This article was first released to Systematic Income subscribers and free trials on Mar. 7
Welcome to another installment of our CEF Market Weekly Review where we discuss CEF market activity from both the bottom-up – highlighting individual fund news and events – as well as top-down – providing an overview of the broader market. We also try to provide some historical context as well as the relevant themes that look to be driving markets or that investors ought to be mindful of.
This update covers the period through the first week of March. Be sure to check out our other weekly updates covering the BDC as well as the preferred / baby bond markets for perspectives across the broader income space.
CEF discounts continued to recover last week across nearly all sectors despite fairly broad-based NAV weakness. EM sectors continue to underperform while the rise in Energy prices continue to support MLP funds.
Overall, March is shaping up to be a third straight down month in total price return terms.
Discounts have tightened a bit over the week, however, they remain about 5% below their levels at the start of the year. The previous recovery in discounts was short-lived so we’ll need to see if the pattern of lower highs / lower lows can be broken.
Treasury yields have fallen back off their peaks – the 10Y yield stands about 0.3% off its mid-February high. The key question for investors is whether yields are likely to move back higher if / when the current geopolitical crisis cools down. If they do it, once again, can hurt those funds that are more sensitive to interest rates.
The following screen can offer some ideas. It shows funds with total NAV performance between -3% and + 5% year-to-date with current yields above 5%. The screen is designed to capture funds that have shown relative resilience in a market environment of rising interest rates, higher credit spreads and weak equity prices.
A few funds worth highlighting are:
- Apollo Tactical Income Fund (AIF) – loan fund trading at a 9.4% discount and a 7% current yield
- Ares Dynamic Credit Allocation Fund (ARDC) – a bond, loan and CLO fund trading at a 7.6% discount and a 7.9% current yield
- PGIM Short Duration High Yield Opportunities Fund (SDHY) – a high-yield corporate bond fund with a relatively short duration of 3, trading at a 10.3% discount and a 7.6% current yield
We continue to hold AIF and ARDC in our High Income Portfolio.
One of the interesting dynamics in the CEF sector is the underperformance of recently launched funds.
We can see this in the discount behavior of a number of funds. For instance, despite its brand name cachet, the PIMCO Dynamic Opportunities Fund (PDO) has lagged the Multi-Sector CEF space and its own PIMCO taxable suite in the recent drawdown.
The same is true for another recently-launched Multi-Sector fund – the Western Asset Diversified Income Fund (WDI) – that continues to trade at a discount well wider of the sector average.
In addition, this is what the Nuveen Core Plus Impact Fund (NPCT) discount looks like versus its sector.
The same is true for (SDHY), (NMAI), (NBXG), (PTA), (PAXS) and (BCAT). In fact, we could not find a recently-launched fund that is trading at a discount tighter to its sector average.
What could explain such an odd pattern?
One driver could be the greenshoe option which helps underwriters stabilize the price of the issued stock by buying back some of it in the market. This, arguably, artificial, demand can lead to underperformance of the stock once it is removed.
Another possible driver is the simple fact that a new fund has no track record which would allow its holders to have some confidence about its historic price and discount ranges. This lack of conviction likely means that investors will let go of funds they are less familiar and comfortable with.
Finally, another driver could be a penalty bid to brokers or investors who flip their IPO’d shares too quickly. Once the penalty bid expires it could lead to increased selling, particularly in a down market where the price of the fund is below its IPO’d price.
This is all well and good, however, the question is whether this dynamic can offer an opportunity for investors. In our view, the answer is yes – whenever a fund’s valuation improves on what looks to be a purely technical driver, it can offer an opportunity. This is particularly the case when the fund manager itself, rather than the fund, has a strong track record.
A useful anecdote is to see what happened to the PIMCO Dynamic Income Fund (PDI) since its IPO in 2012. The fund is one of the very strongest performers (in both price and NAV terms) since its IPO. What happened was that the fund’s valuation collapsed over the first half-year of trading and then slowly improved over the following year-and-a-half. PDI then moved to trade at a significant premium for most of its life to date.
