PTA - Market Volatility Opens Up More CEF Relative Value Opportunities

2023-04-12 05:20:27 ET

Summary

• Recent market volatility has opened up valuation divergences between very similar CEFs, creating opportunities for switches or outright holds.
• This offers income investors an opportunity to pick up additional yield, adopt a more defensive stance, and generate alpha in their portfolios.
• We highlight a number of switches in the High Yield, Multisector, and Preferred CEF sectors.

This article was first released to Systematic Income subscribers and free trials on Apr. 6.

Recent volatility and an air pocket in the CEF market, while painful, creates opportunities for investors. Volatility is more likely to lead to temporary relative mispricings in CEFs while market falls create less of a tax drag for switching positions and can actually allow investors to harvest tax losses to offset current or future gains in the portfolio. In this article we highlight rotation opportunities between pairs of CEFs from the same issuer.

Relative Value Rotation Recap

CEF switches or relative value rotations, as we call them, are a way for investors to get exposure to assets they may be already holding at a cheaper valuation. The point isn't to find the fund with the widest discount or to find the "cheapest" fund there is but to provide the same type of allocation investors are already comfortable with but at a better price.

Relative value rotations have a number of advantages for income portfolios. First, they can provide an additional margin of safety in the portfolio by offering exposure to very similar assets as other funds but at a cheaper valuation. Periods of market weakness tend to see significant weakness in high premium funds while funds already trading at cheaper valuations tend to be more resilient.

Second, relative value rotations can enhance portfolio yield by giving investors access to very similar assets but at a greater discount. The wider the discount, the higher the yield on the same set of assets, all else equal.

Third, relative value rotations can deliver alpha - or an additional return over and above a static allocation.

Finally, switching into a similar but more attractively valued fund can also provide tax-loss harvesting opportunities.

What To Watch Out For

Relative value switches might seem obvious, however, there are a number of things to watch out for.

First, relative value switches make most sense for a pair of very similar funds. For instance it makes a lot of sense to look at relative value in the PIMCO taxable suite where there are a lot of similar funds than to seek relative value between a BlackRock Municipal fund and a Nuveen Preferred fund.

Second, investors should keep in mind the fair-value of discounts. This is because some funds carry higher management fees than other similar funds. So just because fund A is trading at a wider discount than fund B, it doesn't make fund A more attractive. Fund B could still be more attractive despite its tighter discount if it has a lower management fee i.e. if its fair-value discount is tighter than that of fund A.

Third, this may sound obvious but investors should keep an eye on any fund's absolute and risk-adjusted total NAV returns over time. Valuation is an important component of CEF allocation, however, the last thing investors should aim for is to get stuck with a portfolio of value traps.

Current Opportunities

Kicking things off with the PIMCO suite, the PCM Fund ( PCM ) has zoomed ahead of the rest in the suite. For example, this is what it looks like relative to PDI which, itself, is typically no slouch at high premiums.

The proximate catalyst for this sharp PCM revaluation appears to be its somewhat more stable net income profile.

This stronger net income and coverage profile has pushed the PCM premium to a historically high premium against the rest of the suite. The fund's overweight of legacy non-agency RMBS which tend to be floating-rate as well as a lighter derivatives allocation are likely contributing to its more resilient level of net income. However, with the Fed likely to pause and eventually pivot, this is likely to turn into a liability over the next 12 months or so, likely causing its premium to deflate.

The preferreds sector is typically rife with relative value opportunities due to having multiple issuers with pretty similar funds. In the Cohen & Steers suite, the Limited Duration Preferred and Income Fund ( LDP ) has tended to trade at a tighter discount than its sister fund Tax-Advantaged Preferred Securities and Income Fund ( PTA ) due to having a lower management fee. At the moment LDP trades at a wider discount which offers an attractive switch opportunity. LDP has a slightly lower duration footprint than PTA which is an attractive feature now that 10Y Treasury yields have fallen nearly 0.8% from their recent peak.

In the Flaherty suite, PFD is looking rich vs. PFO, though we're still far from the bonkers levels we saw over the last couple of years.

In the High-Yield corporate bond sector, the CSAM Income Fund ( CIK ) looks attractive versus sister fund CS High Yield Bond Fund ( DHY ).

Although CIK trades at a 2% tighter discount, it can actually deliver a higher underlying portfolio yield than DHY due to its unusually low management fee. The chart below shows that the lower management fee drag of CIK can drive a portfolio yield that is 0.6% above that of DHY. The fair-value discount differential of the two funds is around 8% (i.e. CIK trading at a discount 8% tighter than DHY e.g. CIK at 2% discount vs. DHY at a 10% discount).

Takeaways

Recent volatility has pushed around discount valuations of pretty similar funds - a common dynamic which offers a number of attractive switch opportunities for CEF investors. Pursuing CEF rotations can provide an additional margin of safety, while generating alpha and enhancing portfolio yield. This slow-but-steady focus on both defense and offense can keep portfolio income levels and returns on a surer footing over the longer-term. The funds highlighted in this article are also worth a look on a standalone basis.

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