OPP - OPP: This High-Yielding CEF Looks Better And Could Be A Play On Bank Problems

2023-03-13 15:11:03 ET

Summary

• Investors are desperate for income to maintain their standard of living in today's incredibly high inflation.
• RiverNorth/DoubleLine Strategic Opportunity Fund, Inc. invests in a portfolio of fixed-income and other high-yielding assets and employs leverage to give investors an incredibly high yield.
• The market expects that the Federal Reserve will pivot before September, and this fund could benefit if the SIVB collapse does prompt it to do so.
• The fund's distribution was recently cut, and it appears much more sustainable than it did a few months ago.
• The fund is currently trading at a reasonably attractive valuation.

There can be little doubt in anyone’s mind that one of the biggest problems facing Americans today is the incredibly high inflation rate that is gripping the economy. In fact, over the past year, there has not been a single month in which the consumer price index appreciated by less than 6.4% year-over-year:

We have started to see some slowdown recently, but now there are signs that this could reverse itself in the near future. Over the weekend, various officials at the United States Treasury at the Federal Reserve suggested that we may see rate cuts and another bank bailout as a result of the collapse of Silicon Valley Bank. This has caused the market to predict that the Federal Reserve will begin cutting rates by mid-year and undo the progress that has been made fighting against inflation. This is evident by looking at gold prices, which are touching $1,900 per ounce in the futures market in pre-market trading on Monday. This will exacerbate the problem that I discussed in a recent blog post about people being desperate for income.

As investors, the inflation problem affects us too, although we tend to have more flexibility in our budgets than the average person. After all, we also need to pay to heat our homes and put food on our tables. We can put our money to work for us in order to get the extra money that we need to accomplish this in an inflationary environment. One of the best ways to do this is to purchase shares in a closed-end fund ("CEF"). These assets are not discussed very often in the financial markets and investors do not often follow them, which is a shame because these funds can be great for anyone seeking income. In short, they provide investors with a diversified portfolio of assets that can usually deliver a higher yield than pretty much anything else in the market.

In this article, we will discuss the RiverNorth/DoubleLine Strategic Opportunity Fund, Inc. ( OPP ), which is one fund that investors can use for income today. As might be guessed, this fund sports a very attractive 14.59% yield at the current price, however, anything with such a high yield deserves caution as the market apparently feels that the fund will be forced to cut its distribution in the near future. I have discussed this fund before and made such a prediction, which proved prescient as the fund did indeed cut its distribution the next month. However, we still need to use caution as the market still believes that the new lower distribution is unsustainable. As a few months have passed since my last article, this one will specifically focus on the fund’s finances as well as any changes to the portfolio and the market environment that might affect this fund.

About The Fund

According to the fund’s webpage , the RiverNorth/DoubleLine Strategic Opportunity Fund has the stated objective of providing its investors with a high level of current income and overall total return. This is not really surprising considering that this is mostly a fixed-income fund. Fixed-income securities are generally income vehicles, as the name suggests. This comes about because their potential for capital gains is quite limited. After all, these securities have no inherent link to the growth and prosperity of the underlying company. A company will not pay extra money on its debt just because its profits go up! Rather, the prices of these securities are correlated to interest rates. As everyone reading this is no doubt well aware, interest rates in the United States (and elsewhere around the world) have been increasing rapidly over the past year. We can see this by looking at the federal funds rate, which is the rate at which the nation’s commercial banks lend to each other in the overnight market:

As a general rule, when interest rates go up, the price of fixed-income securities declines. This is because the interest rate of newly issued securities corresponds with the market interest rate. Thus, brand-new securities that are issued during a period of high-interest rates will pay more than securities issued during a time period of low-interest rates. As a result, nobody would buy the low-interest rate securities when they can get an otherwise identical one with a much higher yield. Therefore, the market price of these securities must decline if interest rates rise so that they deliver a similar yield-to-maturity as a brand-new security with a higher yield.

The rising interest rates and falling fixed-income prices have certainly had an impact on the market price of the fund. The RiverNorth/DoubleLine Strategic Opportunity Fund is down 34.63% over the past twelve months:

That is admittedly not the kind of performance that will engender a great deal of confidence among more risk-averse investors. However, nearly everything in the market is down over the past year and the most important thing is where it will go from the point of purchase, not what it did in the past. As I mentioned in the introduction, the collapse of Silicon Valley Bank last week has caused some regulators to rethink the monetary tightening policy. Over the weekend, Treasury Secretary Janet Yellen stated that the government will work to set up a vehicle meant to protect depositors against losses due to a bank collapse. It is uncertain what role this new entity will play that the Federal Deposit Insurance Corporation does not, but the market now believes that the Federal Reserve will begin cutting rates in September:

This is a stark reversal from Chairman Powell’s previous comments that rates will remain “higher for longer,” but those comments were also made prior to the collapse of Silicon Valley Bank. If the Federal Reserve does indeed start cutting rates, the share price of the RiverNorth/DoubleLine Strategic Opportunity Fund could begin to rise. As such, purchasing the shares today could allow an investor to bet on policymakers cutting rates and generate an income at the same time. Any gains in the fund would increase your return over and above what the distribution already provides, so that is always nice.

