XYLD - MCN: A Very Good Fund But The Premium Is Irritating

2023-08-08 11:51:27 ET

Summary

• The rapidly rising cost of living has strained the budgets of many Americans.
• Wages have not kept up with the rising prices, forcing people to see alternative sources of income to maintain their lifestyles.
• Madison Covered Call and Equity Strategy Fund offers a high level of current income and gains through a covered call strategy.
• The fund has a history of outperforming covered call indices in terms of total return.
• The distribution is probably sustainable at the current level, but the fund is rather pricey.

There can be little doubt that one of the biggest problems facing the average American today is the rapidly rising cost of living. This is due to the high inflation that has been present in the economy over the past few years. We can see the extent of this inflation 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. This chart shows the year-over-year change in the consumer price index during each month over the past 25 years:

As we can clearly see, the consumer price index generally rose between 0% and 2% annually over the 25-year period. That is a level that economists generally consider healthy, although it still represents a loss of purchasing power and a devaluation of the U.S. dollar. After all, an item that cost $1,000 would cost $1,640.61 after 25 years of 2% annual inflation. We can see that ever since the pandemic of 2020, the consumer price index has been rising much more rapidly. This was caused mostly by the enormous amount of money-printing that took place over the 2009 to 2020 period, especially in 2020. The big problem for consumers though is that wages have not risen nearly as rapidly as the prices of products in the general economy. Some of the most rapid price increases were in food, energy, and basic necessities so people cannot simply avoid inflation by eschewing luxuries.

As such, we have seen many Americans resort to desperate measures such as dumpster diving or pawning their possessions to support themselves. There has also been a sharp increase in the number of people taking on second jobs or entering the gig economy to obtain a few extra dollars just to maintain their standard of living in the face of this inflation. This might be one reason why the jobs numbers are as strong as they are. In short, people are desperate for additional sources of income.

As investors, we are certainly not immune to this. After all, we require food for sustenance, fuel to heat our homes and businesses, and many other things. All of these things cost more money than a few years ago. Fortunately, we do not need to resort to extreme measures to obtain the extra money that is required to buy the things that we want or need. After all, we have the ability to put our money to work for us to earn an income.

One of the best ways to accomplish this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income. These funds, unfortunately, are not very well followed by the financial media and many investment advisors are unfamiliar with them. As such, it can be difficult to obtain the information that we would really like to have in order to make an informed investment decision. This is a shame because these funds have certain advantages over familiar open-ended and exchange-traded funds. In particular, a closed-end fund is able to employ certain strategies that allow it to produce much higher yields than the underlying assets possess. In fact, in some cases, these yields can be higher than anything else in the market.

In this article, we will discuss the Madison Covered Call and Equity Strategy Fund ( MCN ), which is one fund that aims to be helpful for those investors that are seeking income. This is immediately apparent in the fund's 9.65% current yield, which is certainly enough to turn anyone's eye. I have discussed this fund before, but several months have passed since that time, and naturally a great many things have changed. This article will, therefore, focus specifically on those changes as well as provide an updated analysis of the fund's finances. Let us investigate and see if this fund could be a good addition to your portfolio today.

About The Fund

According to the fund's webpage , the Madison Covered Call & Equity Strategy Fund has the stated objective of providing its investors with a high level of current income and gains. This is somewhat surprising considering that this is an equity fund. As we can see here, 81.87% of the fund is invested in common stock with the remainder in cash:

The reason why the objective is surprising is that common stock is not a current income vehicle. As of the time of writing, the S&P 500 Index ( SPY ) only yields 1.45% and the Dow Jones Industrial Average (DJI) yields 1.90%. In fact, even the traditionally high-yielding utility sector ( IDU ) only sports a 2.64% yield at the current level. These numbers are all less than an ordinary money market fund right now. Thus, common stock just does not work for income unless the market were to fall by at least 75% from its current level and that is unlikely in the extreme. With that said, common stock does work fine for current gains if you are able to consistently trade it for profit, which is very easy to accomplish during a bull market but few people are able to be consistently profitable in a flat or a bear market.

With that said, this fund does have a trick up its sleeve to allow it to generate income from a portfolio of ordinary common stocks. As the name of the fund implies, the Madison Covered Call and Equity Strategy Fund employs a covered call strategy, which is one of the simplest options strategies. It is also one of the safest strategies since the fund already owns the stocks upon which the options are written.

