NIE - NIE: Still Uncertain But This Fund Is Better Than Most

2023-09-29 16:23:43 ET

Summary

• Virtus Equity & Convertible Income Fund offers a high level of income from equities, boasting a 10.08% yield compared to the S&P 500's 1.52%.
• The NIE closed-end fund has outperformed the S&P 500 Index on a total return basis since January 2023.
• The fund's performance has recently deteriorated due to market concerns about inflation and rising energy prices, but it still offers advantages such as convertible securities and call options.
• The fund's technology and consumer discretionary weightings pose risks due to a resumption in inflation. Its portfolio does not appear to be positioned properly.
• The fund may or may not be able to sustain the current distribution, but the valuation is reasonably attractive.

The Virtus Equity & Convertible Income Fund ( NIE ) is one of the few funds that has figured out a way to generate a high level of income from equities. After all, as I have pointed out in the past, common equities are not generally very good for income considering that the S&P 500 Index (SP500) only has a 1.52% yield at the current level. That is far less than any fixed-income security delivers right now, and it is in fact much less than even the money market pays. The Virtus Equity & Convertible Income Fund boasts a 10.08% yield at the current price, which is sufficiently high to represent a positive real yield, unlike the S&P 500 Index, as well as beating most other assets in the market.

It has been a little while since we last discussed this fund. The last time that I published an article on the Virtus Equity & Convertible Income Fund was in January 2023. The fund has managed to outperform the S&P 500 Index since that time on a total return basis:

The fund has not done quite as well in terms of price performance, but the total return is by far the more important metric to use with closed-end funds because they deliver the overwhelming majority of their returns in the form of direct payments to investors.

Unfortunately, we can see that this fund's performance has begun to deteriorate significantly over the past few months as the market's optimism about the defeat of inflation and a return to a loose monetary policy has begun to wear off. The fund's shares are down a whopping 4.97% in the past month alone, and unfortunately, there may be some reasons to believe that this decline will continue. This is due to its portfolio not being the best for an era characterized by high energy prices, inflation, and interest rates. We will be sure to investigate this in this article, along with examining the fund's finances and changes to its portfolio.

About The Fund

According to the fund's webpage , the Virtus Equity & Convertible Income Fund has the primary objective of providing its investors with a high level of total return. As is usually the case, the website provides a more detailed description of the fund's objectives and strategies:

The Fund seeks total return comprised of capital appreciation, current income, and gains.

Under normal circumstances, the Fund will invest at least 80% of its net assets (plus any borrowings for investment purposes) in a combination of equity securities and income-producing convertible securities.

The equity component of the Fund may vary from 40% to 80% and the convertible component may vary from 20-60% of assets.

The Fund typically employs a strategy of writing (selling) call options on the stocks held in the equity component, generally with respect to approximately 70% of the value of each stock position. The extent to which the Fund uses this strategy will vary depending on market conditions and other factors. This strategy is intended to generate current gains from options premiums as a means to enhance distributions payable to the Fund's shareholders and to reduce overall portfolio risk.

The Fund's portfolio certainly fits with this description. As we can see here, currently 62.11% of the fund's assets are invested in common equities and 35.04% of its assets are invested in convertible securities:

This fits with the ranges provided in the website's description of the fund's strategy. However, the name of the fund might imply that the fund's allocation to convertible securities is higher than it really is. I will admit that I wish the fund's portfolio were a bit more heavily weighted to convertible securities as they provide a few advantages over common stocks. As I mentioned in my previous article on this fund:

A convertible security is a preferred stock or bond that may be converted into equity under certain conditions. In exchange for this conversion feature, the security will have a lower yield than an ordinary bond issued by the same company. However, the fact that it can be converted into common equity works out pretty well for investors if the common stock of the issuing company skyrockets in value as then the fixed-income investor can receive substantial capital gains from the conversion. In the absence of such common stock appreciation, it provides the safety of a normal fixed-income security.

Thus, convertible securities offer high yields and provide an income just like a preferred stock or bond. The investor does not have to sacrifice the upside potential of the common stock to obtain this income, however. These securities are thus very nice for anyone who needs income today (such as many retirees) but still wants to enjoy the benefits of holding common stock. When we consider how long a retirement can be today, it is important that an investor retains exposure to the long-term capital gains potential of common stock to avoid running out of money.

The dynamic of the market has changed somewhat over the past two years, and now convertible securities are somewhat more attractive even for younger investors who still have a considerable amount of time to accumulate wealth. This is because of the rising interest rate environment. Today, a money market fund is paying around 5% as opposed to basically nothing two years ago. As such, the opportunity cost of holding any common stock with a yield of less than 5% is a lot higher than it was back in 2021. This is why the market declined once the Federal Reserve started raising interest rates with very low-duration and low-yielding sectors such as technology being hit harder than short-duration sectors with high-yields like energy. Convertible securities offer a solution to this problem since they provide a way to retain exposure to low-yielding growth sectors while not sacrificing the safe yield that could be otherwise earned on this money. The technology sector has long used these securities as a way to finance early or mid-stage growth since they tend to have lower interest rates than traditional fixed-income securities and the conversion feature is a nice selling point for investors who are tempted by the high possible long-term gains.

