PTA - CEF Weekly Review: Shareholder Report Coverage Is Borderline Useless Now

Summary

• We review CEF market valuation and performance through the fourth week of January and highlight recent market action.
• CEFs had another strong week with all but the highest-quality sectors rallying.
• Distribution coverage, particularly as shown in CEF shareholder reports, is too stale to be useful in this environment and often sends the wrong signal.
• We also catch up on the Flaherty preferreds CEFs.

This article was first released to Systematic Income subscribers and free trials on Jan. 27 .

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 January. 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

The rally in the CEF space continued this week with another strong result. All sectors except for Agencies and Munis, which were held up by a slight rise in Treasury yields, rallied. Month-to-date, all sectors are in the green with 5 sectors sporting double-digit returns.

January has so far put up the strongest returns in the sector since November of 2020.

Market Themes

Many CEF investors, understandably, like to do due diligence on CEFs that they hold. One of the key tasks in this process usually involves checking up on the fund's net income trajectory and distribution coverage. CEFs have to disclose net income figures in their semi-annual shareholder reports though some do it more frequently as separate monthly releases as well.

However, relying on shareholder reports to gauge net income and coverage levels can result in a very misleading picture, particularly in an environment of shifting interest rates and asset prices such as the one we are going through now.

First, shareholder reports are produced with a significant lag. For instance, the Invesco Senior Income Trust ( VVR ) which we looked at recently and which covers the semi-annual period of March to August was only released on 4-November, more than 2 months after the end of the period in question.

Secondly, the reports are generated twice a year, each covering a semi-annual period (technically, annual reports cover an annual period, however, they can be compared with previously released semi-annual reports to show net income generated in the second half of the annual period). This is in contrast to BDCs and companies more broadly, which release earnings on a quarterly basis (recall that most CEFs are organized as Regulated Investment Companies though they don't behave like companies in this regard). This means that CEF income releases are much less granular and provide a kind of muddled picture in a fast-moving environment.

Thirdly, most credit CEFs use floating-rate leverage instruments and some CEFs also hold floating-rate assets. This means that the net income profile of these funds can change rapidly when short-term rates like Libor change quickly as they have over the past year. Moreover, Libor itself is reset only quarterly and at the start of the accrual period, meaning that by the time securities pay their coupons and are registered in the shareholder report, real-time Libor and forward-looking net income numbers can be very different from the reported figures.

Investors who take shareholder report net income numbers at face value are likely to be surprised by what the funds actually do. For example, many Nuveen tax-exempt CEFs have cut their distributions this year by 30-40% while the recently released shareholder reports show net income drops of "only" 10-15%. In the case of the loan CEF VVR, a glance at the most recent shareholder report shows that it generated $0.028 in income for the semi-annual period versus its new distribution of $0.039 which seems like massive overdistribution. However, it's clear that these funds are adjusting their distributions in "real-time" based on forward-looking income projections rather than what is shown in the shareholder reports. This means that investors relying on shareholder reports are allocating based on stale information and are liable to be surprised when funds don't behave according to what's in the reports.

The best way to gauge net income and distribution coverage of a given CEF is to have a real-time model of how its income behaves at any given time based on today's yield curve. Absent this, investors ought to at least have a sense of whether the figures in the report are lower or higher than what the fund is generating today which is a much more relevant measure.

Market Commentary

Flaherty & Crumrine preferreds CEFs (DFP, FLC, FFC, PFD, PFO) announced another distribution cut. This is the 4th cut over the past year - for a total of around 25%. In Feb 2022 we had an article on FFC with the title "It's time to think about leverage costs". Well, here we are a year later and leverage costs have taken a big bite out of the fund's income. This is in comparison to Cohen & Steers funds whose distributions haven't changed (except for PTA which had a recent raise) or the Nuveen funds whose distributions were cut about half that of the Flaherty funds.

As just mentioned, the Cohen & Steers Tax-Advantaged Preferred Securities & Income Fund ( PTA ) (which is 5% of our Core Income Portfolio) is the only fund in the sector that managed an increase in distributions. It would be wrong to say that only Flaherty funds saw an increase in leverage costs. All funds in the sector have experienced rising leverage costs since all of them have pretty similar Libor + 0.6-0.8% credit facilities.

What's different about the Flaherty funds as it was laid out a year ago is that the funds don't use interest rate hedges. For preferreds funds, interest rate hedges do double duty - they shorten up the duration profile of the portfolio and they also fix the cost of leverage. This kind of seemingly magical manoeuvre was invented over 40 years ago with the use of the humble interest rate swap.

The preferreds funds that use them pay fixed / receive floating. The pay-fixed leg shortens up the duration (essentially offsetting some of the fixed-rate i.e. receive-fixed preferreds) and the receive-floating leg of the swap offsets the pay-floating credit facility.

Cohen & Steers funds are not only fairly aggressive users of swaps (at around 80-85% of their credit facility amounts) but they also locked in very attractive fixed-rates which allows them to pump out much higher levels of income from the leveraged portion of their portfolios (Cohen funds earn something like 4% on the leverage portion of their portfolios while Flaherty funds earn close to zero). For reference, the leveraged portion of the portfolio is about a third of the total portfolio.

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