It should be said that this comparison is not quite apples-to-apples to the recently-launched funds since some of the initial discount weakness for PDI was due to the fact that it was issued at a premium – an unfortunate practice where investors ate issuance costs which is no longer used. That said, the dynamic ex- this effect was still real.
In our view, this shows that some of the recently-launched funds that are trading at relatively cheap valuations can be attractive holds, particularly once a lot of the technical noise has worn off, after about 6-9 months of the fund’s life. Two things that investors should check off before using this strategy is 1) whether the fund’s manager has similar funds with strong absolute and relative total NAV returns ie does the manager have a good track record and 2) if the recently-launched fund in question has a reasonable management fee – a fund with an unusually high fee may trade at a wider discount simply on a fair-value basis.
Overall, we see value in three funds:
- PIMCO Dynamic Opportunities Fund (PDO)
- Tax-Advantaged Preferred Securities and Income Fund (PTA)
- Western Asset Diversified Income Fund (WDI)
Apollo credit CEF Apollo Tactical Income Fund (AIF) reported results – NII for the 6-month period to Dec-21 was $ 0.075 vs. current distribution of $ 0.085 ie coverage of 88%. What’s interesting is that about half of the fund’s loans have Libor floors at or below 0.75% with many holdings between zero and 0.50%. With Libor at 0.5% already, asset side income has already started to increase. That’s probably not yet enough to offset the rise in the cost of the credit facility which is also pegged to Libor however net income should rise after the first couple of hikes since the amount of loans is much higher than the size of the facility. It could take time for the fund to raise its distribution as it might first wait to get coverage up to 100% but we should see a raise eventually if the Fed’s policy rate moves roughly in line with consensus. The fund remains in the High Income Portfolio.
PIMCO announced the first Access Income Fund (PAXS) distribution. Some investors are probably disappointed with the lowish yield of 7% on NAV however recall that PDO also got going at a NAV yield of 7.1%. What this tells us is that PIMCO thinks sustainable yields on their funds are closer to 7% rather than the 8-10% that you still see on their older funds (many of which have continued to trim distributions over time). And this makes a lot of sense – as we have said before it’s not really possible to generate a portfolio yield (as distinct from net investment income yield) north of 8% + in vanilla credit instruments like bonds and loans unless you are holding very crappy assets which very few funds actually do and PIMCO do not.
Stance And Takeaways
Last week we discussed our more constructive stance on the broader CEF market. Specifically, we upsized a number of holdings by rotating from the more resilient senior securities and term CEFs to perpetual CEFs that have sold off more. A number of these CEFs such as PDO and PTA are recently-launched funds which we touched on in the Themes section above. Their attractive valuation, technical weakness and strong historic returns by its managers (as witnessed in older sister funds) gives us confidence in these allocations. These positions have clocked up small gains since then.
Emerging market debt has been an obvious underperformer since the start of the recent geopolitical crisis. The question for investors is whether we are looking at an idiosyncratic or systemic problem for EM. Systematic crises are those that affect a large swath of the EM market such as a global recession or a sharp rally in the USD (which could make external EM debt harder to service). Idiosyncratic crises are those that are more local to a certain region. There is no fine line between the two as seemingly idiosyncratic crises occasionally spill over to become more systemic. The rise in energy prices is one feature that has a systemic character in the current crises, however, other systemic spillovers appear more limited. In short, when the broader EM space falls because of a turn in risk sentiment from an idiosyncratic driver, it can be an attractive time to upsize allocations. A number of EM CEFs have seen their NAVs fall by an amount that is equivalent to having all of their Russia / Ukraine allocations written down to zero along with sizable discount widening which has made them more attractive. So far we have been cautious to avoid catching a falling knife and avoided increasing our allocation to EM, however, if the conflict spillovers do not increase and sector valuations improve further we would consider adding to the sector.