CEFs remain appealing to many income investors as they continue to offer a distribution rate pick-up relative to many other investment options, particularly open-end funds. However, as we like to say, it is important to own CEFs for the right reasons rather than “marketing reasons”. For instance, we occasionally see commentary to the effect that investors who own credit CEFs get something for nothing because CEFs use leverage. For example, the theory goes that if a CEF holds, say, the High Yield corporate bond index at a 4.1% yield currently and uses leverage which costs it around 1%, then it’s getting an additional 3.1% return for free.
Let’s go through some of the key things investors should know before they fall for this pitch. First, CEFs charge a management fee, nearly in all cases, on total assets so the real figure should be 4.1% minus leverage cost (typically around 1%) minus fund expenses (which tend to run around 0.8%) which gets us to about 2.3% passed on to investors on the additional leveraged assets rather than 3.1%. It’s also important to stress that the pricing in the market tells us that the cost of bearing risk to the broader High Yield corporate bond market is 4.2% and investors are only getting 2.3% on the leveraged portion of the assets or about 55% of the “fair-value”.
A second point worth making is that even this 2.3% is very obviously not “free” as it doesn’t include future losses – all of which accrue to investors i.e. investors are taking roughly half the compensation but, obviously, bear 100% of the losses on leveraged assets. About 4% of the HY market has defaulted on average each year which results in a 2.4% of annual losses using the historical average recovery of 40%. Of course this loss assumes the bond goes from par to recovery within the year which is very unusual so we can be conservative and assume a 0.5% loss rate which gets us to a 1.8% compensation for the leveraged bit. Another, often overlooked, cost, is deleveraging – which was very obvious in 2020 when many funds locked in permanent economic losses. The chart below illustrates the potential cost for a typical fund that deleverages when it hits a leverage level of 50% with the NAV remaining around 25% below its starting level even if underlying prices come all the way back.
This is clearly a very close to worst-case scenario given the assumptions involved, but the broad pattern of lower asset prices followed by forced CEF deleveraging followed by a bounceback in prices that many funds failed to take advantage of fully was very clearly visible last year.
We can also see this dynamic in the chart below which plots HY sector funds across CEFs (blue bars), active OEFs (green bars) and passive OEFs (red bars) over the period spanning the start of 2020 and 5-Aug-2020 when the HY index yield was at the same level of 5.33%, having completed a wild roundtrip between these two dates. If deleveraging was a non-issue for CEFs, they should have outperformed as they have higher carry than open-end funds. However, the chart makes it very clear that CEFs were huge underperformers over this time frame relative to OEFs.
If we are conservative and assume this cost is 0.25% annualized then we are down to only an additional 1.55% per annum which is far from the initial “pitch”.
Finally, it’s important to make a distinction between the additional yield on the leveraged portion of the fund’s assets and the additional yield on the fund’s net assets which is what investors ultimately get. A 35% leveraged CEF that holds the HY index at a 4.2% yield with fund expenses of 0.8% and leverage cost of 1% generates a yield on NAV of 4.49% – only 0.29% above the underlying index.
To be clear, this doesn’t mean that investors should avoid leverage or CEFs – we hold many across our Income Portfolios. CEFs are actively managed investment vehicles which can top up “beta” performance via additional “alpha” – a theme we have been focused on. However, it is important investors are clear on the balance of risks and rewards.
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