This week we introduced a new table on our Analytics site. It is called CEF Sector Performance and provides basis information about CEF sectors as well as week-on-week changes.
For each CEF sector the following variables are shown in the table:
- Sector AUM
- Sector Yield
- Sector Discount
- Weekly change in the Sector Discount
- Weekly change in the Sector price return
- Weekly change in the NAV return
The table is sortable by columns and is updated weekly.
Municipal funds are compelling vehicles for closed-end fund investors. These funds offer relatively high yield – a sector average of 5% (and even higher on a tax-equivalent basis) but also resemble risk-free assets as they tend to co-move with Treasuries.
We looked at average returns of Muni CEFs on 17th of May when the S&P 500 fell 1.8%. We show below that the average fund returned +0.3% on the day (and a similar figure on an NAV basis).
We see two main takeaways for investors:
- Muni CEFs in a normal market environment tend to be negatively correlated with equities, although the rally in Munis will be much lower than the fall in equities.
- In a large sell-off (think VIX at 25+) we expect Muni CEFs to be positively correlated with equities as we expect discounts to widen more than the growth in NAVs, so investors need to take care.
The PIMCO closed-end fund suite is well-regarded in the market for the depth of its expertise and track record in generating strong returns. Sometimes, however, the price that investors are asked to pay for the brand is too high. The PIMCO California Municipal Income Fund III is a case in point with the fund trading currently at a premium of 25%.
With a sector yield of around 5%, the fund needs to deliver alpha of around 2% a year in order to justify its valuation. This is simply not the case. In the table below we show Gross NAV Returns (GNR) of PZC as well as 5 top funds in the sector. While the GNR of PZC is significantly higher of the sector average (6.9% vs 4.8%), it is not significantly higher of the top 5 funds.
In order to control for leverage and volatility (a proxy for the riskiness of the underlying portfolio), we divide the GNR by these two figures. We show that on this metric, PZC is well below the top 5 funds. In fact PZC only earns a spot at 29 across the entire sector.
In the near term we plan to develop a screen that ranks the entire CEF universe on this metric in order to help investors gauge alpha in the space.
MLP funds have come off in the last few weeks as oil has sold off. Overall commodity weakness was likely due to slower growth in Chinese activity. The sell-off in oil in particular was due to high inventories caused by shale supply in the US which tends to kick in above the $50 WTI price level. We think this is a relatively short-term phenomenon and expect the rebalancing in the oil market to feed through in the coming months as demand growth remain strong and inflation buoys broader commodity prices.
The following MLP closed-end funds screen well and we think deserve a closer look by investors.
In late March PDI filed an At-The-Money offering with the intention of selling about 20% additional shares into the market at the then current price. The likely impetus for this action is the high premium-to-NAV enjoyed by the fund, which it has earned from high distribution rates and strong price performance.
While we think tactically the share price may come off, we think longer-term the fund will continue to perform due to its low duration and leveraged position on the US housing sector. See our full article on SA.
We update our weekly discount and z-score screens which you can find on our Analytics page.
We show the biggest discounts and premia in the table below.
FXBY – a tiny equity fund tops the discount table at over 30%. Due to its board structure, FXBY is difficult to attack by activist investors and because it carries a high fee the discount is probably justified.
SRF – an MLP fund with a lowish distribution rate is trading at a discount of 16%. MLPs have had a tough few weeks due to the sell-off in oil, however, we think this is overdone and there are a few MLP funds with attractive yields trading at discounts.
Where has all the yield gone?
The last 12 months have seen significant yield compression in the closed-end fund space. In fact out of all the sectors we track, only three have increased in yield and by a very small amount. While this move benefits the portfolios of CEF investors, it also detracts from future performance in terms of new opportunities as well as yield on reinvested capital.
The top right-hand corner is most attractive representing high yield and a yield increase over the last 12 months. Unfortunately, there are no funds in that quadrant currently.
Currently we see value in Mortgage Bond, Senior Loan funds and National Municipal sectors. The MLP sector looks appealing on an absolute yield basis, however the compression we have seen over the last few months suggests cashing in some chips.
A topic that sparks interest in the normally staid world of income investors is arbitrage – a concept typically reserved for high-flying trading operations of Bank proprietary desks and hedge funds.
We often come across posts that offer the following ideas:
- Buy cheap CEF A and sell short CEF B
- Buy cheap CEF A and sell short ETF B
Our first point on these trade ideas is a minor one – let’s not use the word arbitrage. An arbitrage implies risk-free profit within a certain period of time. An example is equity index arbitrage which trades the index (via futures) against the individual components. The CEF ideas listed above are relative-value pair trades – there is nothing “risk-free” about them.
Our second point is more important – operationally it is difficult to sell CEFs and ETFs short. There are two additional wrinkles: first, borrow rates can be on the order of 6-7% so waiting for the pair trade to perform can become painful and secondly, your short position can get bought in at any point without you being notified. If you have a different experience with a particular broker please comment below.
Our third point is that CEF markets can remain “inefficient” for a long time as mean reversion is far from guaranteed so the relative-value pickings are fairly slim, though we would be very happy to be proven wrong here.
One way we look at funds is as a substitution or a switch. For instance currently PZC is the most expensive Muni CEF on a discount basis with a premium of 23.9%. Our take is it is highly unlikely that PZC is able to generate that much alpha in order to justify such a premium. Instead, it is very vulnerable to a price drop in case of a dividend cut. More on this to come from us in the future.
An unmistakable pattern of closed-end fund performance over the last few months has been the steady grind of higher prices and lower discounts. The question is whether this behavior is reflective of broader dynamics in the market. We think the answer is yes and it has to do with the unusual pattern of higher bond and equity prices.
In the chart below we plot the percentage of weekly returns when both bonds and equities finished higher. It is easy to see that 2017 is indeed an unusual period. We think that bond yields overshot to the upside on the Reflation Trade and expectations of inflation, wage and economic growth have come back down to earth along with interest rates. Stocks on the other hand have paid more attention to the expectations of regulatory and policy changes such as the corporate tax plans and softer tones on NAFTA. So while we don’t expect this Goldilocks environment to continue we also don’t expect the ‘nightmare scenario’ of lower bond and equity prices.
One of the side benefits of having constructed our closed-end fund indices is the ability to take a bird’s eye view on the entire CEF universe. Without these tools we are limited to a bottom-up analysis of individual funds which severly limits our analysis.
A visualization we find particularly interesting is a three-variable view across CEF sectors of Net AUM, Distribution Rate and Discounts. It provides a partial answer to the question of – which sectors look attractive right now given a particular yield target? It also gives investors information if they consider switching allocations across sectors.
An unmistakable pattern in the chart below is the positive correlation between distribution rates and discounts – higher “yielding” sectors tend to trade at a premium. That said, a few sectors do stand out – namely Global Equity, Global Hybrid and Limited Duration – these are worth a second look by investors.