This article was first released to Systematic Income subscribers and free trials on Mar. 12.
Welcome to another installment of our CEF Market Weekly Review where we discuss closed-end fund (“CEF”) market activity from both the bottom-up – highlighting individual fund news and events – as well as the 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 second week of March. Be sure to check out our other weekly updates covering the business development company (“BDC”) as well as the preferreds/baby bond markets for perspectives across the broader income space.
Sectors outside the higher-quality ones like Munis and Agencies were down on the week, hammered by banking sector worries in the last two days of the week. Higher-beta sectors like REITs and MLPs underperformed alongside Preferreds which are overweight Banking sector securities.
January gains continued to unwind as this month’s losses approach mid single-digits.
The CEF space has unwound nearly all of its yearly gains.
Discount performance, once again, diverged between fixed-income and equity sectors. Fixed-income discounts remain in the fair-value area and we would wait for a further pullback to add risk.
Muni, Preferred and Loan sectors, among others, screen as attractive in valuation terms.
BlackRock released CEF distribution news and it’s more of the same – Muni funds down and Loan funds up. All 3 BlackRock loan funds hiked. BGT and FRA had big hikes of around 40% which is unusual – you don’t tend to see 40% hikes in the CEF space. In contrast, Muni CEFs saw further cuts.
If we look at the trailing-twelve month distribution trends we see a clear divergence between the two sectors.
On a monthly basis, the median Muni CEF has cut its distribution by 21% over the past 12 months while the median Loan CEF raised it by 28%. This divergence trend is likely to slow down by mid year as short-term rates have moved closer to their likely terminal level. Unless the Fed surprises markets to the upside or downside, we should expect distributions to stabilize towards the end of the year.
John Hancock corporate credit funds JHI and JHS had large cuts of 25-35%. These funds are very unusual in that they pay and declare quarterly and also have a kind of floating quarterly distribution. For this reason they are good indicators of what’s happening for net income across the corporate bond CEF space. JHS is more of an investment-grade CEF while JHI is a HY corporate bond fund.
Western Asset CEFs DMO and WDI released shareholder reports. Both funds saw a 6% rise in net income over the latest semi-annual period (11% rise year-on-year for DMO). WDI has raised the distribution 4 times over the past year and coverage is still north of 100%. It’s surprising DMO net income hasn’t risen faster given its fixed-rate liabilities and primarily floating-rate assets – the inverse floaters in the portfolio and a stale six-month lookback are the likely culprits. On a quarterly basis net income likely rose closer to double-digit levels. Both funds remain decently valued at around 12-13% discounts and are in two of the Income Portfolios.
The pair of largely convertible bond CEFs NCV and NCZ cut distributions by 20%. Recall that one of the funds suspended distributions in 2022 (as it did in 2020) as its leverage rose north of 50% which is something CEFs have to do if they have preferreds. Both funds subsequently held tender offers for their auction-rate preferreds or ARPS (they also have exchange-traded preferreds which were left alone). The trouble with ARPS was similar to the issue faced by the PIMCO CEFs – that their interest rates rose to absurdly high levels due to a multiple applied in the maximum rate calculation (the maximum rate is applied when the auctions fail which has happened since the GFC). Specifically, the formula was 200% x 7-day AA commercial paper which ends up being close to 10% – a crazy thing to pay on leverage for any fund, particularly a convertible fund (converts tend to have very low yields since they derive most of their value from the upside conversion option). The ARPS were replaced by a much cheaper credit facility in the capital structure. The replacement was not done 1:1 but with a total drop of around 25% in total borrowings. Although this deleveraging, unusually, helped net income, the funds took the opportunity to cut the dividend towards a more sensible level.
Stance And Takeaways
The obvious question for investors in light of two bank failures this week is what to do with preferred CEFs which are overweight bank securities. At present we are not selling our preferred CEF holdings for a couple of reasons.
Whereas the GFC involved losses in the largest and most integrated banks, the current crisis has touched relatively niche banks with an uninsured and undiversified depositor base. We could very well see a pass-through to community banks, however, the too-big-to-fail banks are much more resilient. Regulators are also likely to have a much easier time “bailing out” local community banks as they would face much less political opposition than they did saving the major investment banks 15 years ago.
Second, whereas the GFC involved credit losses the present crisis involves duration losses i.e. losses due to interest rate rises on very high-quality securities. These kinds of losses are self-limiting since a worsening of the crisis should go along with a drop in interest rates which would lower the amount of unrealized losses in bank portfolios.
Third, whereas during the GFC, investors (and often bank executives themselves) had little clue as to how much bank losses actually were and, hence, what the value of bank equity was, there is very little doubt today since the securities in question are all highly liquid and tradable. This greatly reduces the tail risk and greatly increases the transparency of the overall sector. One of the key problems of the GFC was that banks themselves didn’t want to deal with each other as they didn’t know who was a good credit and who wasn’t. This is not the case today.
Overall, much depends on what happens with uninsured depositors of SIVB. Ultimately, regulators will likely come up with a systemic solution that protects uninsured depositors across the sector to make sure there is no depositor flight away from weaker banks, something that would exacerbate the crisis. For this reason as well as the key differences today versus the GFC we would look to add to our preferred CEF holdings on further price drops.