2023-08-19 06:51:55 ET
Summary
- We review CEF market valuation and performance through the second week of August and highlight recent market action.
- CEFs rallied slightly on the week but remain in the hold in August.
- CEF distribution changes may affect the historical relative value relationships of similar funds.
- We highlight JQC and OXLC.
Welcome to another installment of our CEF Market Weekly Review, where we discuss closed-end fund ("CEF") market activity from both the bottom-up - highlighting individual fund news and events - as well as the top-down - providing an overview of the broader market. We also try to provide some historical context as well as the relevant themes that look to be driving markets or that investors ought to be mindful of.
This update covers the period through the second week of August. Be sure to check out our other weekly updates covering the business development company ("BDC") as well as the preferreds/baby bond markets for perspectives across the broader income space.
Market Action
CEF returns this week were mostly positive as flat NAVs and tighter discounts combined to push most sectors into the green. Month-to-date however the CEF space is still in the hole, owing to lower Treasuries and stocks.
Discounts remain a few percentage points wider of their historical average level. This is somewhat ironic as CEFs are generating a higher level of portfolio yield today than they were in 2021 when discounts were extremely rich. This suggests that we may see discounts remain wide until the Fed starts to cut rates and allow most credit funds to start reversing previous distribution cuts.
Market Themes
One of the ways we like to generate alpha in our income portfolios is by so-called relative value rotations. This involves moving between two very similar securities based on relative valuation.
One of our favorites is the family of Cohen & Steers preferred CEFs: [[PTA]], [[LDP]] and [[PSF]]. Historically, we have held PTA when it trades at a wider discount than LDP (which is most of the time) and rotate to LDP when the discount gap converges.
As we highlighted recently, LDP cut its distribution, pushing its NAV current yield significantly below that of PTA and driving its discount wider than PTA. We can see this in the chart below.
The obvious question here is will this change the discount trading relationship between the two funds? And if so, does this mean that the rotation strategy parameters need to be recalibrated?
When it comes to how CEFs actually trade, it's certainly true that distribution cuts will tend to see a widening of a discount on a sustained basis. This is not only because of the lower current yield of the fund but also because many investors now view the fund as being less "trustworthy". Going forward we do expect the trading relationship to change and we wouldn't be surprised if LDP continues to trade at a slightly wider discount than PTA - a reversal of its previous position.
However, how CEF discounts trade is not the same as where they ought to trade or what their fair-value is. For very similar funds like LDP and PTA with similar portfolios and similar parameters like leverage and leverage cost, the deciding factor is typically management fees.
And here nothing has changed - LDP has a management fee of 0.7% while PTA has a fee of 1%. On a net asset basis this puts LDP ahead by around 0.5% in yield terms. And this is why our approach will not change, and we will continue to prefer LDP when both funds trade at the same discount.
This does raise the question of why the NAV distribution rate of LDP is now lower than that of PTA. In our view, this is due to non-structural features such as a slightly higher leverage and a slightly lower leverage cost for PTA. Both of these factors combine to push its portfolio yield above that of LDP. However, its lower leverage cost is only locked in for a limited period of time, and the leverage differential could easily shift in the future. For these reasons, we stick with our original rotation approach.
Market Commentary
The Nuveen Credit Strategies Income Fund (JQC) hiked the distribution by 14%. The fund has made fairly tepid hikes since 2022 (13% rise over the last 12 months vs. 32% for the Loan CEF sector median) so it's catching up to the higher level of net income in the portfolio. Overall, the performance has not been particularly impressive, with the 5Y total NAV return about half of the median fund in the Loans CEF sector.
The CLO Equity CEF Oxford Lane Capital Corp (OXLC) reported a 9% gain in the NAV over July. July was a strong month for all credit assets so it would be felt even more in higher-beta assets like OXLC. Loan prices have rallied for a couple of months now, so there is likely less of a tailwind remaining from the asset side.
However, with credit spreads remaining low, many CLOs are starting to get refinanced. This means the CLO Debt tranches are called and replaced with tighter spread alternatives. This boosts net income of CLO Equity securities as there is a smaller outlay for financing the assets of the fund.
It is also a negative to CLO Debt holders, who will now have to reinvest in holdings at tighter spreads. From an overall yield perspective this is not the end of the world as yields are still high and short-term rates have grown over the last few months so the new SOFR resets will be done at higher levels, offsetting some of the credit spread tightening. CLO Debt holders also get paid an additional spread for this callability, much like high-yield corporate bondholders get paid an additional spread for the embedded issuer call option. ETFs like [[JBBB]] and [[JAAA]] which allocate to CLO Debt remain attractive.
For further details see:
CEF Weekly Review: Distribution Changes And Discount Relationships