This article was first published to Systematic Income subscribers and free trials on September 4th.
Welcome to another installment of our weekly 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 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.
It was another tough week for CEFs as all sectors saw their net asset values fall, although discounts were mixed.
The CEF space has fallen about 6% from its recent high and remains about 7% above its recent low.
CEF haircuts on fixed income have partially reversed their recent strength and are in the fair value range, while CEF haircuts on equities remain expensive overall.
The question of whether MLPs can diversify CEF portfolios has been raised on the service. A look at the following chart, which highlights the performance of CEF MLPs this year relative to other sectors, clearly shows that the answer is yes.
Specifically, there are clearly scenarios (like the one we are currently experiencing) in which CEF MLPs can rally while the rest of the CEF space struggles. This scenario has two preconditions – an inflationary environment and a decent macroeconomic backdrop where activity does not fall as much as energy prices rise to ensure the energy sector performs well.
A few things are worth noting. First, the current environment where broader risky assets are selling off but energy is recovering is quite unusual as inflation tends to follow overall economic activity, but of course it can happen. Another way of saying this is that stagflation is still unusual even though it looks like we’re going through it right now. The key point here is that investors should not assume that this type of environment is the new status quo going forward. A much more common pattern for MLPs is what we saw in 2020, where the sector is just a higher-beta version of the rest of the CEF space.
Second, there is a self-limiting element at play since the higher energy prices rise, the more likely an economy is to collapse, leading to lower energy consumption, which would lead to lower energy profits. companies, which would lead to lower returns on MLP. assets.
Third, there is a significant cost to MLP assets which is their high volatility. This has two implications – it is a problem for low conviction investors who would likely buy high/sell low, locking in portfolio losses over time as MLP prices fluctuate. And that poses a serious risk to MLP assets themselves, especially CEFs, which have historically deleveraged and locked in losses during volatile periods. For example, over the past 5 years, the MLP CEF sector has lagged the MLP index by 1% per year despite higher net prices, additional leverage and active management. And over the past 10 years, the MLP CEF sector has generated a total return of 1.8% per year, putting it very near the bottom of the CEF space.
Finally, while MLP CEF distributions are “juicy”, it’s important to keep in mind that they’re about half of what they were in 2015 – so investors who earned returns of 10 % in 2015 are now earning around 5% return on their cost basis, which is not far from where investment grade bonds trade. Distribution risk in CEFs is asymmetric – a sector is much more likely to reduce its distribution by 25% than to increase it by 25%. This is especially true for a very high volatility industry like MLPs. Nothing wrong with using MLPs for a bit of diversification, but it has to be with your eyes wide open.
The start of the month means we have new CEF distribution announcements. In the Invesco suite, the Muni fund (IIM) fell 8%. In the PIMCO PAXS suite increased by 28%, something we suggested was likely to happen (actually, the size of the increase surprised us). For Nuveen, JEMD cut – a fund set to end this year, which is a pattern you tend to see for futures funds as they deleverage. Eaton Vance did something similar with EFL which also cut. EVG and EVF who both raised loan assets.
Loan CEF Apollo Tactical Income Fund (AIF) has released its report to shareholders for the six months ending June. Net profit increased from $0.0717 to $0.0783 or more by 9%. This is below the fund’s distribution of $0.097 which itself has been increased by 8% since the start of the year. This relatively low distribution coverage is very likely as the fund pre-positions itself for a higher net income profile over the coming quarters. Recall that a small portion of the recent Libor rise has translated into net income given the lag with which it occurs. AIF remains in the high income portfolio.
Non-agency RMBS CEF Western Asset Mortgage Opportunity Fund Inc. (DMO) has released its report to shareholders. Net investment income through June was nearly 5% higher than the previous 6 months. Recall that the DMO has a number of advantages in terms of income compared to other credit CEFs. Unlike loans, its assets don’t have Libor floors (you can quibble whether that’s a benefit or not, but DMO has enjoyed a higher level of net income growth than loan funds since the beginning of the year). It has fixed the interest cost of its liabilities until next year – a highly unusual feature in the CEF lending space. And he added borrowing which will also result in higher net income, all else being equal, even as many CEFs have deleveraged. The fact that RMBS assets have been more resilient than more traditional assets like HY bonds is what has allowed the fund to add borrowing and buy assets at attractive valuations. DMO remains attractive at current levels and is part of our high income portfolio.
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