There are both slow and fast fund income drivers. Fast drivers like changes in borrowings and short-term rates are those that move the fund’s income to a different level more-or-less immediately. If these changes are sustainable many funds tend to adjust their distribution rates very quickly in response. So, broad-based deleveraging in March of 2020 was followed very quickly by a wave of cuts.

Short-term rates have a mixed impact on CEFs – funds that allocate mostly to floating-rate assets such as loans are hurt immediately when short-term rates move lower which is why we saw the Loan sector cut the most in 2020 (ignoring MLPs which were decimated by deleveraging). Funds that allocate to fixed-rate assets tend to benefit immediately as well as their leverage costs, which are often tied to short-term rates fall. For example, this is why we saw distribution hikes across the Muni space in the second half of 2020. These funds had been able to maintain their leverage levels due to the high-quality of their assets and benefited when short-term rates fell, which drove their incomes higher. 

The slow drivers of income changes are shifts in yields further out the curve. If yields move steadily lower, funds will struggle to maintain their income levels without taking more risk since fixed-income coupon levels on offer will tend to move lower over time. However, because this is a process that will take time, I don’t expect to see a sharp wave of cuts.

As discussed earlier, the Flaherty funds are seeing the writing on the wall – a lot of their holdings will either realize yields of 0-2% on redemption or their coupons will step down significantly over the next few years (barring some sharp Fed hikes) due to the floating-rate reset mechanism. What is obvious from their small cuts is that they are not going to take the pain in one go but spread it out over time. This means that we should see a number of cuts from them over the coming years which also means that the premiums of their funds will shift lower just like what we saw with PHK and PGP over the years.

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