ECCV - CEF Weekly Review: Investors Continue To Shy Away From Loans And Munis

2023-04-22 07:55:29 ET

Summary

• We review CEF market valuation and performance through the second week of April and highlight recent market action.
• CEFs had another good week as discounts tightened in aggregate. Tepid inflation news and a no-news-is-good-news bank backdrop supported risk sentiment.
• Investors continue to shy away from both Muni and Loan CEFs, however, the narrative for avoiding both sectors is not entirely consistent.

This article was first released to Systematic Income subscribers and free trials on Apr. 15.

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 second week of April. 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 a decent week with the majority of sectors finishing in the green. Most sectors also saw discount tightening - a reversal of recent weakness in discounts.

Year-to-date, all sector total NAV returns (blue bars) are up save for preferreds and CMBS. Preferred CEFs have continued to retrace their losses as no new banks have buckled and bank Q1 earnings released this week were very strong.

Equity CEF sector discounts, which earlier remained oddly resilient, have continued to widen and now trade at the widest level since 2021 and at around the same level as their fixed-income counterparts in aggregate.

Market Themes

The discount valuation picture across CEFs remains somewhat odd.

The chart below shows CEF sector discounts in absolute terms on the y-axis as well as in relative terms as discount percentiles on the x-axis. For example, the tax-exempt Muni sector boasts a discount of around 10% (i.e. the average CEF discount in the sector is 10%) and a discount percentile of 1%, meaning the Muni sector discount has only been wider 1% of the time this century.

The highlighted lower left quadrant shows sectors that are trading at cheap valuations on both metrics. What's interesting here is that the quadrant has both Munis and Loan sectors. This is odd because the two sectors are very different from each other.

First, the duration profile of the two sectors is very different. Its lower duration stance allowed Loan CEFs to outperform since 2022 and caused Muni CEFs to underperform. Two, coupon profiles are different as bank loans are floating-rate while Municipal bonds are fixed-rate. This allowed loan CEFs to increase distributions and pushed Muni CEFs to cut distributions over the past year. Finally, bank loans are significantly lower credit quality than Municipal bonds.

Perhaps the rationale here is that investors are avoiding Muni CEFs because of their underperformance as well as significant distribution cuts this year, a very typical rear-view mirror approach to investing. And investors may also be avoiding loan CEFs due to the common view that a reversal in short-term rates should cause net income compression in these funds while a possible recession and spread widening may cause bank loans to underperform.

On the face of it, this reasoning makes sense however it's inconsistent since it relies on a backward view for Munis and a forward one for Loans. A consistently forward view on Munis would find the sector favorable since a drop in short-term rates would cause Muni CEF net income to increase and spread widening would allow Munis to outperform. The story here remains puzzling however it does offer an opportunity for investors who don't have a precise medium-term view.

Allocating to both sectors creates a kind of a hedged profile. Lower short-term rates would hurt loan CEF net income but improve Muni CEF net income while rising credit spreads would hurt bank loans but likely allow the higher-quality Munis to outperform. This is because credit spread widening would be less in Munis than in corporate securities and because longer-term rates are more likely to fall in a spread widening scenario - we already saw this happen since March of this year.

Market Commentary

Eagle Point CLO funds EIC and ECC put out March NAVs which were down 3% and 6% respectively. Now with bond markets behaving in a more historically predictable way (i.e. Treasury yields move lower on bad news) we are seeing fixed-income assets like HY corporate bonds, which were up in March, outperform during risk-off periods due to their longer duration exposure. Separately, EIC also appears to have moved back to a lower-beta version of ECC which makes much more sense than its very odd underperformance vs. ECC in 2022 despite a lower allocation to the more volatile CLO Equity securities. Whether this solves the fund's long-term poor return puzzle is another question.

Stance And Takeaways

We continue to look through to the eventual Fed pivot in our CEF allocation. This means we are downgrading some of our shorter-duration / floating-rate CEFs to Hold and allocating to longer-duration / higher-quality funds. History shows that markets can wobble soon after the last hike, particularly in an inflationary environment, and this rotation can support portfolios during this potential bout of volatility.

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