Steadily lower CEF yields and recent volatility due to rising Treasury yields have underlined the attraction of alpha-generation strategies. In this article, we take a look at a number of relative value CEF opportunities in the preferreds sector. Specifically, we review previous ideas and highlight new ones across the PIMCO, John Hancock, Invesco, and other funds.
Why Relative Value
It may seem like allocating to CEFs based on a relative value basis is a strategy best suited for highly tactical investors. However, that is not the case. Our approach to relative value allocation in CEFs is firmly grounded on a value and margin-of-safety framework. In short, if investors can achieve a broadly similar asset allocation via a cheaper and more resilient investment vehicle, they should do that, taking into account, as always, any relevant tax considerations.
Another point worth making is that with the yields on both underlying assets and CEFs at historically tight levels, a strategy that can deliver alpha – or an additional return over and above a static allocation is now worth that much more in relative terms. In other words, investors who can generate an additional 1% through CEF relative value in a world of 5% yields are that much more attractive than in a world of 10% yields.
Source: Systematic Income CEF Tool
Something else worth highlighting, particularly in a market environment of rich valuations, is that a relative value approach is defensive. This is because higher premium funds deflate more quickly during drawdowns, meaning investors who continue to be allocated to higher premium funds tend to take heavier losses than those in cheaper alternatives during periods of market volatility. And although there is not always a perfect cheaper alternative, more times than not, there are funds with very similar portfolios and historic returns that trade at more attractive valuations.
For example, the premium differential between the two PIMCO California funds in the chart compressed sharply during the COVID drawdown. This is just one of very many examples.
Source: Systematic Income CEF Tool
Finally, a relative value approach to the CEF space allows investors to avoid losers which is just as important, if not more, as picking winners. For example, many investors were drawn to the Stone Harbor EM Income Fund (EDF) double-digit distribution rate which was not only unusually high for credit CEFs but well above the distribution rate of its nearly identical sister fund, EDI. Needless to say, the recent normalization of the EDF distribution has nearly collapsed the premium differential, driving a negative 26% total price return for EDF over the past 2 years – something that could have been easily avoided for its shareholders.
Source: Systematic Income CEF Tool
The Flavors of Relative Value
There are many different ways to think about relative value ideas. At Systematic Income we follow two different approaches:
1. Price Cointegration: This approach, which is very common for pair trading of stocks, finds funds that share a common price trend with deviations from this trend flagged as potential opportunities.
2. Portfolio Cost: This, arguably more intuitive, approach, which we introduce and describe in this article, tries to identify funds that hold a broadly similar set of assets but trade at an unusual discount differential.
The Portfolio Cost approach illustrates the three principles which form the bedrock of our fund market analysis: margin of safety, not taking uncompensated risk, and CEF market inefficiency.
Margin of safety is the familiar concept applied to the CEF market where we attempt to rotate into similar assets which, for one reason or another, are undervalued by the market.
Holding funds which are trading at elevated valuations rarely makes sense, particularly when there are similar cheaper alternatives. Holding such overvalued funds while there are cheaper alternatives is an example of taking uncompensated risk, something we try to avoid.
Our third principle has to do with the fact that the CEF market displays an unusual amount of inefficiency which is what often allows these relative value opportunities to persist.
Portfolio Cost Relative Value Approach
Our relative value approach hinges on two key factors: 1) Finding pairs of funds holding similar assets and 2) selecting the pairs that are trading at divergent absolute or relative discount valuations.
In order to gauge whether two funds have broadly similar portfolios, we use the following metrics:
- NAV return correlation – This is the familiar metric of co-movement in NAV returns.
- NAV return differential – This metric ensures that a pair of funds have not had widely divergent NAV returns, an obvious sign that the funds do not hold similar portfolios.
- NII NAV yield differential – Net investment income NAV yield is essentially a measure of fund earnings which should be similar for funds holding similar portfolios. We have to be mindful, however, that varying expenses, leverage costs and fluctuating distribution coverage figures can skew this metric somewhat.
Why can’t we just use NAV correlation? The somewhat technical answer to this question is that NAV correlations measure co-movement around the respective trends. So two funds could have a high positive return correlation but steadily diverging trends. So, while a high NAV correlation is necessary, it is not sufficient to identify funds holding very similar assets.
