives us a sense of how the fund’s income-generating capacity has changed over the last couple of years. Funds with an increase or a small fall in EPS are preferrable to those with larger drops in EPS for the simple reason that growing or stable income level is preferrable, all else equal.
The distribution coverage metric is familiar to most CEF investors – there are different ways to measure it – the way we do it here is to use the latest shareholder report net investment income and divide it by the current annualized distribution.
A key point to keep in mind is first, because CEFs only have to disclose their income figures semi-annually and even then at a several month lag, the latest figures for some funds are as far back as December of 2020. And secondly, because shareholder reports across different funds aren’t published for the same periods the periods which they cover are not aligned. This can create a bit of noise when comparing the figures particularly as some fund periods cover the COVID crash and others don’t, however we don’t expect this to materially change the results.
A final point is that the two factors need to be considered together. In other words, the EPS profile has to be considered in the context of current coverage. For example, a fund with a weak EPS trajectory may still be attractive (from a distribution risk perspective) if its current coverage is very strong and a fund with low coverage may be attractive if its EPS trajectory is strong.
The chart below plots the two factors. The area highlighted in green contains funds where at least one factor looks strong i.e. where EPS is stable or growing or where coverage is high. The boundaries of the section are somewhat arbitrary and hence illustrative.
Check out more in-depth and timely commentary as well as Income Portfolios and interactive Investor Tools at our Premium service.
ADS Analytics LLC / Systematic Income provides opinions regarding securities and other related topics on an impersonal basis; therefore no consideration is made towards your individual financial circumstances.
All content presented here is not to be regarded as investment advice or constitute a client / advisor relationship. It is for general informational purpose only.
Trading securities involves risk, so you must always use your own best judgment when trading securities. You assume the entire cost and risk of any trading you choose to undertake. You are completely responsible for making any investment decisions.