2023-05-19 07:34:17 ET
Summary
- Virtus Convertible & Income Fund is a closed-end fund focused on domestic convertible securities and high-yield bonds.
- The fund has a 22% leverage ratio, mainly obtained through an outstanding series of preferred shares.
- We expect more weakness in the common shares, given their high correlation to the S&P 500.
- The preferred shares are more of a rates play at this stage, with a very high and appealing 6.5% yield.
- Despite their 2023 call date, we do not expect the preferred shares to be called this year.
Thesis
Virtus Convertible & Income Fund (NCV) is a closed end fund focused on domestic convertible securities and high yield bonds. We have covered this name before here , and we are revisiting the fund and its components following the CEF's recent dividend cut .
The fund's asset class has performed quite poorly in the past year, hence we are not surprised the fund cut its dividend. In effect, we find it to be a positive corporate action since it preserves NAV. CEFs that fail to cut high dividend yields that are unsupported end up damaging their NAV and returns long term.
From a common share perspective we expect more weakness in NCV. The convertibles asset class has tracked the S&P 500 in the past year with a high correlation, and we think the next leg is down in this market rather than a bull rally:
We can see NCV being more volatile (higher beta) given its leverage, but it tracks quite closely the SPDR Bloomberg Convertible Securities ETF ( CWB ) and the S&P 500 ( SPY ). If an investor thinks we are in a new bull market then NCV should look attractive. We don't. In fact we expect another leg down in the SPY that would see us revisit the 3,500 level. Given that viewpoint the preferred shares in NCV look more attractive than the common shares now.
The 5.625% Series A Cumulative Preferred Shares (NCV.PA) are part of the CEF's leverage structure as we describe below. Unlike a regional bank, where we saw the entire capital structure wiped out, a CEF is a bankruptcy remote vehicle with a stable funding source. There is no depositor base to be had here funding this name. Shareholders in NCV are funding the structure, both the common and the preferred ones.
The preferred shares are perpetual, even if their first call date is now in September 2023. The shares have an 'A' rating from Fitch, which just re-affirmed them:
Fitch has also affirmed the 'A' Long-Term ratings assigned to the Series A Cumulative Preferred Shares issued by Virtus Convertible & Income Fund (NCV) and Series A Cumulative Preferred Shares issued by Virtus Convertible & Income Fund II (NYSE: NCZ).
In effect you need the NCV common shares to lose roughly 70% in value for the preferred shares to have default risk associated with them. We do not think that is the case, and we view these securities being driven by rates only. The shares have a very high yield of 6.5%, indicating the market is not expecting the fund to redeem them now in September. We are of the same opinion here. We think NCV will wait until 2024/2025 when rates would have come down and the fund would have posted a better track record on the common shares in order to redeem the preferred stock via a new placement.
Given our view on the market, we are therefore shying away from the NCV common shares expecting more weakness, but we are long NCV.PA expecting a three year weighted average life here and liking the 6.5% yield from this 'A' rated paper.
CEF Leverage Structure
This CEF leverages itself mainly through preferred shares:
We can see the capital structure is composed of mainly $100 mm of preferred shares, which trade under the ticker ( NCV.PA ). We see many equity CEFs getting their leverage via preferred shares because it is cheaper to do so. Fixed income funds can pledge assets and leverage themselves up via Repo or TRS facilities due to the easiness of trading the collateral.
As a reminder, leverage is the main particular feature for a CEF structure outside the dividend yield. Unlike ETFs which can obtain 2x or 3x returns for an index via swaps, CEFs embed the leverage in their balance sheet because they are companies on their own. It is a very distinctive feature that allows a savvy collateral manager to navigate economic cycles in geared manner.
The Series A Preferred Shares
The 5.625% Series A Cumulative Preferred Shares have a liquidation preference $25.00 per share and are callable starting this year on September 30th. As the name implies, the shares are cumulative. They are currently trading with a 6.5% yield despite the call date this year:
The shares provide for a dividend at the end of March, June, September and December respectively. As outlined above in the Thesis section, we do not feel this series will be redeemed now in September. We anticipate the fund waiting for the yield curve to come down substantially before issuing new shares to replace the current series A.
Conclusion
NCV is a closed end fund focused on domestic convertible securities and high yield bonds. The CEF's common shares have a high correlation to the S&P 500 and a high beta factor. We expect more weakness in the SPY this year, hence a similar down price action in the NCV common shares. The CEF obtains its leverage via its Series A preferred shares (NCV.PA), which are currently yielding 6.5%. The Series A is rated investment grade by Fitch, and it would need the common shares to lose at least 70% of their value in order for us to question their default probability. We feel NCV.PA is a rates play and with yields high we expect the fund to not call the series until 2025 at least. We like NCV.PA over the NCV common.
For further details see:
NCV: The Preferred Shares Look More Attractive Than The Common