NBB - CEF Weekly Review: Key CEF Lessons Of 2022

Summary

• We review closed-end fund market valuation and performance through the second week of January and highlight recent market action.
• CEFs continue to power ahead, stringing together two strong weeks in a row.
• We look at the key lessons of 2022 that can guide investors in their CEF allocation in the future.
• And highlight a mix-up with BBN leverage.

This article was first released to Systematic Income subscribers and free trials on Jan. 14 .

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 January. Be sure to check out our other weekly updates covering the business development company ("BDC") sector as well as the preferreds/baby bond markets for perspectives across the broader income space.

Market Action

CEFs had another strong week this year with most sectors up 5-10% already so far this year, led by higher-beta sectors like EM Equity, Converts and REITs.

Only Muni CEF sectors have seen discount widening, however, a bulk of that is due to the idiosyncratic moves in PIMCO Muni CEFs which suffered sharp distribution cuts, leading to significant premium compression.

Discounts continue to tighten with Fixed-Income CEF sector discounts trading slightly wider to their average this century.

Market Themes

If there was one benefit of 2022 it's in refreshing some of the key lessons of CEF investing. In this section we highlight a few of these lessons as they will be valuable going forward as well.

One clear lesson of 2022 is the drag that leverage costs exert on net income of many leveraged CEFs. Here we focus specifically on the Muni CEF sector.

The chart below shows the rise in leverage costs of the large Muni CEF Nuveen Quality Municipal Income Fund ( NAD ) which is representative of the broader sector.

The rise in leverage costs has compressed net income, particularly since Muni bonds are fixed-rate assets. As the extract from our CEF Tool shows, the average CEF cut its distribution by over 20% over the last 12 months.

This is one reason why we have tilted to CEFs with leverage cost hedges, partially fixed-rate liabilities or partially floating-rate assets - features which would allow funds to mitigate the increase in rising leverage costs.

Another key lesson of the past year is that a difficult market environment makes high-premium CEFs particularly vulnerable . Specifically, a difficult CEF environment makes it increasingly difficult for unsustainable CEFs to keep unrealistically high distributions.

For this reason we saw significant distribution right-sizing over the past year. Good examples are the PIMCO Muni suite which slashed distributions of up to 45% for PCQ. This also caused the fund's premium to collapse versus the two other PIMCO CA Muni CEFs - a typical double whammy for investors who are seduced by unsustainable distributions.

Another lesson that 2022 repeated is the procyclical tendency of CEF valuations . Specifically, discounts tend to move in the same direction as NAVs, particularly when NAV moves are large. This creates another double whammy for CEF investors who not only have to wear large NAV drops but also large discount widening to boot. This makes periods of rich valuations such as 2021 particularly dangerous, something we highlighted at the time.

Another important lesson of 2022 was that term CEFs remained more resilient . Term CEFs have been important parts of our CEF allocation strategy due greater resilience of their discounts as well as the potential return boost from discount amortization in case of termination or tender offer.

This is how Muni term CEFs have performed over the past year relative to their perpetual counterparts.

This chart shows that the discounts of Muni term CEFs have held in much better than discounts of perpetual funds.

Finally, CEF deleveraging was a key theme of the year. The chart below shows what this looks like for the Nuveen Taxable Municipal Income Fund ( NBB ). Leveraged funds with a higher-beta profile such as those with longer-duration assets were particularly affected. Not all funds deleveraged, clearly, which is why it's worth tilting to those with more robust leverage profiles - another strategy we have used successfully. These include funds without leverage caps such as Cohen & Steers preferreds funds, among many others.

Market Commentary

The BlackRock Taxable Municipal Bond Trust ( BBN ) seems to be having an identity crisis. For a while now it has shown a leverage of zero on its website despite having significantly higher managed assets (i.e. total assets) than net assets.

These figures are not consistent - either leverage is not zero (if the asset figures are correct) or managed assets need to equal net assets (if leverage is indeed zero). It seems to be the case that the zero leverage number is the error and the fund has continued to maintain leverage of around 30%

This is not surprising. CEFs tend not to deleverage to zero. Perhaps the only case of this happening was with MLP CEFs in 2020. CEFs instead tend to cut borrowings by as little as possible and as late as possible.

That said, a full deleveraging does make sense in one aspect. Funds like BBN (fixed-rate assets + floating-rate liabilities) are not generating much additional yield with leverage since leverage cost + management fee roughly equals the yield of the bonds they hold with leverage, particularly in the case of higher-quality bonds like taxable Munis.

However, what argues against a full deleveraging are two things. First, if Municipal bonds rally from here, the fund would have locked in economic losses as it wouldn't be able to reverse previous losses due to having fewer assets. And two, its management fee would be significantly cut - not something funds like doing. For these reasons, we shouldn't expect total deleveraging in the CEF space outside of truly catastrophic market moves.

Stance and Takeaways

Corporate yields continue to fall as a result of both a drop in Treasury yields as well as credit spreads. The High Yield corporate bond index yield has fallen below 8% from its 9.5% peak in Sep-2022. This has resulted in strong returns in our HY CEF holdings this year, many of which have returned double-digit or near double-digit figures in just a couple of weeks.

If this trend continue, we would face a very unusual situation of both a highly inverted yield curve (2s10s Treasury yield curve is the most inverted in over 40 years) as well as relatively tight credit spreads (4.2% versus a 6% 2022 peak and 11% 2020 peak) despite a widely anticipated recession. This leaves a much smaller margin of safety for corporate bond investors. If this trend extends we would look to add to higher-quality shorter-duration or floating-rate assets such as the Angel Oak Financial Strategies Income Term Trust ( FINS ), the Cohen & Steers Limited Duration Preferred and Income Fund ( LDP ) among others.

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