With all that said, the RiverNorth/DoubleLine Strategic Opportunity Fund is not exclusively a fixed-income fund. As I discussed in my previous article on the fund, it is actually split into three different parts: traditional fixed-income, alternative fixed-income, and closed-end funds:

This is an interesting combination that actually reduces the fund’s exposure to interest rates somewhat. This is because the “alternative credit” segment includes things such as floating-rate securities that benefit from rising interest rates. These securities will also be negatively impacted by falling interest rates as the amount that the borrower pays declines. In short, these securities tend to have much more price stability than traditional fixed-income securities. As a result, the fund may not actually gain as much if interest rates decline as it would if it were composed entirely of fixed-income securities. Currently, however, the traditional fixed-income segment consists of the majority of the fund’s assets:

Thus, we can likely expect some gains to the fund’s share price if the market is correct about the Federal Reserve’s resolve wavering in the event of the problems at Silicon Valley Bank. In addition, the fund should generate strong capital gains in such an event, which will eventually be paid out to its shareholders. That may further increase this fund’s appeal to those that desire to make a call on interest rates going down. Admittedly, that would be an overreaction since it appears that the problems at Silicon Valley Bank were unique and not evident of a systemic problem, but panic tends to spread more rapidly than anyone expects and the banking system in general has $620 billion of unrealized losses across its security portfolio according to the Federal Deposit Insurance Corporation.

One of the nice things about this fund is that its annual turnover is not particularly high. It had a 44.00% annual turnover last year, which is much lower than most fixed-income funds that describe themselves as “opportunistic.” The reason that this is nice is that it costs money to trade fixed-income securities and other assets, which are billed directly to the fund’s shareholders. This creates a drag on the portfolio’s performance and makes management’s job much more difficult. After all, the fund’s management will need to generate a sufficiently high return to cover these extra costs and still come close enough to the index to satisfy its investors. This is a task that very few actively managed funds manage to accomplish consistently. The RiverNorth/DoubleLine Strategic Opportunity Fund is no exception here, as it managed to beat the Bloomberg US Aggregate Bond Index ( AGG ) during certain periods but failed to accomplish this feat during others:

Personally, I do not think that the Bloomberg US Aggregate Bond Index is the best one to benchmark this fund against because the allocations to closed-end funds and alternative credit are things that the index does not have. However, that is the index that the fund’s sponsor has chosen to use (and indeed the above chart is found on the fund’s own webpage), so we are going with it. One other thing that we notice here is that the fund’s market performance is quite different than the performance of the underlying portfolio. This can create opportunities, which I discussed in a previous article . We will discuss this in just a bit, with particular emphasis on whether the fund is undervalued right now.

Leverage

In the introduction, I mentioned that closed-end funds like the RiverNorth/DoubleLine Strategic Opportunity Fund are able to deliver higher yields than most other things in the market. These funds are, in many cases, able to deliver a higher yield than the underlying assets actually possess. One of the ways in which this is accomplished is through the use of leverage. Basically, the fund is borrowing money and using that borrowed money to purchase fixed-income assets. As long as the purchased assets have a higher yield than the interest rate that the fund needs to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. As the fund is capable of borrowing at institutional rates, which are significantly lower than retail rates, this will usually be the case.

Unfortunately, the use of debt in this fashion is a double-edged sword because leverage boosts both gains and losses. As such, we want to ensure that a fund is not employing too much leverage because that would expose us to too much risk. I do not usually like to see a fund’s leverage over a third as a percentage of its portfolio for this reason. As of the time of writing, the RiverNorth/DoubleLine Strategic Opportunity Fund’s levered assets comprise 34.77% of its assets, which is admittedly a bit over this level. However, in this case, it is probably acceptable because fixed-income securities in general tend to be reasonably safe and the fund’s 551 positions reduce a lot of risk due to diversification. In addition, we can expect this leverage percentage to come down if the events of last week prompt the Federal Reserve to pivot earlier than it would have originally. Thus, the balance between risk and reward is probably acceptable here, even though on paper the fund’s leverage is higher than we normally like to see.

