2023-12-10 09:14:14 ET
Summary
- We review CEF market valuation and performance through the first week of December and highlight recent market action.
- CEFs had a good week with rising NAVs due to falling Treasury yields and higher stock prices.
- The XAI Octagon Floating Rate & Alternative Income Term Trust is proposing to convert into a perpetual fund, highlighting the ease of changing a fund's term structure.
- NRGX has started trading as PDX; we expect its discount to tighten over the medium term.
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 first week of December. 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
It was another good week for CEFs with all sector NAVs rising due to falling Treasury yields and higher stock prices. November came in as the best month since at least 2021.
Systematic Income
Discounts continued to recover from their recent dip but remain well wider of their historical average this century. In our view, until leverage costs start to decrease, we don't expect much discount tightening from current levels.
Systematic Income
Market Themes
The CLO/Loan CEF XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ) asked shareholders to approve a proposal to turn into a perpetual fund. Recall that right now it's a 2029 term CEF.
This development once again highlights how easy it can be to change a fund’s term structure. This may come as a surprise to many analysts and investors who talk about term CEFs as having a "maturity" or as being guaranteed to terminate.
XFLT doesn’t say much in the press release except that it’s in the best interests of shareholders. Oddly enough, it changes the topic quickly and talks about how the conversion will allow the fund to grow its common share base.
How many shares there are in the fund is not a relevant metric for shareholders. It is only relevant to the fund’s managers, who get to earn more fees on a larger share and asset base. The fund’s share base has grown very quickly as it has been an aggressive issuer of new shares via its at-the-market program.
For instance, the fund had around 7m shares in 2017 and this has now grown to 35m shares. Because XFLT tends to trade at a premium, selling shares at-the-market is an easy way to add equity capital. While the share count itself is not relevant for shareholders, the fact that the shares are issued at a premium is as it’s accretive to the NAV.
Over the last 5 years, this has generated an additional 8% of NAV value, or about 1.5% per annum. However, more importantly, issuing new equity capital has allowed the fund to add new assets which has allowed it to generate more fees. Management fees have grown from about 2m in 2018 to 7.1m in 2023. Unless the fund moves to trade at a discount, this trend is likely to continue.
Because the fund's adviser XAI is, to put it kindly, a boutique investment manager ($428m AUM, XFLT looks to be its only fund) the fee stream it gets from XFLT is an existential issue for it, unlike for a manager like Nuveen which cares more about doing the right thing and delivering on the actual premise of term CEFs.
Because XFLT has tended to trade at a premium, it can argue it is doing shareholders a favor since cancelling the term feature means the premium will not deflate to zero over the fund's lifetime. However, doing this also removes several benefits of term CEFs such as mitigating the possibility of a deeper discount in the future (term CEFs tend to trade at tighter discounts than their perpetual counterparts - see JPI) as well as lower price volatility.
In our view, cancelling the term feature is not a compelling proposition from an economic perspective. Moreover, managers who launch term CEFs should stay true to the original mandate of the fund, rather than the bait-and-switch that is happening here.
Market Commentary
The PIMCO CEF NRGX has started trading as the largely credit-focused PIMCO Dynamic Income Strategy Fund ( PDX ). As discussed previously, the discount hasn't moved a whole lot on the conversion, even widening a tad in the last few days.
The key risk for the fund is reducing its oversized Venture Global private equity position. We expect the fund's valuation differential with the rest of the PIMCO taxable suite to narrow over the medium term, though not fully close.
Systematic Income
Stance And Takeaways
The continuing CEF rally has been supported by shifting market expectations of significant rate cuts over the next 18 months. The current forward rate curve shows that the market expects around 7 cuts over the next 18 months.
If this comes to pass, it is likely to fuel the second leg of the CEF rally, particularly as net income for most fixed-income CEFs would rise due to the drop in leverage costs. Much depends, however, on whether the Fed is able to thread the needle and achieve a soft landing. A recessionary outcome, while pushing net income higher, would also likely result in wider credit spreads, which would be painful for the broader CEF space.
For further details see:
CEF Weekly Review: Term CEFs Don't Always Deliver (On The Term Feature)