NAD - CEF Weekly Review: Coverage Continues To Stabilize

2023-09-03 00:28:22 ET

Summary

• We review CEF market valuation and performance through the fourth week of August and highlight recent market action.
• CEFs were down with Munis underperforming due to the continued rise in Treasury yields.
• Coverage of leverage CEFs continues to stabilize due to the rolling over of short-term rates.
• FMY hiked its distribution but remains unattractive as a mortgage CEF option.

Welcome to another installment of our CEF Market Weekly Review, where we discuss closed-end fund ("CEF") market activity from both the bottom-up - highlighting individual fund news and events - as well as the 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 fourth week of August. Be sure to check out our other weekly updates covering the business development company ("BDC") as well as the preferreds/baby bond markets for perspectives across the broader income space.

Market Action

CEF returns were mixed this week with Munis underperforming due to the continued rise in Treasury yields and credit sectors holding in well. Month-to-date all sectors but Loans are down.

August has now more than shaved off the positive returns accrued over July.

Discounts across both fixed-income and equity sectors widened over the last couple of weeks.

Market Themes

The other day we updated July CEF coverage figures on the service. One trend that's noticeable is that the stabilization of coverage of many fixed-income funds. The coverage chart of the Nuveen Quality Municipal Income Fund ( NAD ) is shown below.

This has happened for a couple of reasons. One, funds have made distribution cuts to reflect their lower net income due to the rise in leverage costs. And two, the rise in short-term rates, which anchor leverage costs, has slowed significantly. This doesn’t mean we won't have any more distribution cuts but it does mean that the vast bulk of the cuts is behind us.

To get a better sense of a stabilization in net income we can check on the fund's leverage costs over time as shown below. The continued rise since 2020 has now leveled off.

Borrowings have also been steady recently for the fund after falling twice - a typical pattern across the credit CEF space.

Overall, we see that the drop in net income has slowed though not fully subsided yet. For instance, while over the first 6 months of the past year net income fell $0.09 it fell $0.06 over the second 6 months and only $0.02 over the last 3 months.

It may take some time for net income of leveraged CEFs to fully stabilize. However, if the market consensus of 0-1 more rate hikes is correct, this should happen over the next 3-6 months.

Market Commentary

The mortgage CEF First Trust Mortgage Income Fund ( FMY ) hiked the distribution by 14%. The distribution rate on NAV is still very low at just 6.2% - very low for a credit CEF.

The fund is pretty unusual due to its sizable Treasury futures exposure (the rest is split between Agency and non-Agency MBS) which it appears to use for the purpose of tactical duration exposure. Few funds do this sort of tactical trading and those that do don’t talk about it a whole lot.

It’s unusual because Treasury futures take up space in the portfolio that could be used for other purposes whether credit selection or generation of higher level of income than what’s available in Treasuries. They also seem to have been caught out by the rise in Treasury yields over the past month as the end of July Treasury futures position looks to be elevated.

In terms of income, the semi-annual period through April looked to be running below the previous distribution of $0.055. However, a lack of Section 19 notices for the fund suggests that its income was beating the pre-hike level.

The discount doesn’t look very compelling particularly in the context of the low distribution. JLS and DMO look more attractive as mortgage funds with both wider discounts and yields.

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