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.
After a brief sell-off after the election due to the impact of rising interest rates, closed-end funds have been on a one-way track to higher returns.
A large part of the reason for this strong performance is the unsually conducive environment of lower yields and higher stock prices. This type of co-movement is relatively unsual in markets because lower yields tends to be associated with a risk-off environment.
In the current case however, we are witnessing a split in bond and equity returns. The benign explanation for this is that equities are heading higher because of policy and regulatory events which don’t have an outsize influence on bond yields. The less benign explanation is that similarly to 2008, bonds and equities are disagreeing on the macro picture with bonds taking a more pessimistic view.
Watch this space!
In this post we would like to introduce a weekly screen that we have now added to the Analytics page. The screen shows the top and bottom 10 closed-end funds sorted by Z-Score, calculated as a weekly 3-year standard deviation of the fund discount.
We find that the cheapest funds by our metric are interestingly all muni funds and, perhaps not suprisingly, funds that have recently cut their dividends.
There are a number of reasons why muni funds have struggled to maintain distribution rates:
- Increased cost of leverage due to rising short-term costs. As financing transactions (repos etc) are much more short-term in nature, at least relative to the maturity of the assets in the portfolio, an increase in interest rates hurts the NII of funds as they are unable to recycle into higher-yielding assets as quickly.
- Some muni bonds have been called which decreases the yield on fund assets
- Some funds have hedged their interest rate exposure due to expected interest rate hikes by paying on interest-rate swaps which has a drag on net portfolio returns
Muni funds have had a roller coaster year – first trading at a huge premium which collapsed as interest rates began their march higher and have now taken another whammy from distribution cuts. We do not believe they are yet a slam-dunk opportunity but are certainly more attractive than they were before.
The PIMCO closed-end funds are well-regarded in the market for their solid management and attractive distribution rates. A particularly attractive feature of PCI (as well as PDI) is the special dividend that is typically a multiple of the regular distribution.
We decided to have a look at the PCI financials to see what amount of Net Interest Income the fund is able to generate and how that stacks up against the total (regular plus special) distributions it has paid out in the past. We expected the NII to be in line with the total distribution from NII in the belief that PCI typically overearns its regular distribution and the left over cash goes to pay for the special dividend at year end.
What we found was very different – it turns out PCI has always underearned its total distribution. The obvious question is if this is the case where does the special dividend come from? We see the following alternatives:
- ROC: funds often return capital to investors (in various constructive and destructive ways). However PCI (if one believes CEFConnect) has not returned capital to its investors.
- Capital gains: if a fund has a capital gain, it can choose to pay out this gain to investors (as short-term or long-term capital gains). Apart from a single tiny payment, PCI has not done this. Moreover, the net realized and unrealized gains since 2013 for the fund are negative.
- UNII: funds can return accumulated UNII to investors. In the case of PCI the fund typically returns all of the accumulated UNII to its investors at the end of the year.
So, what we have is a puzzle (at least for us). This doesn’t mean that PCI is in danger of cutting its dividend as the regular distribution remains well-covered however it creates some uncertainty on the sustainability of the special dividend.
In our last post we looked at divergences across economic indicators and financial markets. In this brief post we look at a key divergence in the CEF market.
To first give some background – CEFs normally trade at a discount which is typically valued using a Z-Score, defined as a standard-deviation of that discount over some time period, normally 1 or 3 years. The Z-Score gives investors a sense of how unusual the current discount is relative to the time period in question.
The second important thing to know is that Z-Scores normally oscillate in relation to the risk appetite in the market. If risk appetite is strong then discounts compress and Z-Scores increase and vice-versa. As one would expect, Z-Scores typically move together with the VIX.
What has happened recently is that Z-Scores have diverged from the VIX. The VIX has risen as stocks sold off, tensions increased in Syria and North Korea and Trump’s program hit a few snags. Z-Scores, however, have jumped higher.
Part of the reason is that the increase in volatility has been steady and relatively contained (so far). Another reason is that yields have fallen which is typically a boon for leveraged fixed-income funds. Another possibility is that CEFs have repriced higher (reaching a new plateau!) however this feels unlikely to us given the recent path of inflation and the stance of the Fed.
