GOF - GOF: Market Performance Is Misleading

2023-07-27 14:53:32 ET

Summary

• Investors are desperately in need of income today in order to maintain their lifestyles in the face of incredibly high inflation.
• Guggenheim Strategic Opportunities Fund invests primarily in a fixed-income portfolio to provide its investors with a high level of income.
• The GOF closed-end fund's shares in the market consistently deliver higher returns than its portfolio, making it look like the portfolio performs better than it actually does.
• The fund is raising capital and distributing this new money to investors as opposed to covering its distribution out of investment returns.
• The fund is incredibly expensive, which is a big concern.

There can be little doubt that one of the biggest problems facing the average American today is the incredibly high level of inflation in the economy. This high level of inflation has caused the cost of living to rise at a fairly rapid pace and made it ever more difficult for many people to keep their bills paid and their families fed. I discussed this in numerous previous articles and blog posts, such as this one .

We can very clearly see the scope of this problem by looking at the consumer price index, which claims to measure the price of a basket of goods that is regularly purchased by the average person. As we can see here, this index has increased by more than the 2% annual pace that economists generally consider to be healthy during each of the past twelve months:

This problem becomes even more apparent when we consider that inflation compounds, just like stocks in a portfolio. As such, the fact that the recent 3% year-over-year growth came on top of a 9.1% year-over-year increase in June of last year means that prices across the economy went up 12.37% in only two years. The wages that people are paid for their jobs have not gone up nearly as rapidly, which results in a significant financial pinch. This is probably one reason why the job reports keep coming in so strong despite numerous other signs of economic weakness. In short, people have been forced to take on a second job just to maintain a lifestyle that they previously enjoyed with one job. Clearly, people are desperately in need of income to maintain their standard of living.

As investors, we are not immune to the increasing cost of living. After all, we all have bills to pay and require food for sustenance just like anyone else. In addition, we may occasionally desire some luxuries in our lives. All of these things cost money and are considerably more expensive than they used to be. Fortunately, we have the ability to put our money to work for us to earn an income so we do not have to resort to some of the desperate measures that we are seeing others engage in.

One of the best ways to do this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income. These funds are unfortunately not very well followed in the financial media and many investment advisors are unfamiliar with them. It can therefore be difficult to obtain the information that we would really like to have to make an informed investment decision. That is a shame because these funds offer a number of advantages over ordinary open-ended and exchange-traded funds. This is because a closed-end fund is able to employ certain strategies that have the effect of boosting the effective yield of the fund's portfolio beyond that of the underlying assets or indeed just about anything else in the market.

In this article, we will discuss the Guggenheim Strategic Opportunities Fund ( GOF ), which is one fund that can be used by investors that are looking to earn a high level of income. This is apparent in the fact that the fund yields 13.68% as of the time of writing. However, just about any time a fund's yield reaches that level, it is a sign that the market expects that the distribution will be cut in the near future. We, therefore, want to pay special attention to the fund's finances in our analysis. I have discussed this fund before, but a few months have passed since that time so naturally a few things have changed. This article will focus specifically on those changes and provide an updated analysis of the fund's financial condition. Let us investigate and see if the fund could make sense for purchase today.

About The Fund

According to the fund's webpage , the Guggenheim Strategic Opportunities Fund has the stated objective of providing its investors with a high level of total return, primarily through income and capital appreciation. This is a strange objective for this fund when we consider that it is a fixed-income fund. As we can see here, fully 79.84% of the fund is invested in bonds, although it does have some exposure to common stocks:

The reason why the fund's objective is a bit surprising considering this allocation is that fixed-income securities such as preferred stocks and bonds do not provide much in the way of capital appreciation. After all, an investor will purchase a bond for face value when it is issued, receive a regular coupon payment from the bond's issuer, and receive face value back when the bond matures. Thus, there are no net capital gains from bonds, and over their lifetime the only investment return that is provided is the coupon payments that go out to the investors. This is because bonds have no inherent link to the growth and prosperity of the issuing entity. The same is true of preferred stocks, except that they have no maturity date. This is the reason why most fixed-income funds only have the provision of current income as their investment objectives. This one claims total return, although the only things in the portfolio that are actually total return vehicles are the common stock and convertible positions. These two instruments only account for 14.91% of the portfolio, so the potential for capital gains is somewhat limited.

With that said, it is possible to earn capital gains through trading bonds prior to their expiration despite the fact that these securities have no net capital gains over their lifetimes. This comes from the fact that bond prices change with interest rates in the market. It is an inverse relationship, so when interest rates rise, bond prices fall and vice versa. This is due to the simple fact that a bond is issued with a coupon rate that is based on the market interest rate as of the time of issuance. As such, during a period of rising rates, newly issued bonds will have higher coupon rates than existing rates. In such an environment, nobody will purchase an existing bond when they can purchase an otherwise identical brand-new bond that has a higher coupon rate. As such, the price of the existing bond needs to decline to the point that it delivers a similar yield-to-maturity as the brand-new bond.

