JPT - JPC: Merger Arbitrage Opportunities

2023-10-16 08:57:23 ET

Summary

• Nuveen Preferred and Income Fund, Nuveen Preferred & Income Securities Fund, and Nuveen Preferred & Income Opportunities Fund are set to merge, with shareholders' approval obtained.
• The merger will result in the three funds becoming one legal entity, JPC, leading to narrower discounts to NAV.
• There is an arbitrage opportunity for investors to consider stemming from this merger.
• The article presents the risk/reward profiles for shareholders in the three funds, and the merger mechanics.

Thesis

The consolidation in the CEF space continues, with a suite of Nuveen preferred equity funds now set to merge after their shareholders' approvals:

October 13, 2023 -Common and preferred shareholders, as applicable, of Nuveen Preferred and Income Fund (JPT) , Nuveen Preferred & Income Securities Fund (JPS), and Nuveen Preferred & Income Opportunities Fund (JPC) have approved a proposal to merge the funds. The mergers will combine each of JPT and JPS into JPC. Subject to the satisfaction of certain customary closing conditions, the mergers are expected to become effective before the market opens on November 6, 2023.

The monthly distributions typically declared the first business day of the month for JPT, JPS, and JPC will be replaced by pre-merger distributions declared on October 24, 2023 with a record date of November 3, 2023. The payable date will remain December 1, 2023. Following the mergers, the surviving fund, JPC, may declare a post-merger distribution, which, to the extent made, is expected to have a record date of November 16, 2023 and be payable December 1, 2023.

Starting November 6, the JPT and JPS tickers will disappear, with only JPC surviving. The merger will be done at NAV levels, with each JPT and JPS shareholder being allocated a proportional amount of shares in JPC as per their current holdings.

The shareholders' approval was the last step in this process, with the Board of Trustees being the first one to propose the corporate action.

We find the merger approval to be beneficial, with the surviving fund being a much larger entity with a better profile in the market. Ultimately that should result in narrower discounts to NAV as time passes.

Merger Arbitrage Opportunities

The three funds are trading at different discounts to net asset value:

The merger approval translates into the three funds soon to become the same legal entity with only one NAV and one market price. That will result in the three CEFs seeing their discounts to NAV narrow to the same level.

There is a wider than expected divergence in discounts to NAV here. There is a 2% difference between JPS and JPC, which is going to close out. Since all of the CEFs are going to merged into JPC, we believe the lower CEF discount is going to prevail. Therefore, there is an arbitrage opportunity to take advantage of.

Any investors who want to purchase JPC should actually now buy JPS instead, since they can get the fund at a risk free 2% discount. Purchasing JPS shares now for example purely results in an investor holding the name until November, when it gets allocated JPC shares.

A more complex trading strategy to monetize the spread is to go long one of the names while concurrently shorting the other with a similar delta.

What should you do as a shareholder?

If you are a buy-and-hold investor who is happy with their risk allocation to this asset class you can just stay put. As a JPT or JPS shareholder you will be automatically allocated JPC shares with the same market value as the ones held before. The new fund profile is going to be very similar from a collateral perspective, thus there is nothing to be done.

If you want to increase your exposure to this asset class on the back of the higher for longer rates environment, you can now take advantage of the merger arbitrage opportunities described above, where one can purchase JPC via JPT or JPS shares, which are now cheaper from a discount to NAV perspective.

Conversely, if you are a JPT or JPS shareholder and you want to decrease your exposure to this asset class, all else equal (i.e no changes in preferred equity prices), you should wait for the merger to consummate before selling your shares since you will get a 'bump-up' in market price from the discount narrowing.

Fund Holdings

All three funds contain portfolios of preferred securities, mainly from financial institutions:

The main risk factor is default risk, which is not necessarily correctly captured in their ratings matrix:

While most of the collateral is investment grade, as we saw with the regional banks crisis in March/April, banks are a sector with very binary outcomes. If there is a run on a bank, it will go under irrespective of the rating, and all the capital structure is wiped-out (senior notes, preferred shares and common equity).

The main risk factor with smaller banks in today's environment is represented by higher rates, and their impact on 'held-to-maturity' and 'available-for-sale' portfolios:

With rates higher on the year, unrealized losses on lenders' balance sheets have ballooned yet again to net figures in excess of $600 billion. As we have seen before earlier in the year, the market can get spooked by these figures, even if they still sit in the 'unrealized' profit and loss line.

Furthermore all three Nuveen CEFs run high leverage ratios. JPC for example currently sports a 38% leverage ratio. Leverage amplifies returns and volatility, and will have a negative impact on investor returns if the market tanks again:

As we can see from the above graph the price action on JPC has been quite volatile in the past year, with the drawdown from March/April still in place.

From a structural standpoint a high leverage ratio translates into a high cost of funds, with all vehicles experiencing high expense ratios on the back of higher Fed Funds. Until the Fed starts cutting rates leverage is going to hamper these CEFs, with less benefits even in a benign market.

Conclusion

JPC is a fixed income CEF. The fund invests in preferred securities, mainly from financial institutions. The CEF is now set to absorb its sister funds JPT and JPS in November, with shareholders having approved the merger.

With all the approvals in place there are merger arbitrage trades to take advantage of, since the three CEFs are trading at different discounts to NAV. Upon the November merger completion date, the three funds will become one legal entity, namely JPC, and that fund is trading at a tighter discount to NAV currently. Investors wanting to buy JPC should actually purchase JPS shares since they are trading at a 2% wider discount when compared to JPC.

All three funds contain financial institutions preferred equity, asset class which is going to be under pressure until the Fed starts cutting rates.

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