DMO - CEF Weekly Review: Don't Handicap CEF Returns

2023-08-06 05:01:29 ET

Summary

• We review CEF market valuation and performance through the last week of July and highlight recent market action.
• CEFs continued to march higher this week, closing out July in good form.
• CEF returns should be gauged in the context of the broader asset class rather than just within the narrow sector.
• We highlight the distribution hike of the residential mortgage focused CEF DMO.

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 last week of July. 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

CEFs had another strong week to close out an equally strong July. However, unlike in previous weeks, discounts joined the rally along with NAVs. Higher-beta sectors like equities, REITs and MLPs ended up in the lead.

The aggregate CEF space has recovered nearly all of its post-February drawdown in total return terms.

Discounts moved off recent lows however remain relatively wide, in contrast to the continued rally in NAVs.

Market Themes

Covered call CEFs have done very well this year in the broader CEF space. The sector delivered the strongest NAV gains though total price returns lagged somewhat due to discount widening.

Across the CEF space it's fair to say that covered call CEFs have delivered a strong result. However, an important question to ask is whether that is the right universe with which to gauge a "strong result".

Covered call CEFs hold baskets of stocks (directly or indirectly) and sell call options on individual stocks or indices in various amounts. This suggests that gauging whether these are "strong results" requires a comparison of what the underlying stocks have done at the same time.

If we look at those CEFs that have the S&P 500 as their equity benchmark we get the following year-to-date picture. The chart shows that in total NAV terms SPY is the top performer with the average covered call CEF quite a bit behind. This suggests that to say that covered call CEFs have delivered a "strong result" means we have to handicap them and pretend that investors don't have access to the underlying equity basket.

There are three common pushbacks here. The first is - you shouldn't look at covered call fund performance vs. stocks in an up year. These funds really deliver during down years. This comment always strikes us as slightly masochistic as though some investors only enjoy outperformance during down years.

However, if we look at 2022 total price returns, we see that SPY is in the middle of the pack. Some of the covered call CEFs have indeed outperformed stocks in a down year though just as many underperformed. The reason we look at total price returns in this chart is to drive home the message that CEF discounts tend to widen during down years so even if their total NAV returns are superior to stocks, the widening in the discounts will tend to erase that NAV outperformance.

The second pushback is that we can't just look at returns over any one year. That's perfectly fine - the following chart shows the annual underperformance of each fund vs. the S&P 500 since their inception with all of them underperforming stocks.

The third pushback is that covered call CEFs have yields well above that of stocks. That's perfectly true however stocks leave investors better off in total wealth terms which is really what it’s all about once you’ve decided on an asset class. This underperformance of equity benchmarks is very much a feature of covered call funds so it’s not something that is likely to change in the future.

To gauge the performance of covered call CEFs without reference to their underlying baskets (over any time frame) seems artificial - there is no reason to handicap CEFs this way.

Market Commentary

The primarily residential-mortgage CEF DMO hiked its distribution a few weeks ago by about 5%. It’s a fund that’s been highlighted several times in the past as one whose net income should benefit from the rise in short-term rates.

Within the Multi-Sector CEF space it’s done fairly well, outperforming the sector since 2022 in total NAV terms as well as outperforming a number of funds with substantial mortgage holdings like PCM and the DoubleLine CEFs. Its net income has risen about 11% since the start of 2022. It has also been able to add borrowings which created an additional net income tailwind.

However, because of its relative overdistribution, DMO hasn’t been able to raise until recently. Arguably, even now the fund is overdistributing with coverage of 80% however that understates a further rise in net income due to short-term rates having increased around 0.8% since the start of the year (the period for which we have the most recent net income figure). DMO remains in the High Income Portfolio.

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