NAD - CEF Weekly Review: The Mirage Of 8+% Through-The-Cycle CEF Yields

2023-04-10 05:00:47 ET

Summary

• We review CEF market valuation and performance through the last week of March and highlight recent market action.
• CEFs had a strong week with nearly all sectors finishing in the green as investors appreciated no bad bank news and looked to a likely upcoming Fed pivot.
• We take a look at whether CEFs are able to generate 8%+ yields rain or shine.
• And highlight Putnam Muni CEF cuts.

This article was first released to Systematic Income subscribers and free trials on Apr. 2.

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 March. 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 enjoyed a bounce this week with only the Agency MBS sector seeing a drop in NAVs. All but 2 sectors also saw tighter discounts. Preferred CEFs outperformed along with higher-beta sectors like REITs and MLPs.

Despite the volatility caused by the wobble in banks, CEFs enjoyed a rally over March in NAV terms. However that was offset by a widening in discounts which drove a negative total price return.

Fixed-income discounts tightened slightly from their recent oversold levels however remain relatively wide.

Market Themes

Many income investors are attracted to CEFs for a whole host of reasons such as being able to find assets they can't in open-end funds, wide discounts, leverage and, of course, high distribution rates, among them.

A particularly appealing aspect of CEFs is that they tend to feature high distribution rates, rain or shine. This is in contrast to, for instance, the high-yield corporate bond market, whose yield appears to be much more volatile. For example, the yield of this sector bounced from an 8% peak yield in 2018, then fell to 5% prior to COVID, then blew up to a double-digit figure and then fell to 4% and is now trading around 8.5% (see blue line in chart below). While underlying asset yields bounce around, CEFs can often feel like they offer the typical 8%+ yield in any market environment. We can see this in the chart below which shows that the trailing-twelve month High Yield CEF sector distribution rate (orange line below) never fell much below 8%.

This apparent flooring of CEF distribution rates is very appealing for investors who want to receive high single-digit yields whatever is happening in underlying markets.

For credit CEFs, there are two elements that can support stable high single-digit distributions. One is that CEFs have some discretion over how much they distribute and many will choose to distribute a bit more when underlying asset yields are low (i.e. run at a low distribution coverage) and vice-versa.

The other element that supports relatively stable high single-digit CEF yields is that the CEF net investment income yield is not the same thing as the yield of a corporate bond portfolio. This may sound odd since a bond CEF is just a portfolio of bonds so the two yields should be the same. However, a bond yield is a function of two things: coupon income and pull-to-par. Net investment income yield only accounts for coupon income and ignores pull-to-par.

The chart below shows the difference between these two yields for a 5Y bond with an 8% coupon. YTM or yield-to-maturity is the true yield of the bond which takes into account both income and pull-to-par while current yield only takes into account the bond's coupon income. This current yield is what you see as the net investment income yield of the bond CEF. We can see that current yield is much more stable at different bond prices than yield-to-maturity.

Another important aspect here is that, if we only focus on current yield as the representative yield of the fund, then we end up overstating the fund's yield when yields are low / prices are high and understating it when yields are high / bond prices are low.

What this means in practice is that the true underlying portfolio yield of CEFs is much more variable than it looks in practice if all we do is look at its distribution rate or even net investment income yield.

More importantly, when yields are low / prices are high true CEF portfolio yields will be significantly below these two other yield metrics. The chart below shows the trailing-twelve month distribution rate of HY bond CEFs (orange line) against their more true portfolio yield (i.e. the yield-to-maturity discussed above). Note the large divergence in 2021 when CEFs boasted an 8% distribution rate despite having portfolio yields closer to ~4%.

The way we get to the ~4% HY CEF portfolio yield in mid-2021 is via the following disaggregation. Here, we can see that there is no way we can get anywhere near an 8% true yield number if we start at around 4.25% yield-to-maturity / yield-to-worst corporate bond yield figure. Sure, some CEFs tilt to lower-quality assets which will tend to have higher yields than what we see in the HY corporate bond index but this lower-quality tilt will obviously come with higher expected losses as well.

The good news here is that this is not a problem we need to worry about now since underlying bond / credit asset yields are high and this is a reason why we like CEFs much more than we did in 2021. However, if/when asset yields start to fall, investors will need to consider how "real" those high single-digit CEF distribution rates truly are. They key takeaway here is that through-the-cycle 8%+ CEF yields are not a reality for the vast majority, if not all, credit CEFs.

Market Commentary

Putnam Municipal CEFs PMM and PMO saw large cuts in the distribution of 25% and 34%. The setup was pretty typical - the funds had yields around 1% above the sector average. There was obviously no good reason for that and distribution coverage in the 60s confirmed this. As usual, because of this higher distribution rate, the funds enjoyed an expensive valuation, trading at small premiums before the cut despite the average Muni CEF trading at a discount of around 11%. The cut precipitated a sharp widening of the discounts towards sector average levels, delivering a typical one-two punch for holders.

Stance And Takeaways

As the Fed nears the endpoint of its hiking cycle, we are beginning to look forward to the stabilization in longer-term interest rates and eventual cuts. This eventual development will benefit leveraged longer-duration securities like Muni CEFs, particularly if we see further macro headwinds ahead.

In line with this, we made a rotation in our Muni Income Portfolio from the short-term Muni mutual fund ( NVHAX ) to CEF ( NAD ). NVHAX has outperformed Muni CEFs by around 10% over the past year given its shorter-duration profile, very low leverage and lack of discount dynamic. This resilience can now be monetized to add capital to the higher-beta perpetual CEFs as the backdrop is now more supportive for their outperformance.

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