CEF Weekly Review: What’s Behind CEF Loan Forgiveness Underperformance?

This article was first published to Systematic Income subscribers and free trials on September 11.

Welcome to another installment of our weekly Closed-End Fund (“CEF”) Market Review where we discuss CEF market activity both from the bottom up – highlighting individual fund news. and events – as well as top-down – providing an overview of the wider 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 first full week of September. 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.

Market action

CEFs had an overall positive week as higher Treasury yields were more easily digested by the credit and equity-focused CEF sectors. The municipal sectors underperformed.

Year-to-date sectors that have underperformed are longer duration ones like Munis as well as emerging markets and higher beta convertibles.

Despite an overall bullish mood in the CEF space, haircuts widened, overall, in the CEF equity and fixed income sectors.

Market themes

There was a question on the service as to what to make of the fact that discounts on CEF loans have significantly underperformed those on HY bond funds recently.

The behavior of the two CEF sector haircuts was very interesting. At the end of 2021, CEF haircuts on loans were larger than HY bond CEFs, as shown in the following chart.

Then, when it became clear that the Fed was about to embark on a series of hikes (i.e., support loan fund income levels), CEF haircuts on loans outperformed HY bond CEFs by around 8% through February. This however did not last long. Since then, CEF haircuts on loans have consistently underperformed HY bond CEFs.

Now the CEF loan sector’s haircut is about 4% higher than the CEF HY bond sector’s, which is oddly a bit worse than the situation in 2021. It’s as if none of the Fed hikes ( that allowed loan fund income levels to rise relative to bond fund income levels) was irrelevant to the relative valuation. What’s more interesting is that year-to-date loan CEFs are down 6.4% in terms of total net asset value, while HY bond CEFs are down 15%. Again, it’s as if this outperformance didn’t happen. So what’s going on? Why is the market ignoring the fact that CEF income levels on loans have improved dramatically while CEF income levels on HY bonds have fallen and why is the market also ignoring the much better total net asset value performance of CEFs on loans?

One answer here is that the CEF market is far from efficient and we shouldn’t expect the price action to make much sense. Often it is better to take advantage of opportunities and simply move on.

That said, it is possible that there is a rationale for this. The first is that rising rates put increased pressure on borrowers who now have higher interest charges to manage, while bond borrowers do not face increased interest charges (of course, some borrowers have both bonds and loans). So, all other things being equal, loans are now riskier than bonds, which could drive investors away from loans even as income from loan funds increases.

It’s also possible that the market is starting to think that an upcoming recession means that Treasury yields will fall as inflation peaks and falls. In this case, HY bonds will outperform loans, all other things being equal, which could lead investors to buy bonds rather than loans.

Third, HY bond yields have already risen sharply (due to the sharp drop in bond prices) as loan investors have to wait for Libor to fully make its way into cash flows, which is only happening. ‘with a lag. In other words, HY bond yields have already risen almost as much as loan income levels are expected to rise. The difference is that bonds did it entirely through a steeper price drop rather than organically through higher coupons like loans did.

Finally, CEF investors could simply target the assets that have fallen the most, with the idea that buying the most affected assets should generate greater capital gains in the future. In our view, this is highly unlikely since for HY bonds to undo all of their decline, Treasury yields would need to return to levels of 1-1.5%. It’s quite difficult given the messages from the Fed and the level of inflation. If this happens, it will be because the US economy has collapsed, in which case credit spreads will rise more than Treasury yields will fall, meaning HY bond prices will fall even further.

On the whole, there are no fully satisfactory explanations. At the same time, this is what makes the CEF space quite attractive to investors with well-defined views.

Market Commentary

The Ares Dynamic Credit Allocation Fund (ARDC) has released a report to shareholders. The net result increased by approximately 8% compared to the previous year. This is despite some deleveraging and holding bonds in half of its portfolio. On the other side of the ledger (i.e. the factors pushing earnings higher) are the lack of Libor floors on CLO holdings as well as the fact that around half of its liabilities are fixed. The fund issued fixed rate term private bonds with a weighted average dividend yield of 2.81% – this is now well below the level at which Treasuries are trading.

The fund recently increased its distribution to $0.1025, but its net income was $0.1133, so there is still plenty of room to increase the distribution. In addition, the net income number is obviously lagging, as the rise in short-term rates has not fully materialized and short-term rates continue to rise. The fund has $228 million in floating rate assets versus about $90 million in floating rate liabilities – this differential feeds directly into income. More broadly, this combination of variable rate assets and fixed rate liabilities (in part or in whole) is obviously good in this environment.

The boards of directors of the Nuveen Intermediate Duration Municipal Term Fund (NID) and Nuveen Intermediate Duration Quality Muni (NIQ) have previously approved a proposal to eliminate their term structure. The way it usually works with Nuveen is that now it is up for a shareholder vote and the shareholders will generally approve the proposal, i.e. they will vote to change the term funds to perpetual funds.

Approval is the only reasonable step because shareholders lose nothing by approving and gain the continued existence of the fund. The reason shareholders lose nothing is that if approved, there will be a takeover bid for all shares at 100% of net asset value – economically this is the same as wait for the termination since in both cases, the discount will be zero.

We can say that the takeover bid is even better than a termination since the fund experiences less slippage in the settlement of its portfolio since only part of it must be settled in the event of a public bid. purchase while the whole must be settled in the event of termination.

If the remaining assets are greater than $70 million, the funds will continue to be perpetual funds. For investors who want to stay with the fund, it still makes sense to offer the shares at 100% of net asset value and then redeem the shares of the fund. Indeed, it is very likely that the shares will start trading at a discount after the tender offer – in line with the rest of the sector.

CEF Tool Update

This week we added a new feature to the CEF tool for subscribers that lists recent paid distributions. It can allow investors to quickly assess the payout profile of a given fund on a stand-alone basis as well as against its industry peers.

Position and takeaways

This week, we switched from the municipal futures funds NID and NIQ mentioned above to the Angel Oak Financial Strategies Income Futures Trust (FINS), primarily investment grade. While NID and NIQ did not emerge unscathed from the struggles of the Muni sector, they have significantly outperformed the sector with an average total net asset value return of -9% this year compared to -20% for the Muni CEF sector.

A big part of the reason is that the term structure of these funds has anchored their rebates closer to zero, as the following chart for NID shows. FINS presents an attractive income profile that will continue to benefit from high and rising short-term rates. The current valuation offers a good entry point as its discount has widened thanks to the recent resizing of its distribution.