The current market environment for CEF investors is one of both expensive asset prices and historically tight discounts. Such an environment may drive many investors to rotate out of CEFs into lower-beta open-end funds that typically don’t carry leverage and have no discount volatility, enabling them to withstand drawdowns better than CEFs. A middle-ground option are target term CEFs which tend to feature a lower duration / beta profile, modest leverage and greater discount control relative to perpetual “standard” CEFs – very attractive features if the market hits a bump on the road. In this article, we take a look at a number of target term CEFs and highlight a few that remain attractive.
Why Target Term CEFs?
Target-term CEFs, as we discussed in our primer, are a subset of term CEFs. Unlike “normal” or perpetual CEFs, both target-term and term CEFs share a (an expected) termination date. However, unlike term CEFs, target-term CEFs have a target NAV which they aim to deliver back to investors at termination, typically set at the initial NAV level.
Many investors put a lot of focus on this target NAV, however, we wouldn’t put a lot of stock into it but would focus rather on a related feature. This feature is the tendency of target term CEFs to hold fixed-income assets roughly corresponding to their termination date (which is why it makes sense to target a return NAV in the first place). In other words, a fund five years away from maturity is much more likely to terminate close to its initial NAV if its assets also are five years in maturity as they would be expected to mature at par, providing more certainty as to the eventual value of the fund’s portfolio.
What this means is that 1) fixed-income target-term CEF tend to feature low duration that roughly matches the time to their termination dates and 2) the fund’s duration will move lower over time as the termination date approaches. A perpetual CEF, on the other hand, will turn over its portfolio in order to keep duration at its target level, in effect, selling off assets with nearer maturities and buying assets with longer maturities.
This dynamic of relatively low duration is itself attractive on two fronts. First, it may be attractive to investors in the current market environment of an uncertain inflation outlook and, hence, medium-term path of interest rates. And secondly, it may be attractive in a risk-off market environment as well since a lower duration limits the amount of the price drop due to sharply wider credit spreads. In other words, lower-duration assets offer a kind of lower-beta exposure to assets.
It’s tempting to point to loans as assets that also feature low duration, however, loans only have one of the two risk mitigants that target term CEFs have. Because loans can have relatively long maturities they can exhibit large drawdowns and volatility in a weak market when credit spreads widen significantly. In other words, they can have low duration but a high beta. Shorter-maturity assets, which tend to feature heavily in target term CEFs, have both low durations (low interest-rate sensitivity) and low beta (low sensitivity to credit spreads).
As with anything, these attractive features also have downsides, two in particular. First, lower-duration assets earn a lower interest rate due to the steepness of both the interest rate and the credit spread curves. For example, 10-year Treasuries are trading at a yield of 1.59% vs. 0.30% for three-year notes. Longer-dated corporate bonds provide an additional pick-up over their shorter-term counterparts due to the fact that longer-term credit spreads are higher than shorter-term credit spreads.
The second downside is that, just as lower-duration assets are less sensitive to a market sell-off, they’re equally less sensitive to a further market rally. In our view, this is less of a concern at the moment given the asymmetry in historic credit valuations as the following long-term chart of high-yield corporate bond credit spreads makes clear. Current valuations are close to their historically expensive levels and, hence, there’s much more room for weaker price action than there is for an equally-sized rally.
Source: FRED
The second attraction of the target-term structure is that a target-term CEF is much more likely to actually terminate than a term CEF. This is because of the feature mentioned above – that target-term CEFs tend to hold assets with maturities around its own termination date. So, in order for a target-term fund to become a perpetual fund, it would need to fundamentally change its mandate and portfolio, whereas a term CEF could just carry on as before. This greater certainty around its likely termination provides a firmer anchoring of the fund’s discount as well as a discount amortization tailwind, which we call the pull-to-NAV yield, that is more certain or bankable, in a manner of speaking.
So, just as a lower duration stance of most target-term CEFs provides a measure of downside control as far as asset prices or NAVs go, their stronger discount anchoring (due to the fact that the discount will be zero on the fund’s termination) provides support for its discount in times of volatility. This is particularly appealing when discounts are trading on the expensive side in fixed-income sectors as the orange line below shows.
Another way to compare discount valuation between target term and perpetual CEFs is to look at where each group is trading. The chart below shows the average discount of the target term CEFs in the high-yield sector (orange line) and the average discount of perpetual CEFs in the same sector. We chose this sector because it has the most number of target-term CEFs at 4.
The chart shows two things. First, it shows that target term CEFs have historically traded at a tighter discount than their perpetual counterparts in the sector. This is not surprising given the discount anchoring dynamic discussed above. And, secondly, the discount differential between target term and perpetual high-yield sector CEFs has compressed – something more clearly seen in the chart below.