It should come as no surprise then that the Virtus Equity & Convertible Income Fund is heavily weighted toward the technology sector. This is the fund's largest single sector holding at 29.77%:

This is higher than the S&P 500 Index's weighting to the technology sector, which is a bit concerning in the current environment. This is because of the resurgence of inflation. As everyone reading this is no doubt well aware, the year-over-year headline inflation rate bottomed out in June and has been increasing since then:

This creates a lot of headwinds for the technology sector because it implies that the Federal Reserve's fight against inflation is far from over. As such, interest rate cuts may not be forthcoming in the near term, which means that investors are more likely to favor short-duration assets instead of long-term ones. This has been the case since the start of July, which was about the time that inflation started trending up again. As we can see, technology ( IYW ) has greatly underperformed energy ( IYE ), which is a short-duration sector, since that time:

As I have pointed out in previous articles, JP Morgan recently projected that the current global shortage in energy will increase over the remainder of the decade, with crude oil production being approximately 7.1 million barrels per day below demand by 2030. The CEO of Goldman Sachs recently made similar comments, suggesting that the Federal Reserve will have to keep raising interest rates throughout 2024 to try and stop the inflationary pressure of rising energy prices. That will not be good for the technology sector, as we saw in 2022 and again since July. When we consider the impact that rising inflation and energy prices will have on consumer finances, it is difficult to make a case for the consumer discretionary sector either, which is the second largest holding in the fund.

This fund does have two things going for it that partially offset the risks of its two largest sector holdings being in a precarious position given the current macroeconomic outlook. The first of these is the fact that some of these holdings are convertible securities as opposed to common stocks. The convertible securities provide a guaranteed return in the form of a coupon payment. They also sit higher in the capital stack, meaning that an investor in one of these securities has some protection in the event of an issuer bankruptcy or liquidation.

The second advantage that this fund has over an ordinary common stock fund is that it writes call options against some of the positions in the portfolio. The upfront premiums that the fund receives from the option sales offset some declines in the market price of the securities. Admittedly, neither of these is sufficient to offset all of the risks of the fund's current weightings, but investors are almost certainly going to be better off here than they would with an all-common stock fund with a similar portfolio.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the Virtus Equity & Convertible Income Fund is to provide its investors with a high level of total return. In order to accomplish this, the fund invests in a portfolio of common stocks against which it writes call options. As I discussed in a previous article (linked earlier), this strategy can create a very high artificial yield from a common stock portfolio when executed properly. In addition, the fund invests in convertible securities that boast yields that are similar to fixed-income securities but offer substantially more capital gains potential. The fund can utilize the conversion feature in certain circumstances to realize these capital gains and generate significant profits. As is the case with most closed-end funds, this one collects the money that it realizes through its investment portfolio and pays it out to its shareholders, net of expenses. We can generally expect that this will result in the fund having a very high yield.

This is certainly the case, as the Virtus Equity & Convertible Income Fund pays a quarterly distribution of $0.50 per share ($2.00 per share annually), which gives it a 10.08% yield at the current price. This fund has been reasonably consistent with its distribution over the years, as it last cut it during the Great Recession that accompanied the late 2000s financial crisis and has been raising it ever since:

This history is likely to appeal to anyone who is seeking a safe and secure source of income to use to pay their bills or finance their enjoyment of life. However, it is always critical that we analyze the fund's ability to pay its distribution, as the market and economic environment today is substantially different than the one that existed over the decade prior to the pandemic. Let us analyze the fund's finances to this end.

Fortunately, we have a remarkably recent document that we can consult for the purpose of our analysis. As of the time of writing, the fund's most recent financial report corresponds to the six-month period that ended on July 31, 2023. This is perhaps the newest report that is available from any closed-end fund right now, which is nice as it should give us a good idea of how well the fund performed during the bear market bounce that dominated most of the first half of this year. The fund may have been able to exploit this situation given its technology-heavy portfolio, as that was by far the strongest sector during the first half of this year. The situation was perfect for capital gains if the fund managed to realize them before the market started to sell off again.

During the six-month period, the Virtus Equity & Convertible Income Fund received $2.117 million in interest and $3.361 million in dividends from the assets in its portfolio. When we subtract the foreign withholding taxes that the fund had to pay, it reported a total investment income of $5.475 million during the period. The fund paid its expenses out of this amount, which left it with $2.171 million available for shareholders. That was, unfortunately, nowhere near enough to cover the $27.709 million that the fund paid out in distributions to its investors. At first glance, this is likely to be concerning as the fund's net investment income was nowhere near sufficient to cover the distribution.

However, a fund like this has other methods through which it can obtain the money that is needed for the distribution. For example, this fund is primarily an equity fund, so capital gains are likely to be a significant component of its total return. Capital gains are not considered to be investment income for tax purposes, but they obviously are still money that the fund can pay out to investors. Fortunately, the fund did manage to do fairly well here during the first half of 2023. It reported net realized gains of $10.521 million and had another $61.283 million in net unrealized gains. Overall, the fund's net assets went up by $46.266 after accounting for all inflows and outflows during the period. Thus, it technically did manage to cover the distribution during the period.

However, the concerning thing is that the fund was only able to cover the distribution by paying out some of its unrealized gains. These are unrealized gains and can be very easily erased by the market when it turns, as it did over the past three months. Thus, it is uncertain whether or not the distribution is actually secure or not. The fund failed to cover its distribution during the previous full-year period so if it loses its net unrealized gains in a market correction then it will have serious problems sustaining the distribution.

Valuation

As of September 28, 2023 (the most recent date for which data is available as of the time of writing), the Virtus Equity & Convertible Income Fund has a net asset value of $22.14 per share but the shares currently trade for $19.88 each. This gives the fund's shares a 10.21% discount on net asset value at the current price. That is a very large discount that is more attractive than the 9.64% discount that the shares have had on average over the past month. It is not a substantial improvement over the average, though. Nonetheless, the current price does seem reasonable if you like this fund.

Conclusion

In conclusion, Virtus Equity & Convertible Income Fund has an excellent strategy and convertibles are in general a great way to play long-duration sectors. The fact that it has substantial equity allocation reduces its appeal over a pure-play convertible fund though, especially in the current environment. I remain unconvinced that the fund's potential outweighs its risk right now, but it is certainly a more worthy option than many other funds on the market.

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