KIO - CEF Weekly Review: Wide Discounts Make Rights Offerings Necessary

Summary

• We review CEF market valuation and performance through the third week of January and highlight recent market action.
• CEFs had another strong week with most sectors seeing both NAV gains and discount tightening.
• With most funds continuing to trade at discounts, rights offerings remain a common, if not the most desirable, way to raise additional capital.
• We also highlight distribution cuts from RiverNorth.
• We continue to see value in decent-quality funds with pockets of floating-rate assets that also trade at attractive valuations such as FINS and DMO.

This article was first released to Systematic Income subscribers and free trials on Jan. 22 .

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 third 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

CEFs had a strong week as most sectors saw gains in NAVs and tightening of discounts. Year-to-date, three sectors are already sporting double-digit gains with all sectors in the green. The second worst-performing sector is up 4%. The worst-performing sector of California Munis is, arguably, a special case, given the large distribution cuts and premium compression in that sector.

Both equity and fixed-income sector discounts have rallied 3-4% from the end-of-year levels. Fixed-income sector discounts are trading in line with the historic average while equity sector discounts are on the expensive side.

Muni and Loan CEF sectors look cheap on a discount basis, having both wide absolute discounts and low discount percentiles (i.e. being unusually wide relative to their own history). This is interesting because the two sectors are polar opposites, having very different quality and duration profiles.

Market Themes

Although CEF valuations have retraced off their lows in 2022, the space is not exactly expensive. For example, the percentage of funds trading at a premium remains fairly low - around 16%.

This dynamic has a knock-on effect on how CEFs raise capital. Specifically, a fund that is trading at a premium would normally either do an at-the-market offering, dripping new shares into the market slowly or it would do a secondary public offering at a premium to the NAV. This is a win-win for investors and the fund because it is accretive to the NAV (good for investors) and additive to assets (good for managers who collect fees on total assets).

However, when funds are trading at a discount, there are fewer options. Funds have to request special permission to issue shares below the NAV which is why they don't like doing it. This is why funds often turn to rights offerings when they trade at a discount as a rights offering requires no shareholder permission. This is because a rights offering is non-dilutive, i.e. a given shareholder can continue to maintain their relative holding in the company by subscribing to the rights.

Although voting non-dilution sounds good, it's not relevant for retail investors who own a miniscule amount of the fund to begin with and don't care about how much voting control they have. What matters more for retail investors is that a rights offering is typically dilutive to the NAV, meaning it causes a fall in the NAV, all else equal, as existing shareholders subsidize the additional discount offered in the rights with existing fund assets.

The KKR Income Opportunities Fund ( KIO ) recently announced a transferable rights offering. For a fund like KIO, which trades at a significant discount, (around 8% at the time of the announcement) the rights offering is highly dilutive.

For instance, based on the subscription pricing (max of 92.5% of price and 82% of NAV), the price of new shares could be offered to investors at a 16-18% discount). Such a large discount results in a significant NAV dilution, i.e. a drop in the NAV, all else equal, for the simple reason that $1 of the fund’s net assets is offered out at $0.82 cents or so.

In order to not lose money on the rights offering you’d want to either exercise or sell them (ticker KIO RT). Gauging the pricing of the rights is tricky so the easiest thing to do is to exercise the rights. However, this means that holders will end up with more shares of KIO than they probably wanted so it’s worth selling some before getting more shares otherwise you’ll end up with more KIO than your original holding. Selling existing shares during the formula calculation period (carried out across four days preceding the expiration date of 16-Feb) ensures that there is minimal price differential between the sold and newly acquired shares. The NAV dilution from the rights offering looks to be around 4% at current levels which is fairly chunky as these things go. Typically, the share price drops when rights offerings are announced to reflect both the dilution as well as the fact that some investors just don't like to participate in them and sell their shares. KIO has just raised its distribution, likely to prevent the price from falling too much or to even possibly close the discount gap to avoid a large NAV dilution. The way rights offerings are usually pitched by the funds is that they want to take advantage of existing or potential opportunities. It's something they say, however it doesn't make it true. That sort of explanation is intuitive because the managers get new capital to allocate to new assets but on a NAV basis it doesn't really hold water because the fund can always just rotate assets into new assets anyway from existing holdings. Bank loans can be traded so this is not hard to do unlike for BDCs. One view is that the fund is using this opportunity to deleverage but that would be a very expensive and long way to deleverage. If they wanted to deleverage they could just sell holdings without doing the offering. In the end, the fund wants to grow assets. A drop in market value of the portfolio (KIO is a very high-beta fund and has significantly underperformed the loan sector last year) caused the fees to go down. The rise in income is an opportunity to raise the distribution which is also a good opportunity to do the RO since the raise should close the discount a bit.

Market Commentary

RiverNorth CEF distributions were cut significantly from 2022 levels (RIV by 25%, OPP by 30%, RSF by 14%). Recall that distributions of these funds are managed to a percentage of the NAV – 12.5% for RIV and OPP and what looks to be 10% for RSF. It goes without saying that the double-digit managed distribution policies don’t actually reflect true portfolio yields of these funds which tend to have modest yields. The drop in the NAVs over 2022 caused the funds to significantly cut the distributions given their formulas. However, even in a normal environment these funds will continue to cut distributions over time because overdistributions eat away at the NAV, causing it to fall, all else equal.

Stance And Takeaways

Given the trajectory of Libor over the past year, we expect a surge in net income to start filtering through some CEFs over the next few months. Because of both a lag in how Libor flows through coupons of floating-rate securities (on a quarterly basis with the coupon set at the beginning of the accrual period) and the lag with which many CEFs declare their net income position (on a semi-annual basis for many funds) the actual impact of short-term rates on net income is not immediately apparent however it doesn't make it any less real. This is why we continue to see value in funds with pockets of floating-rate assets, particularly those that continue to trade at attractive valuations. This includes the Angel Oak Financial Strategies Income Term Trust ( FINS ) and the Western Asset Mortgage Opportunity Fund ( DMO ), trading at 8.6% and 9.7% yields, among others.

For further details see: