2023-07-29 06:46:37 ET
Summary
- We review CEF market valuation and performance through the third week of July and highlight recent market action.
- CEFs continued to rally in July, buoyed by a soft landing narrative.
- Short-term and longer-term rates have a very different impact on CEF net income and NAV changes, so it's always important to differentiate the two.
- Flaherty preferred CEFs made another distribution cut, while VCIF decided to rebrand itself as a CLO CEF.
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 third week of July. 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
CEFs had a strong week, with most sector NAVs and discounts rallying. Broader markets have caught on to a soft landing narrative, which has supported prices nearly across the board.
Systematic Income
The CEF space has rallied sharply since its May trough and is approaching the highs for the year.
Systematic Income
CEF discounts have tightened somewhat but remain relatively wide.
Systematic Income
Today's combination of relatively wide CEF discounts and relatively tight credit spreads (marked by a red dot below) is somewhat unusual by historic standards, as the following chart suggests. Typically, credit spreads are wider given today's CEF discount levels or, alternatively, CEF discounts are usually tighter given today's credit spreads.
Systematic Income
Market Themes
This week, we wanted to touch on a common but not very informative way of talking about interest rates that we often see in the commentariat. A recent headline touched on one of our fund holdings - the Tax-Advantaged Preferred Securities and Income Fund (PTA) - saying that the fund has recovered recently, in part due to a slower pace of rate increases. This formulation clearly suggests the discussion has to do with short-term interest rates, where the Fed has indeed slowed down the pace of hikes relative to earlier in the hiking cycle.
It remains odd that commentators are not willing to separate short-term rates from longer-term rates. In any case, if short-term rates rose but at a slower pace, it would still have acted as a tailwind on preferred CEF NAVs by further reducing net income - exactly the opposite of what is suggested. In fact, the reason a fund like PTA has seen NAV gains recently has nothing directly to do with stability in short-term rates. If we want to be precise about it, the recent NAV gains are linked to the broader tightening in credit spreads.
If we stick to interest rates, however, short-term rates don't actually have any direct impact on the fund's assets and a fairly small impact on its net income. What has a sizable impact on the fund's assets are longer-term rates. For instance, PTA NAV was about the same in March 2023 as it was in May 2022 despite the fact that short-term rates rose about 4% in that span.
Furthermore, short-term and long-term rates don't move in sync. For instance, 10Y Treasury yields are at the same level they were at the end of September last year, however short-term rates have doubled since then.
Sure, since the end of 2021 both short-term rates and longer-term rates have risen, but the two don't always co-move. Longer-term rates are, roughly speaking, expectations of short-term rates over a future period of time.
The takeaway here is that investors need to be clear what exactly they mean when they talk about interest rates. This is because "interest rates" don't exist. There is the entire yield curve. Different points on the yield curve don't move in sync with each other, and they don't have the same effect on fixed-income CEF net income and NAVs.
At the very least, investors need to recognize the different impacts of short-term vs. longer-term rates. Otherwise, investors will likely get the wrong end of the stick and potentially make uninformed allocation decisions.
Market Commentary
Flaherty preferreds funds are out with another distribution cut - they have been cutting like clockwork. This looks to be the 6th cut from the previous 2021 peak. The cumulative cut is about a third, which roughly lines up with what's happened to net income of their leveraged assets. Leveraged assets make up roughly a third of their total assets. At this point, the net income of leveraged assets has moved to zero, cutting a third off the funds' net income.
The Vertical Capital Income Fund (VCIF), which used to be a whole-loan residential mortgage CEF, has fallen on its sword and will rebrand itself as the Carlyle Credit Income fund, change the ticker to CCIF and change its allocation strategy to CLO Equity and Debt.
In the asset sale process the NAV fell from $9.96 to $8.27, presumably because its previous assets were too illiquid / small to be sold at the NAV, rather than that VCIF was cooking the books.
The whole thing is odd as VCIF is already a very small fund ($85m of net assets based on the last NAV) and Carlyle is basically stripping it of any identifying characteristics. Seems there would be less work to just IPO a new fund, particularly with Carlyle's brand recognition. By foregoing an IPO Carlyle do save on the IPO fees (which managers pay these days rather than the investors) however there is a matter of Carlyle making a $10m payment to the shareholders which throws a wrench into this logic.
Carlyle is the biggest CLO manager with around $50bn of CLOs under management. At this point the fund is trading at around a 5% discount to NAV which is the widest discount in the CLO Equity space (e.g. [[XFLT]], [[EIC]], [[ECC]], [[OXLC]], [[OCCI]]). Unless we see further NAV drops, that looks like a decent entry point.
A couple of moving parts are still happening - a $25m tender offer, $40m equity infusion by Carlyle and $15m of new shares issued to Carlyle. A new monthly dividend of $0.0551 was declared - equivalent to 8% on NAV, which will be raised to 12% over time. Even after the raise, that's quite low as far as CLO Equity funds go, so it should rise unless the NAV drops further.
For further details see:
CEF Weekly Review: 'Interest Rates' Don't Exist