PAXS - CEF Weekly Review: Unleveraged CEF Income Is Holding Up

Summary

• We review CEF market valuation and performance through the first week of February and highlight recent market action.
• CEFs notched another good week with EM sectors underperforming.
• We discuss how unleveraged CEFs are able to maintain a more stable level of income in this environment.
• And highlight news from the preferred CEF FPF as well as two Nuveen term Muni CEFs.
• This week we rotated to PAXS, which is trading unusually cheap versus the rest of the PIMCO taxable suite.

This article was first released to Systematic Income subscribers and free trials on Feb. 5 .

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 February. 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 another good week with most sectors finishing in the green. Underperformers were Emerging Market sectors, likely due to the Adani fall-out as well as the Chinese spy news. Year-to-date, higher-beta sectors like REITs and Convertibles remain in the lead, both notching up 15+% gains.

January was the second strongest month for the CEF space in the post-COVID period, as bond / stock correlation turned positive once again, but, importantly with prices moving higher this time around.

Sector discounts continue to tighten and are trading roughly in the midpoint between the highs and lows over the past couple of years. Loan and Muni sectors remain at the widest discounts.

Market Themes

In an article last year we discussed some of the ways investors can tilt to funds whose income will remain relatively resilient. Among these were unleveraged CEFs which we highlight this week in the context of the Muni sector.

The chart below shows the change in distributions over the past 9 months for both high-leveraged CEFs (i.e. those with leverage in the range of 30+%) and those with low/no leverage (i.e. those with leverage below 10%).

These changes are clearly not a coincidence and reflect the income dynamics of these funds. As discussed previously, the key drivers of lower income for leveraged Muni CEFs are 1) deleveraging and 2) rising leverage costs.

A good example of deleveraging is shown below for the PIMCO Municipal Income Fund II ( PML ) which, after boldly raising borrowings in March was forced to cut them twice by substantial amounts. This required the fund to sell income-generating assets in order to pay down its borrowings, causing its net income to fall.

Turning to leverage cost, the chart below shows the leverage cost trajectory of the Nuveen Quality Municipal Income Fund ( NAD ) which continues to rise. Muni CEFs have floating-rate leverage instruments such as tender option bonds or variable-rate preferreds without an ability to offset this on the asset side as Muni bonds are fixed-rate. There is some hope that leverage costs may stabilize given the drop in the SIFMA index due to the technical jump over the end of the year. At any rate, leverage cost is likely to stabilize in the coming months as the Fed has already significantly slowed down its pace of hikes.

The key takeaway here is that unleveraged CEF income can remain relatively resilient as these funds don't face the prospect of either deleveraging or bear rising leverage costs. This doesn't mean, however, that investors should dump all leveraged Muni CEFs in favor of their unleveraged counterparts, particularly if they are bullish on Muni assets. This is because unleveraged funds hold fewer assets for a given dollar of NAV and hence provide less upside in case of a rally, such as the one we are going through this year. Once Muni yields fall to less attractive levels, it can make more sense to rotate to unleveraged CEFs or even open-end funds with more conviction.

Market Commentary

Preferred CEF First Trust Intermediate Duration Preferred & Income Fund ( FPF ) released a shareholder report with net income down around 10%. The fund has performed OK historically - its 5Y total NAV return is a touch below the sector average. What let it down a bit in 2022, as was the case with the Flaherty preferreds CEFs, is the lack of interest rate hedge which causes it to run with a higher duration and which causes its net income to drop at a faster pace when short-term rates rise. We continue to favor the Cohen & Steers CEFs in the sector.

Nuveen Term Muni CEFs ( NID ) and ( NIQ ) have announced a plan to liquidate (NID by March and NIQ by June of this year). Interestingly, the funds have not pursued the more common pattern for Nuveen term CEFs of offering a tender offer at NAV and seeing if there are enough remaining assets to convert to a perpetual fund which is what they did with JPT).

The explanation from Nuveen is that the funds have specific illiquid assets (13% of NID and 4% of NIQ) which they aren't able to sell down which means their weight would increase even more in case of a tender offer. Very importantly, if these illiquid securities cannot be sold by the termination, investors will be given a portion of a so-called liquidating trust which holds these securities.

In theory, investors may have to hold these securities until their maturity if the funds can't sell them. It's not clear what these are and whether they are coupon-paying securities (more palatable) or zero-coupon bonds. We suspect as investors realize that they can get stuck with an unlisted / untradable position (albeit small), the discount of the funds will widen out which could actually provide a tactical opportunity, particularly for NIQ where this illiquid position is small.

Stance And Takeaways

This week we made a switch from the PIMCO credit CEF ( PDO ) to its sister fund ( PAXS ) in the High Income Portfolio. As the chart below shows the discounts of the two funds have diverged to an unusual degree.

This chart shows the valuation differential more clearly with PDO trading at a 7.5% higher valuation vs PAXS.

In our view, PAXS offers a more attractive allocation in the PIMCO taxable suite as it's trading at a 20% cheaper valuation relative to the rest of the suite.

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