As everyone reading this is no doubt aware, this is exactly the environment that the United States has been in for the past eighteen months. Since March 2022, the Federal Reserve has been aggressively raising interest rates in an attempt to combat the high level of inflation in the economy. As we can see here, the effective federal funds rate was 0.08% in January of 2022 but it sits at 5.08% today:

As was generally expected, the Federal Reserve raised its federal funds target rate by 0.25% yesterday but this has yet to be reflected in the effective federal funds rate data. The bond market largely shrugged off yesterday's rate hike, largely because it was already priced in. However, the bond market did not shrug off the fact that rates have increased by 525 basis points since the start of last year. We can see this quite clearly in the fact that the Bloomberg U.S. Aggregate Bond Index ( AGG ) is down 5.13% over the trailing twelve-month period:

Surprisingly, the Guggenheim Strategic Opportunities Fund held up much better than the bond market as a whole. The fund is only down 0.13% over the same one-year period:

This is very surprising, although this fund does include some things that will hold up better than ordinary bonds during rate hike periods. We can see this by looking at the fund's portfolio. Here is what the fact sheet lists as the fund's asset portfolio:

In particular, we can see the 29.8% allocation to bank loans. These are normally floating-rate securities, so their coupon rate actually increases when interest rates go up. As such, these securities should be able to maintain a very stable price in a rising-rate environment because they will always deliver a yield that is competitive with newly issued debt securities. We can see this quite clearly in the fact that the floating-rate index ( FLOT ) has actually gone up over the past year:

This is in direct defiance of the decline that we saw in fixed-rate bonds but it is hardly unexpected given the fact that these securities are much more desirable than ordinary bonds in a rising-rate environment. The strong performance here would help to offset some of the weakness that the fund's other assets would exert on the overall performance of the portfolio.

With that said, the floating rate securities only account for a minority of the portfolio. They therefore cannot explain all of the strength that this fund has exhibited relative to the aggregate bond index over the past year. In fact, they do not and part of the explanation for the discrepancy comes from the fact that the Guggenheim Strategic Opportunities Fund is a closed-end fund. As such, its shares do not always trade in line with the performance of the portfolio. This is important because the fund's portfolio has not been performing as well as the shares have in the market. This is shown by looking at management's own performance data:

As we can see, the fund's portfolio only delivered a 6.62% total return year-to-date. However, the shares delivered a 12.03% total return over the same period. The same is true over the trailing one-year period, as the fund's portfolio only delivered a 9.42% total return but the shares delivered a 13.78% total return over the same period. The same thing happened in 2022, as the fund's portfolio had a -11.67% total return but the fund's shares only delivered a -5.00% total return in the market. Thus, a big portion of the fund's respectable market performance since the start of 2022 has been investors willing to overpay for the actual performance that the fund's portfolio delivered. That is probably not sustainable indefinitely, so there could be a reversal and a decline in the market price at some point.

One thing that we notice in the chart that details the portfolio composition is that the Guggenheim Strategic Opportunities has a fairly high allocation to high-yield corporate bonds. These are what are known as "junk bonds" and they account for 34.8% of the portfolio right now. This is something that may be concerning to more conservative investors, and indeed it has presented risks at times. After all, we have all heard about the high default risk that comes along with junk bonds. That is not something that will be comforting to those investors that are highly concerned with the preservation of principal.

Fortunately, we can gain a bit of comfort by looking at the credit ratings that have been assigned to the bonds in the fund's portfolio. Here they are:

An investment-grade bond is anything rated BBB or higher. As we can clearly see, that only describes 36.73% of the portfolio. The remainder of the bond assets are junk bonds. However, we can see that 58.87% of the bonds in the fund are rated either BB or B by the major rating agencies. According to the official bond rating scale , companies whose securities are issued with these two ratings have sufficient financial strength to sustain their current debt obligations and can probably continue to make payments on their obligations even in the event of a short-term economic shock. Thus, the risk of default should be very low here (although it is not zero). Between these highly-rated speculative and investment-grade securities, we have 95.6% of the fund's bond portfolio accounted for. When we combine that with the fact that this fund currently has 1,335 holdings, the conclusion is that the risk that we will be hurt by default-related losses is very low. We should not really have to worry about the fund's portfolio as it is diversified enough to protect the shareholders.

Leverage

In the introduction to this article, I stated that closed-end funds such as the Guggenheim Strategic Opportunities Fund are capable of employing certain strategies that have the effect of boosting their yields beyond that of any of the underlying assets. One of these strategies is the use of leverage. In short, the fund borrows money and then uses that borrowed money to purchase various fixed-income securities. As long as the purchased securities have a higher yield than the interest rate that the fund has to pay on the borrowed money then the strategy works pretty well to boost the effective yield of the portfolio. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, this will usually be the case. It is important to note though that this strategy is nowhere near as effective at boosting the portfolio's returns with interest rates at 5% as it was with interest rates at 0%.

