This article was first published to Systematic Income subscribers and free trials on May 14.
Welcome to another installment of our weekly CEF market review where we discuss CEF market activity both from the bottom up – highlighting news and events on individual funds – as well as top-down information – offering insight into the broader market. We also try to provide historical context as well as relevant themes that seem to be driving the markets or that investors should be aware of.
This update covers the period up to the second week of May. Be sure to check out our other weekly updates covering the BDC as well as the preferred/baby bond markets for insights across the entire income space.
This week was very similar to what we have seen so far this year but also very different. It was similar in that most CEF sectors ended in the red with only two sectors – Agencies and Taxable Munitions – generating gains.
And it was different in the sense that the higher quality sectors eventually outperformed. This contrasted with the earlier dynamic of underperforming higher quality sectors. And that, in turn, was of course tied to the fact that the first leg of the selloff was driven by rising Treasury yields, while this second leg of the selloff was driven by widening credit spreads, Treasury yields being relatively stable.
All sectors are down for the month of May, with the seven best performing sectors all beginning, appropriately, with the letter “M”. In addition to MLPs, which are clearly supported by rising commodity prices, higher quality sectors like agencies and munis are supported by their higher quality, making them more resilient in times of widening credit spreads .
The sell-off in the CEF index accelerated this week, driven by both widening credit spreads and falling stock prices.
Fixed income discounts continue to widen, as shown in the chart below (orange line). Equity discounts (blue line) have also moved closer to the bottom of their range so far this year.
Looking further ahead, fixed income sector discounts are at attractive levels, as shown below, while CEF equity sector discounts are still relatively expensive.
Refreshing our 5Y “Back Up The Truck” chart first discussed in early April, we see that we have moved considerably closer to the “BUTT”. In our view, it is worth adding additional capital at current levels, even if underlying credit spreads could widen for the simple reason that 1) credit spreads have already climbed significantly above their end-2021 levels (i.e. around 50%, rising from 3% to 4.5%), 2) leverage costs are still relatively low, although rising, 3) haircuts are at attractive levels and 4) credit yields (if not spreads) are at historic lows with a 91% 10-year percentile, i.e. the yield bond credit yield has only been higher 9% of the time over the past 10 years. At the same time, the chart highlights that CEF yields may continue to deteriorate and investors should leave some dry powder in store.
We also obviously use the acronym “BUTT” to make fun of other commentators who like to call every two weeks for “Back Up The Truck” and have done so since the start of the year despite the fact that CEF valuations n weren’t that cheap.
A good question is whether the CEF market behavior of the past few weeks can be described as a capitulation. Capitulation can be a useful market dynamic to assess because it creates an asymmetrically positive flow picture. During the breakout, weak hands exit the market, which, in turn, reduces selling pressure going forward. In our view, some of the signs of CEF capitulation would be:
- Similar prices move across all sectors without regard to quality,
- absolute great drawdown
- big moves wider in discounts,
- abnormally high volume,
- increase in the CEF beta of major assets such as stocks or treasury bills, and
- nonlinear behavior in CEF returns.
Let’s examine them in turn.
A sign of surrender would be a baby with bath water momentum – if we saw higher quality sectors such as Munis or Agencies experience similar downgrade movements to lower quality sectors such as high yield bonds or loans. The evidence here is mixed – the rebate movements of the Muni sector have not been excessive and the widening of the agency sector is average. On the other hand, the downgrade movement in the Investment-Grade CEF sector is very large, while the downgrade movement in the EM debt sector is not so large – mixed signals at best.
Two, glancing at the sliding draw over 1 year in the CEF index shows it is now the third largest this century only behind the COVID and GFC levies. That said, we have to be careful here because, as we repeatedly pointed out at the end of 2021, the CEF market was also unusually expensive. This means that the size of the drawdown is arguably less relevant than it seems – like a 50% off garment that was marked up 20% before the sale.
Three, fixed income sector discounts (orange line) are now quite wide historically, but not in the double-digit zone we saw during the GFC, energy crash, 2018 market meltdown, or COVID pullback. Equity sector discounts remain at medium levels.
Four, CEF volumes are high but far from end-2018 or GFC levels.
Five, Beta CEF to stocks has been at fairly average levels over the past 5 years.
Sixth, CEF Price Behavior seems to have accelerated downward recently with fewer and smaller dead cat bounces.
Overall, the evidence is mixed – some measures point to capitulation, but most do not. That said, if this is a sellout, while an interesting question, it may not be the right question to ask.
First, because capitulation is only really knowable after the fact. Second, even a high probability of capitulation does not mean that asset prices cannot fall further. And third, because the capitulation may never come, with markets stabilizing or continuing to decline at a slower pace.
In our view, valuations are about as attractive as they have been outside of truly historic market shocks such as the GFC or the COVID period. The question for investors is whether we are going to see a shock of a similar magnitude or whether our own baseline scenario of macroeconomic confusion with a shallow recession is more likely. Investors with a prior view may want to sit on the sidelines while those in our camp may want to start snacking.
Position and takeaways
Over the past week, we have moved in three directions in our CEF outlook. First, we increased the CEF allocation in our income portfolios, taking advantage of more resilient allocations in baby bonds, preferred stocks and open-end funds. Second, we have shifted towards higher yielding credit allocation – previously we have focused on adding higher quality CEFs such as munis while waiting for the credit expansion phase of the current drawdown to occur , which is finally here. And third, we looked to longer-duration credit assets, with the idea that these assets are more likely to benefit from a recession when interest rates should, at least partially, reverse their downward trend. increase this year.
The High Yield CEF sector meets these three criteria. Our favorite pick in the sector is the Credit Suisse Asset Management Income Fund (CIK) which has a deeper discount than the sector average, an above-average current yield and a much better historical performance relative to the sector. It is trading at a discount of 9% and a current yield of 9.9%.