NFJ - NFJ Using Calls To Supplement Income Just A Tiny Bit

2023-08-10 11:29:07 ET

Summary

• NFJ runs a predominantly equity portfolio with convertibles thrown in.
• Separate teams are assigned to manage the equity and the fixed income sleeve.
• Options are written on the equity portion to supplement income generation.
• We review this closed end fund and provide our verdict.

The common theme in almost all the funds that we have covered is their primary objective of earning high current income for their unitholders. Some do it by investing in common equities, some in hybrid instruments like preferred or convertibles, while even bonds float the boat of few of these funds. Leverage is the thread that binds a lot of closed end funds together, a tool so to speak to achieve their raison d'etre of high income. This crowd favorite magnifies returns when the cost of borrowing is low, and functions as a deadweight on the portfolio otherwise. We have covered several that employ this strategy and things are decidedly less cheery for the two we wrote on recently ( here and here ), OFS Credit Company Inc ( OCCI ) and DNP Select Income Fund ( DNP ). Employing options to boost income is another popular strategy and this, when done right, is one of our favorite tools. We recently wrote on a couple of these and while we gave both a neutral rating, we liked Eaton Vance Tax-Managed Buy-Write Income Fund ( ETB ) far more than Voya Global Equity Dividend ( IGD ). Today, we will dive into the strategy and results of another closed end fund that uses options to supplement income.

Fund Snapshot

Virtus Dividend, Interest & Premium Strategy Fund ( NFJ ) primarily aims to generate high current income with its investment strategy. While the desire for capital appreciation is there, it comes in second. It accomplishes these goals by investing around 75% of the portfolio in equities and the balance in convertible securities. We saw a few convertible debentures like Exact Sciences Corporation ( EXAS ) 0.375% 01-MAR-2028 and Live Nation Entertainment, Inc. ( LYV ) 2.0% 15-FEB-2025, in the fund's June 30, 2023 portfolio listing . The managers are not too fussy about credit ratings on the convertibles and we can see that reflected in the most recently available data.

Covered calls are deployed on around three fourths of the portfolio as that comprises the equities. Under normal market conditions, at least 80% of the portfolio is invested securities that generate dividends, interest or option premiums. We can see below, that as of June 30, the option premiums were virtually nothing relative to the total portfolio value and would provide negligible downside protection if the stock market tide were to turn for the worse.

We know that the above data is a bit stale and the composition may have changed by now, especially since this fund has a very robust portfolio turnover based on the data from the last few years.

But supporting the June 30 data is the most recent annual report, where we can see that realized premiums form a small portion of the net income and this proportion is even lower if we consider the unrealized portion.

That tells us that the calls are generally way out of the money and hence fetch small premiums and/or they aren't written on the entirety of the common equity positions. This exposes the fund to market gyrations which will not be fun when the market cracks. On a positive note, the fund is unleveraged, which means it is not investing borrowed money and hence does not have interest on debt cannibalizing its bottom line.

In terms of sector section, at June 30, their equities portion was heavily concentrated in the financial sector, with industrials, consumer discretionary, real estate, information technology and healthcare, each forming at least 10% of the portfolio.

Fixed income formed around 20% of the portfolio at June 30. Information technology formed the largest chunk at close to 25% of that portion of the portfolio, followed by healthcare, Consumer discretionary, and financial sectors.

Last but definitely not least, this fund has two managers, NFJ Investment Group manages the equities and related options, whereas Voya IM manages the convertible securities portion of the portfolio. Prior to July 2022, the convertible portion was managed by AllianzGI, a firm that was found guilty of fraud relating to another fund. The assets along with the managers of the AllianzGI funds were transferred over to Voya and it was business as usual in terms of the investment strategies and the hands steering the ship.

Performance

As we have deduced above, NFJ is set up to do well in bull markets, but due to the extremely limited back stop provided by options, it would fail to hold up in bear markets. We can see that in action in the calendar year returns from the fund website . Note the negative performance and the years in question.

Of course, the lack of options backstop was only part of the reason, the main culprit was the sector allocations. In the most recent annual report, management has explained the reason for the fund underperformance.

In the equity sleeve, relative performance results versus the Russell 1000 Value Index were due to negative sector allocation, while stock selection was effectively neutral over the reporting period. Selection was strong across the financials and consumer discretionary industries. However, these gains were offset by holdings in the energy and industrials industries that failed to keep pace with the benchmark. An overweight in technology and an underweight in energy detracted. Conversely, underweight positions in communication services and financials contributed to the Fund’s 12-month returns.

Source: Annual Report

The benchmark index for the fixed income portion is ICE BofA U.S. Convertibles Index also did better than what NFJ's allocated portion did. The fund had an annual expense ratio of around 0.96% (after subsidies), which makes the relative performance against the respective indices even worse (their comparatives in the annual report are before expenses).

The bull market has returned this year, and has been very resilient so far. We can see that NFJ is also sharing in the joy.

Verdict

NFJ is trading at a discount to its NAV currently, but that is hardly an anomaly as we can see.

With the amount of protection provided by options, to call this one an options fund would be a reach. It basically follows the market trajectory and performs more or less like an equity fund. Even the fixed income portion fails to support the downward trajectory due to poor sector selections. Overall, 2022 shows the fact in an emphatic manner that the fund's NAV tracked benchmarks, almost tick for tick.

The yield of around 8% based on the last price of $12.51 may attract the income crowd, but since it is quarterly, it may be less of a fan favorite due to lack of monthly inflows. We would not be a buyer even at this discount as we are confident that we can do a bit better in a down market, with proof in our 2022 performance . We rate this a 6 on our potential pain scale.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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