The big risk with call options is that the option will be exercised against the call writer and the call writer will have to go out and buy the stock to deliver to the call buyer. As stock prices have no theoretical maximum, that could result in infinite losses because the option writer still has to sell the stock at the strike price.

This fund does not have that risk because it already owns the stock that it would have to deliver if the call option is exercised. Thus, the worst thing that can happen is that it has to sell the stock for a price that is less than it could get in the market. If the fund writes the call appropriately though, it could still get a price that results in a capital gain. The way that the fund gets income from this is that the call buyer has to pay an upfront premium for the call option, which the fund gets to keep regardless of whether the option is exercised or not. If the option does not get exercised, this basically results in income for the fund. That is the fund's goal with its strategy.

In my previous article on the Madison Covered Call and Equity Strategy Fund, I pointed out that this fund has very different holdings than most other equity closed-end funds. This continues to be the case, which can be clearly seen by looking at the largest positions in the fund:

This is probably the only time that I have seen Transocean ( RIG ) among the top holdings of any fund, including ones that only invest in the energy sector. We also see APA ( APA ) and T-Mobile U.S. ( TMUS ), which are also fairly rare holdings for equity funds. It almost appears as though this fund is trying to invest in stocks that are rather volatile because these usually carry the highest option premiums. As such, writing covered call options against these stocks is much more profitable than writing them against a stable blue-chip company. We can also see this somewhat by looking at the yields of Global X's three covered call index funds:

(all figures from the fund sponsor.)

The Nasdaq 100 (NDX) and Russell 2000 (RTY) are both more volatile than the S&P 500 Index (SP500), so writing covered calls against them is somewhat more profitable. This fund is choosing individual companies and writing covered calls against them, which could prove to be a somewhat better strategy. In addition, this fund is not mechanically writing at-the-money call options like these three index funds do, so it still has some upside potential because it will still receive any stock price appreciation between the purchase price of its stock and the strike price of the option. Finally, this fund is only overwritten against 86.6% of its portfolio as of the time of writing. Thus, it has full upside potential on those securities that it has not written any call options on.

The largest positions in the fund have changed substantially since the last time that we discussed it. In fact, only Las Vegas Sands ( LVS ) and APA were in the portfolio the last time that we discussed the fund. All eight of the remaining positions in the fund's largest holdings list have been added to the fund's portfolio within the past several months. The fact that so many of the fund's positions have changed could lead an investor to assume that it has a very high annual turnover. That is certainly the case, as the fund had a 104.00% annual turnover last year, which is very high for an equity closed-end fund.

The reason that this is important is that it costs money to trade stocks, options, or other assets. These expenses are billed directly to the fund's shareholders, which creates a drag on the overall performance of the fund. That makes management's job more difficult, as management will need to earn a sufficient return to cover the trading expenses and still have enough left over to deliver an adequate return to the shareholders. There are very few management teams that are able to do this on a consistent basis, and this usually results in actively-managed funds being unable to outperform a comparable benchmark index.

With that said, the Madison Covered Call and Equity Strategy Fund has obliterated all three of the Global X covered call index funds over the past three years:

It is uncertain whether that is due to some of the inherent problems with the index funds' strategy of just mechanically writing covered call options or the true skill of the management team. This same outperformance does hold true over much longer time periods though, so it does seem that this fund could be a better choice than any of the covered call index funds, even though its yield is a bit lower. Naturally, past performance is not necessarily indicative of future performance, but the fact that this outperformance is true over the five- and the ten-year periods too (for the index funds that go back that far) does give us a certain amount of confidence in the ability of the fund's management team.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the Madison Covered Call and Equity Strategy Fund is to provide its investors with a high level of current income and current gains. The fund seeks to achieve this by using a buy-write strategy and pocketing the premiums from the call option sales. It also seeks to get some capital gains from the stocks in the portfolio that are not overwritten. As is the case with most closed-end funds, it then pays out the investment profits from this strategy to its investors.

As such, we can assume that this fund would boast a remarkably high distribution yield. This is certainly the case, as it currently pays a quarterly distribution of $0.18 per share ($2.16 per share annually), which gives it a 9.65% yield at the current price. The fund has been remarkably consistent with its distributions over the years, as it has stayed steady at the current level since the Great Recession nearly fifteen years ago:

This distribution history will almost certainly appeal to any investor that is seeking a stable and secure source of income to use to pay their bills and finance their lifestyles. It is admittedly somewhat surprising that this fund has been able to achieve a consistent distribution over time when many other ones in the sector have not been able to accomplish the same task. For example, the Eaton Vance option-income funds were forced to cut their distributions late last year.