We’ll check back to see how this resolves. Till then,
One cannot be blamed for feeling exasperated by the current state of the markets. There are conflicting signals in all corners, some pushing, others pulling – divergences everywhere!
Taking a brief survey of the current state of affairs we find:
- Central Bank divergence: the Fed has embarked on a hiking cycle while the other Central Banks are firmly standing pat in a dovish mode and only beginning to fiddle with the existing QE programs.
- Monetary Policy vs. Market Reaction divergence: the Fed has begun sounding out the market on its $4.5trn balance sheet reduction, specifically focusing on reducing its MBS position which increased by $1trn since 2014. The reaction to this in the rates markets? A slow and steady grinding lower in yields.
- Business Cycle Indicator divergence: For the first six-month period since the end of the financial crisis the commercial and industrial loans fell on bank balance sheets. This stands in sharp contrast to other coincident and leading indicators of the US economy which are flashing green.
- Politics vs. Market divergence: After the new administration, the markets rallied in anticipation of pro-growth and business-friendly initiatives such as the corporate tax cuts and infrastructure spending. The Obamacare repeal was intended to release the savings necessary to pay for the corporate tax cuts. When the repeal failed, the markets took in stride, though it is unclear where the savings for the tax cuts will now come from.
- Hard vs Soft Data divergece: There is an unusual split in the consumer and business sentiment indicators and actual economic activity releases – the sentiment is sky high while actual business activity is ho-hum.
- Asset Class divergence: Global equities have performed very strongly so far in 2017 while credit spreads and yields have not reflected the same risk appetite.
While we can come up with reasonable explanations for all of the above – the sheer number of apparent divergences seems odd. What does all this mean for investors?
- We can be looking at the end of the current business, credit and market cycle which tend to feature a significant rise in divergences. If this is the case, then investors should lighten on leverage, acquire some tail risk protection and rebalance towards defensive portions of their portfolios.
- A rise in divergences can be viewed positively as an opportunty to find alpha – divergences across asset classes benefit the skillful (or lucky) investor.
- Investors who are averse to tactical trading may be able to take advantage of market divergences by rebalancing their portfolios on any significant deviation from their benchmarks which may allow them to buy assets that have underperformed and sell assets that have outperformed.
Every challenge presents an opportunity.
YYY (Yieldshares High Income ETF) is an ETF of closed-end funds (CEFs) split among the various CEF sectors. Roughly speaking it is composed of fixed-income and dividend funds so first-order sensitivies will be to treasury yields and equities.
What makes today an interesting day for YYY? Today both yields and equities are lower which means that one would expect YYY to be mostly unchanged while the basket constituents have relatively dispersed returns.
Is this a good day for YYY? We are tempted to say yes – bonds are up, equities are down – net the position is flat and we are just clipping coupons. However, as with anything, if we look under the hood a few key questions come up:
- Why are some equity funds up and bond funds down in the breakdown below? This seems to run counter to the macro asset performance we just highlighted.
- How likely are we to have a day when both bonds and equities are down? What happens if we see inflation push up wages and corporate margins or if the Fed makes a mistake to the dovish side and loses the grip on rates? What if Trump tries to bring back his talk of “discounts” or the Democrats try to play hard ball on the debt ceiling negotiations? Are there structural market shifts towards a negative correlation between yields and stocks?
- YYY tries to be clever by selecting a diversified basket of funds ranked by yield, discount and liquidity. It does not try to allocate across the maximum number of sectors and it does not take into account any of the portfolio allocation methods that take volatility into account which means that investors may end up holding a portfolio skewed in risk toward just a few funds.
All of these are interesting questions and particularly relevant to investors who keep an eye on volatility, yield sustainability and drawdown control. As we always say – details matter! All of these we will review in future blogposts and in the newsletter. Till then.
This is our inaugural post which begins our dedicated online presence. In the upcoming posts, we will publish brief comments on macro-economic and financial market events along with our analysis. Our Analytics page contains some of the tools we find useful in our work, so please have a look around.