Unfortunately, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not using too much leverage since that would expose us to an outsized amount of risk. I generally do not like to see a fund's leverage exceed a third as a percentage of its assets for this reason. Fortunately, the Guggenheim Strategic Opportunities Fund satisfies this requirement as its levered assets currently comprise 24.19% of the portfolio. Thus, this fund appears to be striking a reasonable balance between risk and return. We should not have to worry too much about the fund's use of leverage.

Distribution Analysis

As mentioned earlier in this article, the Guggenheim Strategic Opportunities Fund has the stated objective of providing its investors with a high level of total return. In order to accomplish this, the fund invests primarily in bonds and other fixed-income assets, which deliver nearly all of their returns in the form of direct payments to investors. The fund then applies a layer of leverage to boost the effective yield of its portfolio above that of even the junk bonds in its portfolio. It then pays out its net investment gains to the shareholders via distributions. As such, we can assume that this fund will probably have a very high yield itself.

This is certainly the case, as the Guggenheim Strategic Opportunities Fund pays a monthly distribution of $0.1821 per share ($2.1852 per share annually), which gives it a 13.68% yield at the current price. This fund has been remarkably consistent with its distributions over the years:

This is one of the best track records of any fixed-income fund in terms of consistency, which will undoubtedly appeal to anyone that is seeking a stable and secure source of income to use to pay their bills or finance their lifestyles. However, one is forced to ask how this fund has been able to achieve such consistency when pretty much every other fund using a similar strategy has been unable to accomplish that task. Thus, there is a very real possibility that the fund is paying out more than it can really afford to, which is not sustainable over any sort of extended period. We should investigate the fund's finances to determine if this is likely to be the case.

Fortunately, we do have a very recent document to consult for this purpose. As of the time of writing, the fund's most recent financial report corresponds to the full-year period that ended on May 31, 2023. This makes this one of the most recent reports available for any closed-end fund as well as a much newer report than we had available to us the last time that we discussed this fund. It should also give us a very good idea of how well the fund handled the challenging bond market conditions last year as well as the strength that we saw this year.

During the full-year period, the Guggenheim Strategic Opportunities Fund received $116,145,399 in interest and $9,982,864 in dividends from the assets in its portfolio. This gives the fund a total investment income of $126,128,263 over the course of the year. The fund paid its expenses out of this amount, which left it with $84,370,795 available for the shareholders.

This was nowhere close to enough to cover the $244,326,113 million that the fund paid out in distributions during the period. This is quite concerning at first glance as we generally like a fixed-income fund to be able to fully cover its distributions out of net investment income.

With that said, the fund does have other methods that can be employed to obtain the money that it needs to cover the distribution. In particular, it might be able to earn some capital gains by trading bonds and exploiting price fluctuations. Unfortunately, it generally failed at this during the period as the fund had net realized gains of $24,993,182 but this was offset by $125,820,760 net unrealized losses.

Overall, the fund's net assets declined by $18,921,287 over the period after accounting for all inflows and outflows. The decline in net assets would have been much larger, but the fund did a $212,399,119 capital raise during the period. This capital raise ultimately funded most of the distribution, as even the net investment income plus net realized gains was not enough to cover the distribution.

I generally do not like to see a fund relying on new capital to fund its distributions as such a situation is not sustainable over the long term. This fund has done that for two years in a row, as it failed to have sufficient net investment income plus net realized gains to cover its distributions for the past two years:

The distribution is only sustainable as long as the fund can continue to bring in outside money to satisfy those return of capital distributions. It has succeeded in doing this so far as the fund's net assets as of May 31, 2023, were higher than they were on May 31, 2021. However, the big question is whether or not it can continue to do that indefinitely.

Valuation

It is always critical that we do not overpay for any assets in our portfolio. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. The usual way that we value a closed-end fund like the Guggenheim Strategic Opportunities Fund is to look at the fund's net asset value. The net asset value of a fund is the total current market value of all the fund's assets minus any outstanding debt. This is therefore the amount that the shareholders would receive if the fund were to be immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can get them at a price that is less than the net asset value. This is because such a scenario implies that we are purchasing the fund's assets for less than they are actually worth. This is not the case with this fund today. As of July 26, 2023 (the most recent date for which data is available as of the time of writing), the Guggenheim Strategic Opportunities Fund had a net asset value of $12.42 per share but the shares currently trade for $16.04 per share. This gives the shares an incredibly high 29.15% premium to the net asset value. That is above the 28.43% premium that the fund has averaged over the past month as well as being an incredibly expensive price to pay for any fund.

Conclusion

In conclusion, the Guggenheim Strategic Opportunities Fund is a reasonably good bond fund, but its portfolio does not perform nearly as well as the fund's share price. The fund has been consistently raising capital in the market and then using that new money to sustain its distribution. It is uncertain how long this can be sustained, and when combined with the incredibly high premium that the shares carry it may not be worth it.

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