What this suggests is that, at least relative to the history of the last five years, HY perpetual CEFs are unlikely to deliver discount outperformance relative to target term CEFs going forward. The reason this chart starts where it does is that the current target term CEFs in the sector only started trading in 2016 and later. If we go further back we see that the post-2016 period featured relatively wide discount valuations and that, in fact, the average HY CEF sector discount got as high as a 10% premium in what looks to be 2002-2003 and 2012.
What this suggests is that perpetual CEF discounts may continue to outperform those of target term CEFs since it’s very unlikely for target term CEF valuations to reach anywhere close to a 10% premium – that would be too irrational even for the notoriously irrational CEF market. In other words, while perpetual CEFs look fairly expensive relative to target-term CEFs, they could get even more expensive if valuations retrace to their century-high levels.
While we would not be surprised for the average high-yield sector valuation to move up into premium territory and stay there for some time, particularly, as we appear to be in the early stage of a new market cycle, the fact that the sector discount is trading at seven-year tights does suggest asymmetric risk/reward in perpetual CEF valuation.
In fact, we would argue discounts actually are more expensive than they appear in the chart. This has to do with the fact that underlying asset yields are much lower than they were in 2012 (high-yield corporate bond yields were nearly 2x as high in 2012 as they are now). This means that CEF fees are taking out a much bigger chunk of the income generated by funds today than they did in 2012 and this is very important for discounts from a fair-value perspective.
In summary, target-term CEFs offer a measure of protection against rising interest rates as well as market weakness due to their, often, low duration profile. And they also can provide stronger discount stability due to their discount anchoring in the likely termination scenario. The downside of this is that they tend to be lower-octane funds which makes them less appropriate for investors who continue to expect strong capital gains in the current environment or who are happy to reach for yield. Overall, however, we view both NAVs and discounts as relatively rich which suggests that investors should consider allocating a part of their portfolio to target term CEFs.
Some Opportunities
In this section, we highlight a number of target term CEFs that remain reasonably attractive. It’s fair to say that term CEFs, more broadly, don’t offer a magic oasis of cheap funds in an expensively valued CEF desert. One way to gauge valuation in term CEFs is to track the average pull-to-NAV yield which is simply the annualized expected performance tailwind from the discount (or premium) compression to zero on the expected termination date i.e. a fund two years away from termination and trading at a 3% discount has a 1.5% PTN Yield.
The chart below shows this metric over the last five years. The chart makes it clear that, on average, the PTN Yield is right around zero and looks to be fairly expensive. That said, there are some opportunities in individual funds and, even at a zero PTN Yield, term CEFs can be attractive due to their lower duration profile and discount control relative to perpetual CEFs.
The Nuveen EM Debt 2022 Target Term Fund (JEMD) has an expected termination date of Dec-2022 and is trading at a 4.46% current yield and a 1.1% discount. The fund allocates to sovereign and corporate high-yield rated Emerging Market issuers. The fund’s duration is 2.1 which is very low for a credit fund and it has leverage of 22%. The fund’s discount should provide an additional 0.7% annualized tailwind into the likely termination.
Nuveen’s JHAA has an expected termination date in December 2023 and is trading at a 3.81% current yield and a 2% discount. The fund allocates primarily to US high-yield corporate issuers and has a duration of 1.8 and leverage of 24%. The fund’s discount should provide an additional 0.8% annualized tailwind into the likely termination.
The First Trust Senior Floating Rate 2022 Target Term Fund (FIV) has an expected termination date in February of 2022 and is trading at a 2.4% discount and a laughable 1.3% current yield. We call the yield “laughable” because it’s so low but also because it’s not representative of what the fund’s portfolio actually yields which is pretty close to the loan sector average level. The portfolio yield-to-worst is a healthy 4.68% before its 29% leverage. If we assume that the fund’s leverage and fees roughly offset we get to an expected annualized return of 9%+ or so into the termination early next year. The fund clearly appears to use its low current yield as a way to conserve NAV to be able to hit its target which is currently a couple of percent above the current NAV. The fund’s weighted-average portfolio maturity of 3 is quite a bit longer than its termination date which presents some mark-to-market risk on the termination. The other consideration to keep in mind is that First Trust, unlike Nuveen, doesn’t have a track record of how they treat term CEFs so we don’t know what they will do. However, the downside risk of about 2% to the discount seems reasonable. In other words, it’s reasonable to assume that the fund’s discount will move roughly to the sector average of about 4% from its current level of 2% if the fund decides to cancel the termination date on a shareholder vote which offers an attractive risk / reward for the likely upside scenario.
Source: Systematic Income CEF Tool
Takeaways
Target term CEFs have a role to play in income portfolios because they provide a middle ground investment vehicle – providing the active management, leverage and less liquid asset holdings of perpetual CEFs but also a lower beta due to their lower duration profile and stronger discount control. These risk-mitigating features look attractive in the current environment of both expensive asset and discount valuations.
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