And for measures of cost we use both absolute and relative metrics: discount differentials as well as the percentile rank of the most recent discount differential relative to history. We try to identify fund pairs that not only trade at a large discount differential, but also trade at a differential that appears extreme relative to its own history.
It may seem self-evident, but it is still worth asking why we are looking for funds with more attractive discounts. After all, there are many examples of funds trading at a premium that just keeps steady or grows with time. One reason is that funds with wider discounts tend to be less fragile in the sense that any negative surprise, be it distribution cuts or performance, is punished much less by the market. For example, just last year PHK and PGP suffered double-digit daily losses on negative distribution surprises.
The second reason why we look for funds with more attractive discounts is that wider discounts translate into lower prices which in turn translate into higher yields, all else equal. This allows investors to allocate less capital to achieve a given income stream.
Whenever talking about PIMCO CEFs, we would be amiss to ignore historic valuations. Current average discount of the PIMCO funds is close to a historic high. And while relative value opportunities can still make sense at elevated absolute levels of valuation, investors should keep this in mind to make sure it still suits their investment approach.
A Quick Recap
The last time we highlighted CEF relative value opportunities was about a year ago when we focused on the preferreds sector which tends to be particularly rich in rotation alpha.
We highlighted the divergence between FPF and DFP – two preferreds CEFs that, though they are managed by different fund families, have broadly similar portfolios and historic returns.
Source: Systematic Income CEF Tool
At that point, DFP ran up to a low-double-digit premium advantage over FPF which didn’t make a ton of sense. The chart below shows that while total NAV returns (orange bars) since that point are about the same, FPF has more than double the price return (blue bars) of DFP.
Source: Systematic Income
Another pair we highlighted was the Flaherty preferreds CEF pair of PFD and PFO where PFD ran out to an unusually high premium advantage over PFD. Though the fund kept on going for some time after the article, its premium has recently collapsed.
Source: Systematic Income CEF Tool
The net result is that while the two funds delivered similar NAV returns, their total price returns are hugely different.
Source: Systematic Income
It’s important to highlight that these recommendations are not based on just valuation divergence. This, in and of itself, would not be particularly interesting since lots of funds see changes in their valuation for all kinds of fundamental reasons. The key is that the portfolios selected for our relative value recommendations pass a number of other tests such as total NAV returns, NAV return correlation, and net investment income NAV yields to ensure that their portfolios are broadly similar. This means that the relative value divergence is unlikely to be driven by any fundamental reason and is more likely to mean revert. This can give investors more confidence that by rotating they are acquiring a similar set of assets at a more attractive valuation.
A final pair is also in the Flaherty suite when DFP rallied to about a 7% premium differential over FLC. Since then, the premium differential reversed with FLC trading above that of DFP.
Source: Systematic Income CEF Tool
Since then, though DFP actually managed a stronger total NAV return than FLC, FLC delivered a total return that is nearly double and about 10% above that of DFP, equivalent to about a year-and-a-half of distributions. At current valuations, our view is that DFP is now slightly cheap to FLC given its lower fee and similar portfolio.
Source: Systematic Income
In the sections below, we highlight current relative value opportunities we see in the market.
PIMCO Tax-Exempt California Funds
- PIMCO California Municipal Income Fund (PCQ)
- PIMCO California Municipal Income Fund II (PCK)
- PIMCO California Municipal Income Fund III (PZC)
The trio of PIMCO California tax-exempt funds has been on our radar for some time. The recent premium divergence between PCQ and PZC/PCK hit a record high – PCQ and PZC premiums are shown in the charts below.
Source: Systematic Income CEF Tool
The reason why PCQ has been rewarded with a much higher premium has to do with its higher distribution rate on NAV. As the extract below from our CEF Investor Tool shows in the NAV Current Yield column, PCQ distributes 5.63% on NAV while PCK distributes 4.32%.
Source: Systematic Income CEF Tool
Investors interpret the higher NAV distribution rate of PCQ as a proxy for its higher underlying income. The reality is far from the truth. While PCQ does have a higher NAV NII yield, it is not as high as its higher distribution rate suggests.
