This article was first released to Systematic Income subscribers and free trials on Sep. 4.
Welcome to another installment of our CEF Market Weekly Review where we discuss CEF market activity from both the bottom-up – highlighting individual fund news and events – as well as 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 first week of September. Be sure to check out our other weekly updates covering the BDC as well as the preferreds/baby bond markets for perspectives across the broader income space.
It was another tough week for CEFs as all sectors saw lower NAVs though discounts were mixed.
The CEF space has fallen around 6% off its recent peak and remains about 7% above its recent trough.
Fixed-income CEF discounts have partially reversed their recent strength and are in the fair-value range while equity CEF discounts remain expensive in aggregate.
The topic of whether MLPs can diversify CEF portfolios came up on the service. A glance at the following chart, which highlights how MLP CEFs have performed this year versus other sectors, clearly shows the answer is yes.
Specifically, there clearly are scenarios (like the one we are living through now) when MLP CEFs can rally while the rest of the CEF space struggles. This scenario has two prerequisites – an inflationary environment and a decent macro backdrop where the activity doesn’t drop as much as energy prices rise to ensure that the energy sector performs well.
A few things are worth noting. First, the current environment where broader risky assets sell off but energy rallies is fairly unusual as inflation tends to follow overall economic activity but it obviously can happen. Another way of saying this is that stagflation is still unusual even if it appears we are going through it right now. The key point here is that investors shouldn’t assume that this kind of environment is the new status quo going forward. A much more common pattern for MLPs is what we saw over 2020 where the sector is just a higher-beta version of the rest of the CEF space.
Two, there is a self-limiting element at play since the higher energy prices rise the more likely an economy is to fall over which would cause a drop in energy use which would lead to lower corporate energy profits which would lead to lower returns on MLP assets.
Three, there is a significant cost to MLP assets which is their high volatility. This has two implications – it’s a problem for low conviction investors who would likely buy high / sell low, locking in losses in their portfolio over time as MLP prices gyrate. And it poses a serious risk to MLP assets themselves, particularly CEFs, which have historically deleveraged and locked in losses in volatile periods. For instance, over the last 5 years, the MLP CEF sector has lagged the MLP index by 1% per annum despite net higher prices, additional leverage and active management. And over the last 10 years the MLP CEF sector has delivered a 1.8% total return per annum which puts it very close to the bottom of the CEF space.
Finally, while MLP CEF distributions are “juicy” it’s important to keep in mind they are about half of what they were in 2015 – so investors who got into 10% yields in 2015 are now earning around 5% yields on their cost basis which is not far from where investment-grade bonds are trading. Distribution risk in CEFs is asymmetric – a sector is much more likely to cut its distribution by 25% than to raise it by 25%. This is especially true for a very high-volatility sector like MLPs. Nothing wrong with using MLPs for a bit of diversification but it has to be with eyes wide open.
Start of the month means we have new CEF distribution announcements. In the Invesco suite the Muni fund (IIM) cut by 8%. In the PIMCO suite PAXS raised by 28%, something we suggested was likely to happen (truth be told, the size of the raise was a surprise to us). For Nuveen, JEMD cut – a fund that is expected to terminate this year which is a pattern you tend to see for term funds as they deleverage. Eaton Vance did something similar with EFL which also cut. EVG and EVF which have loan holdings both raised.
Loan CEF Apollo Tactical Income Fund (AIF) published its shareholder report for the six months to June. Net income increased to $0.0783 from $0.0717 or over 9%. This is below the fund’s distribution of $0.097 which itself was raised by 8% since the start of the year. This relatively low distribution coverage is very likely because the fund is pre-positioning for a higher net income profile over the coming quarters. Recall that little of the recent Libor rise has actually made it into net income given the lag with which it happens. AIF remains in the High Income Portfolio.
The non-agency RMBS CEF Western Asset Mortgage Opportunity Fund Inc. (DMO) published its shareholder report. Net investment income through June was higher by close to 5% versus the previous 6 months. Recall that DMO has a number of income advantages versus other credit CEFs. Unlike loans, its assets don’t have Libor floors (you can quibble about whether this is an advantage or not but DMO has enjoyed a higher level of net income growth than loan funds since the start of the year). It has fixed the interest cost of its liabilities until next year – a very unusual feature in the credit CEF space. And it has been adding borrowings which will also result in higher net income, all else equal, even as many CEFs have deleveraged. The fact that RMBS assets have been more resilient than more traditional ones like HY bonds is what has allowed the fund to add borrowings and buy assets at attractive valuations. DMO remains attractive at current levels and is part of our High Income Portfolio.
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