WDI - CEF Weekly Review: The Real Risk For Term CEFs

2023-08-12 10:10:27 ET

Summary

• We review CEF market valuation and performance through the first week of August and highlight recent market action.
• The CEF rally paused this week due to the Fitch downgrade and lower than expected jobs numbers.
• Investors and commentators often focus on the wrong risks of term CEFs.
• It was fairly quiet on the CEF distribution front - we highlight a few changes from Eaton Vance and Western Asset.

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 first week of August. 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 came to an end this week as all CEF sectors posted lower NAVs while discount action was mixed. The Fitch downgrade and lower than expected jobs numbers were enough for the markets to pause and reevaluate how far they've come over July.

The average CEF sector discount remains wider of its historic average level. Discounts tightened only slightly over July and are unlikely to move meaningfully tighter in absence of lower leverage costs.

Market Themes

This week we came across a couple of term-CEF related comments which are bound to cause some confusion. And since term CEFs remain part of our CEF allocation strategy, we thought it made sense to provide some additional context to make sure investors make the right decisions in their allocation.

One was a reader comment saying - what's the point of a term CEF that doesn't have its portfolio maturing at the same time as the fund. Obviously, there is confusion here between target term CEFs and term CEFs.

Target term CEFs are those that hold assets maturing roughly around the same time as the fund's expected termination date. The reason they are called "target term" is that they target to return their starting NAV back to investors. This rarely works out for various reasons but it makes a lot more sense to target a specific NAV when your assets mature at around the same time as the fund itself terminates.

For many asset classes it would not be practical to have target term CEFs such as municipal bonds which tend to be quite long-dated (though with call options) and preferreds most of which are perpetual. Moreover, it would not necessarily be desirable to hold target term CEFs as it limits investors to holding short-maturity assets. In short, the term CEF feature is very attractive regardless of the underlying portfolio.

Another comment was about a specific term CEF with an upcoming termination date and how that offers an opportunity for investors. The "key risks" of the fund were the portfolio weighted-average maturity being longer than the termination date and the term date being possibly extended for 6 months.

We can offer a bigger risk for investors, which is that the fund doesn't actually terminate, and its discount therefore widens substantially, causing quite a bit of pain for shareholders.

Many commentators love to assume, for some reason, that all term CEFs will always terminate despite numerous examples that they don't (e.g. [[BSL]], [[DMO]], etc).

It was also interesting that the fund was pitched when its discount was significantly tighter than the sector average level. That doesn't strike us as an opportunity. Rather, term CEFs offer an attractive opportunity when their discounts trade at around the sector average level.

When this happens, it creates a positively asymmetric situation. If the fund terminates, its discount goes to zero. If it doesn't terminate, the discount shouldn't move a whole lot because it is already trading at the sector average level - tails you win, heads you don't lose.

Market Commentary

It was generally a quiet month for CEF distribution changes. With short-term rates flatlining we aren't going to see the kinds of moves we did over the last year.

A couple of changes to note. Eaton Vance loan CEFs [[EVF]], [[EFT]] and [[EFR]] hiked a bit.

A number of Western Asset CEFs hiked as well such as the bond funds [[IGI]], [[GDO]], [[HIO]], [[HYI]] and [[MHF]]. Hikes for bond funds don't make a lot of sense particularly for leveraged funds like GDO. Indeed GDO net income has been falling.

Unleveraged funds, on the other hand, like HYI and IGI can boost net income by rotating into higher-coupon bonds and perhaps that's what they have been doing. Nuveen unleveraged Muni CEFs have also hiked recently.

A couple of other Western Asset CEFs such as DMO and WDI which we hold in our Income Portfolios enjoyed a hike as well. This makes a bit more sense as they hold floating-rate assets. This is the second consecutive hike for DMO while WDI has been hiking like clockwork.

Elsewhere, the Carlyle Credit Income Fund (CCIF) (the new CLO CEF from Carlyle that took over [[VCIF]]), is holding a $25m tender offer (about 30% of shares). The election period for the CCIF tender is till 14 Aug. It looks as though investors can buy the fund now and tender it back to Carlyle at the NAV.

The big question is what is the NAV going to be? Last month it was $8.27 versus the current price of $7.82 which gives around 5% of margin. There were some stub assets in the fund that VCIF couldn't sell, so they could create a drag on the fund though it's unlikely to be very large. Separately, the fund is likely to be mostly invested in cash which should create a small tailwind to the NAV. If it acquired CLO Equity assets in July that should be good news for the NAV as the asset class has rallied sharply over the month.

Interestingly, Saba holds about 8% of the fund so they see something interesting here. Overall, the opportunity is not massive and could be a loss however it looks interesting for tactical investors.

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