What’s worse is that because investors bid up the price of PCQ, the income they receive, once the premium differential is taken into account, is actually lower than that of the other two funds. In other words, investors tilt to PCQ because its NAV distribution rate is higher but end up receiving an NII yield on price that is actually lower. We can see this in the Covered Yield column in the table above which is equivalent to the NII Yield on Price. It is clear that the market bids up the premium of PCQ until its distribution rate at 4.09% is roughly equal to that of PCK at 4.03% and ignores the fact that its NII yield on price is now well below the other two funds in the PIMCO California tax-exempt suite.
One way we can see this dynamic is by looking at the coverage and UNII trends of the three funds. Because PCQ overdistributes, its coverage (left chart, red line) has consistently been below that of PCK. Its UNII (right chart, red line) is also on a very different path and will shortly dip into a deficit. This suggests it is likely to make a heavier cut to its distribution – something that investors already experienced with PTY.
Source: Systematic Income CEF Tool
John Hancock Hybrid Funds
Unlike the other pairs/trios of funds in this article, this pair of funds carry somewhat different portfolios. The PDT portfolio is 44% in preferreds and 39% in common shares while the HTD portfolio is 31% in preferreds and 55% in common shares. On a sector basis, both funds put a heavy focus on utilities and financials with a decent allocation to the energy sector as well.
The chart below shows that while the two portfolios track each other fairly well, PDT has pulled away from HTD, particularly coming out of the COVID drawdown. That said, its 3y total NAV return is 9.7% versus 8.6% for HTD – not a million miles away.
Source: Systematic Income
It seems that PDT has been rewarded for this outperformance with a valuation that is 20% above that of HTD – something that looks a tad rich. After all, even if PDT can, in fact, deliver 1% annual NAV outperformance in perpetuity – (a big if since it hasn’t done that consistently and the two funds are run by the same managers), paying a 20% premium for that 1% is steep.
Source: Systematic Income CEF Tool
Virtus AllianzGI Multi-Sector Funds
This pair of funds is very similar – boasting similar portfolios, leverage levels, and returns. The 3y total NAV return differential between the two funds is just 0.28% (13.92% vs. 13.64% CAGR). The key difference between the two funds is that NCZ has a higher leverage cost of 1.46% on net assets vs. 1.12% of NCV due to its higher reliance on fairly-expensive $25-par preferreds.
Historically, NCV has traded at a higher valuation which reflects this lower leverage cost. From a fundamental valuation perspective, the current valuation difference of 4% is not far from fair value. However, the market has not awarded NCV a consistent valuation premium – the right-hand chart below shows that the valuation difference between the two funds has been highly mean-reverting. This dynamic offers an opportunity for more tactically-oriented investors.
Source: Systematic Income CEF Tool
Invesco CMBS Funds
We have held one of these funds (depending on valuation) in our High Income Portfolio since inception in Q3 of 2020 for their partial floating-rate profile, term structure, niche sector, and cyclical exposure to a recovering economy via commercial mortgage securities. These funds tend to fly under the radar but over the past year, they have delivered total returns north of 30%, easily outpacing the vaunted PIMCO taxable funds which managed “only” around 21% on average.
IHTA has slightly longer maturity assets that match its 2024 target maturity date and so tends to behave in a higher beta fashion than IHIT. Apart from this, the portfolios are broadly similar.
IHIT is currently trading at an elevated valuation relative to IHTA – about 4% higher. That doesn’t sound like much but it’s at the higher end of a mean-reverting pattern we can see in the right-hand chart below. Plus, given the fund’s expected 2023 termination, its 4% premium is beginning to act like a headwind for its performance.
Source: Systematic Income CEF Tool
There are many other ideas for which there isn’t enough space. Subscribers and free trial users can peruse all the opportunities in our CEF Investor Tool, sorted by fund similarity and alpha potential. A screenshot of the Municipal sector is provided below as a starting point for investors who want to do their own homework.
Source: Systematic Income CEF Tool
Takeaways
Steadily lower CEF yields and elevated price volatility have underlined the attraction of pursuing relative value opportunities in the CEF space – strategy that offers a way to generate additional alpha for investors. It can also provide an attractive diversifier and an independent source of returns for income investors who are now facing a harder hill to climb after a strong year-and-a-half of performance.
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