Distribution Analysis

As stated earlier, the primary objective of the RiverNorth/DoubleLine Strategic Opportunity Fund is to provide investors with a high level of current income. In order to achieve this, it invests in fixed-income assets along with closed-end funds. Closed-end funds tend to have a very high yield and the average coupon of the fixed-income securities in the portfolio is 5.92% so these are not exactly low-yield bonds. The fund then applies a layer of leverage to boost its yield further. As such, we might expect that the fund itself has a remarkably high yield. This is certainly the case as it currently pays out a monthly distribution of $0.1021 per share ($1.2252 per share annually), which gives it a jaw-dropping 14.59% yield at the current price. The fund has unfortunately not been particularly consistent about its distribution over the years, and it has been declining since 2019:

This is something that may be a bit of a turn-off to those investors that are seeking a stable and secure source of income that can be used to pay their bills. The fact that the fund cut its distribution back in January is especially likely to be concerning to these investors, although anyone that read my previous article on this fund was not caught off guard by this event. The fund’s history is admittedly not the most important thing to anyone buying today, though. This is because anyone buying today will receive the current distribution at the current yield. As such, the most important thing for a new investor is the fund’s ability to sustain its current distribution.

Fortunately, we do have a remarkably recent document that we can consult for the purposes of examining its distribution. The fund’s most recent financial report corresponds to the six-month period that ended on December 31, 2022. As such, this is a much more report than we had available the last time that we discussed this fund, which is quite nice since it should give us a good idea of how well the fund performed during the rising rate environment that was prevalent in the second half of 2022 and possibly gives us some further insight into the reasons for the distribution cut. During the six-month period, the RiverNorth/DoubleLine Strategic Opportunities Fund received $9,561,661 in interest and $2,320,466 in dividends from the assets in its portfolio. When we combine this with a small amount of income that was received from other sources, the fund had a total income of $11,899,608 during the period. It paid its expenses out of this amount, which left it with $9,533,592 available for the shareholders. That was, unfortunately, nowhere close to enough to cover the $18,812,328 that the fund actually paid out in distributions during the period. This could at least partially explain the distribution cut as fixed-income funds usually need to pay their distributions solely out of net investment income.

With that said, the fund does have investments in closed-end funds that may have provided it with capital gains or even return of capital distributions. It also may have had some capital gains itself, as there was an opportunity to make money trading bonds even if the general trend was down. Unfortunately, it was unsuccessful at this as the fund reported net realized losses of $3,200,775 and had another $12,918,266 net unrealized losses during the period. The fund did issue new shares during the period, which brought in $34,086,326 during the period. That offset its losses and the fund’s assets did increase by $5,951,031 during the period after accounting for all inflows and outflows. However, those new shares increase the fund’s expenses with respect to the distribution and a large portion of the new money that it raised went out to the former shareholders via the distribution. As such, the distribution cut makes a great deal of sense since paying distributions by continual capital raises is not sustainable over any sort of extended period. We will need to wait until the fund releases its annual report in June before we know if this new distribution is sustainable, but it is probably much closer to the fund’s actual net investment income assuming that figure remains relatively stable.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate a suboptimal return on that asset. In the case of a closed-end fund like the RiverNorth/DoubleLine Strategic Opportunity Fund, the usual way to value it is by looking at the fund’s net asset value. The net asset value of a fund is the total current market value of all of the fund’s assets minus any outstanding debt. It is therefore the amount 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 buying the fund’s assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of March 10, 2023 (the most recent date for which data is available as of the time of writing), the RiverNorth/DoubleLine Strategic Opportunities Fund had a net asset value of $9.80 per share but only traded for $8.48 per share. That gives the fund a 13.47% discount on the net asset value at the current price. This is a bit better than the 11.68% discount that the fund had on average over the past month. Thus, the price today certainly seems to be reasonable.

Conclusion

In conclusion, the RiverNorth/DoubleLine Strategic Opportunity Fund, Inc. is looking much better than it did a few months ago. In particular, it is looking like it could be a good way to profit if the Federal Reserve actually lowers interest rates in response to the collapse of Silicon Valley Bank. There is, of course, no guarantee that this will happen as it would be in stark conflict to its fight against inflation, but monetary policymakers have made so many stupid decisions over the past fifteen years that I put nothing past them. In the absence of a rate cut, the fund’s distribution now appears to be much more sustainable, and it could therefore deliver a pretty solid total return even if the share price remains flat. When we consider that the fund’s shares are trading at a pretty large discount today, it might actually be a reasonable purchase.

For further details see: