Recent conversations with subscribers suggest that many are concerned about CEF distribution cuts. In this article we take a look at a few techniques that investors can use to lessen the risk of a cut. We also highlight a number of investment options across CEFs and senior securities.
Distribution cuts often deliver a double-whammy to investors. First is the obvious cut in income and, secondly, is the likely knock-on impact on the fund’s discount valuation. This is because investors will often rotate away from a fund that cut its distribution, leading to a widening discount or a lower premium. This dynamic leads to the broader valuation pattern of the CEF market that, to some extent, sets discounts and premiums so as to compress price distribution rates relative to their NAV distribution rates. In other words, funds with high NAV distribution rates will tend to trade at higher valuations.
The poster child for this dynamic, though far from the only one, has been the PIMCO Global StocksPLUS & Income Fund (PGP) which has made distribution cuts historically, each of which has been associated with a deflation of its premium, delivering sharp losses to investors each time.
The price return per annum of the fund over the last five years is close to zero despite a NAV return per annum of about 16%. This dynamic highlights one way for investors to position in order to limit the impact of distribution cuts which is to tilt away from richly valued funds since a fund with an expensive premium is more fragile to a distribution cut. Its premium will tend to deflate faster than a fund that is reasonably valued, all else equal, leaving less capital for investors to allocate to another security.
Another technique is to use the timing of distribution announcements. One version of this technique is to simply rotate out of the fund prior to the announcement and get back in once the risk of a cut has passed. Personally, we actually don’t find this one a slam dunk for a couple of reasons. First, this technique is only really suitable for a tax-sheltered account which limits its use across investors (those who have sizable allocations in taxable accounts) and sectors (tax-exempt funds are unlikely to be in tax-sheltered accounts anyway). Secondly, most CEFs are not particularly liquid and can incur significant slippage which can sum to a greater cumulative loss over time than the potential loss avoided by sidestepping a cut. Thirdly, if a significant number of investors practice this technique, it will make it unprofitable as investors will end up selling low (after other investors have pushed down the price through their selling) and buying back higher. Fourthly, though the CEF market is not completely efficient, it is also not completely inefficient which means that there is a pricing in of various kinds of risks, including distribution announcements. In other words, by avoiding the distribution announcement, investors are also avoiding the likely compensation for bearing the risk of remaining in the fund through the distribution announcement.
One way to partly mitigate these issues is to use funds with quarterly distribution announcements where announcements are made for three months at once rather than just the upcoming month. While most funds declare distributions on a monthly basis, some fund families do so quarterly such as Legg Mason / Western Asset, PGIM, BlackStone, Cohen and Steers and others. For example, the Western Asset Mortgage Opportunity Fund (DMO) is one such fund. A number of other CEFs, particularly, in equity-linked sectors, make quarterly distributions which achieves much the same thing.
Another technique is to hold funds with managed distribution policies or MDPs. Sectors like Agency, Global Income, Loans, Equity and others have a sizable number of funds with these policies. An important point is that MDPs are different and not all are “level distribution” policies. Some link the distribution to the last month NAV or a rolling NAV, or even price, average. However, the distribution changes of these funds can be anticipated in advance. It is also worth emphasizing that distribution policies can change so there is no guarantee of their future stability.
For example, the Wells Fargo Income Opportunities Fund (EAD) has a policy of paying out 8% on the last 12-month rolling NAV average. As we have highlighted earlier, the fund’s distributions are set to increase as the low-NAV months of the first-half of 2021 are leaving the observation window.
Another set of techniques relies on tracking some of the fund’s features or historic performance. For example, tracking distribution coverage, particularly for funds with monthly disclosures, can be useful, though it is far from our favorite method as it’s essentially a backward-looking approach which makes it difficult to anticipate distribution changes since it doesn’t take into account actual drivers of income and is vulnerable to a head fake.
From a cross-sector perspective, we find it useful to compare the net NAV trends of different funds over the last few years as illustrated by an extract below from our CEF Tool. The 3-year net NAV percent change is simply the change in the fund’s NAV ex-distributions over this period. This metric highlights which funds are more or less likely to be overdistributing, leading to an erosion of NAV. Unless funds raise additional assets through rights, ATM or secondary offerings, the drop in assets will worsen the fund’s scale and viability and will likely lead to a distribution cut, in order to preserve assets and, hence, fees.
Source: Systematic Income CEF Tool
For example, a loan fund that looks attractive on this metric (as well as others) is the BNY Mellon Alcentra Global Credit Income 2024 Target Term Fund (DCF).
Tracking fund leverage is very useful as well as it can provide indications of medium-term changes in the fund’s income level. For example, after their deleveraging in March and subsequent distribution cuts, the four Nuveen preferred CEFs have built up their borrowings nearly back to their early-2020 level which should, at the very least, support distributions and, possibly, increase them. The chart below shows the steady increase in borrowings of the Nuveen Preferred & Income Opportunities Fund (JPC).
Source: Systematic Income CEF Tool
Finally, it is important to say, that distribution changes are ultimately at the discretion of the fund managers and their board so no technique is entirely foolproof. For this reason we also find it useful to have allocations to individual preferreds and baby bonds, which have defined dividends. Although these can often be deferred, this would happen only in extreme circumstances.
For example, the Wells Fargo 7.5% Series L (WFC.PL) is a non-callable perpetual preferred, trading at a 5.38% yield – an attractive level for a split investment-grade rated stock of a major bank. On the higher yield end we like the Qurate Retail Group 8% Series A (QRTEP), rated BB- by Fitch and trading at a 7.86% yield with a kicker if called prior to 2028. Finally, there are a number of mREIT preferreds we covered recently, with 2027 call dates such as the New York Mortgage Trust 8% Series D (NYMTN), trading at a 8.13% yield to its call date after which it will float if not redeemed.
Increasing CEF premiums and falling underlying asset yields have increased the level of concern in the income investment community about potential distribution cuts. And although no single technique is foolproof in mitigating the likelihood of a cut in CEF holdings there are a number of things investors can do. Paying attention to net NAV, leverage trends and distribution coverage, tilting away from richly valued funds, holding funds with MDPs and using the timing of distribution announcements is likely to improve investor outcomes. Finally, allocating a portion of the portfolio to senior securities, where the issue of cuts is largely moot, is worth considering.
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