Of course, the Eaton Vance funds were also very heavily invested in the technology sector, and that was one of the worst-performing sectors in 2022. The Madison Covered Call and Equity Strategy Fund, as already shown, has a bit more flexible portfolio so it will change its portfolio around when one sector is encountering difficulty. Overall, a covered call writing strategy does tend to produce relatively stable results over time, but it is still hard to believe that it could be perfectly consistent.

As such, we want to analyze the fund's finances in order to determine how sustainable the distribution really is. After all, we do not want to be the victims of a distribution cut since that would reduce our incomes and almost certainly cause the fund's share price to decline.

Unfortunately, we do not have an especially recent document that we can consult for that purpose. As of the time of writing, the fund's most recent financial report corresponds to the full-year period that ended on December 31, 2022. As such, this report will not provide us with any insight into the fund's performance so far this year. That is a shame as the market has generally been much stronger year-to-date than it was in 2022 so the fund has probably had the opportunity to make some profits. However, this is a newer report than we had available the last time that we discussed this fund so it should be useful for an update. In addition, management's ability to handle a challenging market is sometimes more insightful than its ability to handle a strong one. After all, anybody can make money in a bull market.

During the full-year period that ended on December 31, 2022, the Madison Covered Call and Equity Strategy Fund received a total of $381,884 in interest along with $2,425,083 in dividends. After we net out the money that the fund paid in foreign withholding taxes, the fund reported a total investment income of $2,784,529 during the period. It paid its expenses out of this amount, which left it with $1,106,216 available for shareholders. As might be expected, that was nowhere close to enough to cover the $15,115,784 that the fund actually paid out in distributions during the period. At first glance, this is likely to be quite concerning as the fund's net investment income was not nearly enough to cover the total payout.

However, the fund does have other methods through which it can generate money that can be paid out to the shareholders. In particular, it might have been able to earn some capital gains or option premiums to cover the distributions. That was, in fact, the case. During the full-year period, the fund reported net realized gains of $13,325,566 that were only partially offset by net unrealized losses of $7,677,912. Overall, the fund's net assets declined by $8,063,764 after accounting for all inflows and outflows. In short, the fund did fail to completely cover its distributions over the course of the year. However, the fund's net investment income combined with net realized gains was $14,431,782, which is pretty close to the amount needed to cover the distribution.

The fund's net assets were almost flat over the two-year period that ended on December 31, 2022, so it came very close to covering the distribution. When we consider that the market has been reasonably strong so far this year, the distribution is probably reasonably safe, but we should still pay close attention to the fund's semi-annual report covering the first half of this year when it is finally released.

Valuation

It is always critical that we do not overpay for any assets in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. In the case of a closed-end fund like the Madison Covered Call and Equity Strategy Fund, the usual way to value it is by looking at the fund's net asset value. The net asset value is the total current market value of the fund's assets minus any outstanding debt. This is, therefore, the amount of money that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can obtain them at a price that is less than the net asset value. This is because such a scenario implies that we are acquiring the fund's assets for less than they are actually worth. This is, unfortunately, not the case with this fund today. As of August 7, 2023 (the most recent date for which data is available as of the time of writing), the Madison Covered Call and Equity Strategy Fund had a net asset value of $7.35 per share but the shares traded for $7.48 each. This gives the fund's shares a 1.77% premium to the net asset value at the current price. This is admittedly a very small premium, but it is still quite a bit higher than the 0.81% premium that the shares have had on average over the past month. As such, it might be a good idea to wait for the fund's shares to come down a bit in price before purchasing.

Conclusion

In conclusion, the Madison Covered Call & Equity Strategy Fund looks like a reasonably good way to obtain the extra income needed to maintain your standard of living in today's highly inflationary environment. The fund does a lot of securities trading, which runs up its expenses but also makes it flexible during challenging markets. In particular, the fund managed 2022 surprisingly well. The fund's options strategy works well for flat markets as well. Overall, this does look like a good fund that can add both income and diversity to your portfolio, but the current price is a problem. The Madison Covered Call and Equity Strategy Fund's premium is not particularly large but it still exists, so anyone buying today is overpaying for the fund's assets.

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