CEF Weekly Review: Ignore Yield-On-Cost Outside Of Tax Considerations

This article was first released to Systematic Income subscribers and free trials on Dec. 18.

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 December. Be sure to check out our other weekly updates covering the business development company (“BDC”) sector as well as the preferreds/baby bond markets for perspectives across the broader income space.

This will be our last CEF Weekly for the year – happy holiday to our readers!

Market Action

CEFs were mixed this week; however, most sector discounts moved wider. This is a trend that has been in place for about a month now as the following chart shows. This widening in discounts in the face of fairly stable NAVs suggests that investors may be moving out of CEFs either for the purpose of tax-loss harvesting or for other reasons.

This discount weakness is particularly apparent in fixed-income sectors where the median sector discount stands not far from this year’s low of 10%.

Year-to-date, underperforming sectors are higher-beta or longer-duration ones such as REITs, Converts and Taxable Munis. MLPs is the only sector that’s up and Utilities round out sectors that have done better than a 10% drop. EM Equities is the only sector whose discount moved in the opposite direction of its NAV which is otherwise a common pattern for large NAV moves.

Market Themes

There was a discussion of the concept yield-on-cost on the service, which is something that many investors turn to when deciding how to allocate their capital. This concept arises particularly when comparing investing opportunities today versus a period when prices were lower.

For example, let’s say a fund is trading at a 10% yield today but an investor acquired it when it was trading at a 12% yield, i.e. when its price was significantly lower than now (let’s assume unchanged distributions for simplicity). The view that many investors take is that, well – I can’t afford to reallocate the capital that’s tied in this fund because I can (mostly) no longer find a 12% yield anywhere else.

This way of looking at the portfolio then locks investors into certain positions they acquired at much lower prices. Our view is that this approach is incorrect – the 12% yield in the fund may have been true when the position was acquired but it’s no longer true. The capital allocated to the fund is now earning the 10% yield that it features today. The capital allocated to the fund at any one time yields exactly the same for everyone – the yield where it trades at the moment.

The price rise that pushed the fund’s yield from 12% to 10% has increased the amount of capital dedicated to the position. In other words, in order to support the same income from the fund as when it was acquired, the investor now has to dedicate more of her capital to the position and this lowers the yield from 12% to 10% in the example. Many investors act as though that capital gain and increase in capital dedicated to the position does not exist but it’s very much there, embedded within the original position.

This also means that it’s much easier to analyze what your capital is yielding in any asset – there is no need to go back to the cost basis – just look at the yield of the asset today and there’s your answer.

Mind you this does not take tax considerations into account. Rotation out of a position with large capital gains may have a tax implication and that implication needs to be considered. This is what is referred to as capital gains handcuffs – a large gain in a taxable account makes it more difficult to sell a position because it would entail a large tax cost, assuming no offsetting capital losses. This year this situation is less likely and, of course, in a tax-free account it doesn’t exist.

Market Commentary

Blackstone credit CEFs Blackstone Senior Floating Rate Term Fund (BSL), Blackstone Strategic Credit Fund (BGB) and Blackstone Long-Short Credit Income Fund (BGX) hiked their distributions by 10-20% with BSL at the higher end. The larger hike for BSL had much more to do with its weirdly low distribution rate of just 6.3% on NAV versus about 8.9% for the loan sector, a disparity that we have highlighted before.

BSL does have a higher proportion of floating-rate assets at around 95% versus about 80% for the other two funds, which helps drive its income higher relative to the other two funds. Interestingly, BGX and BGB offset this somewhat by having higher leverage levels as well as having fixed-rate preferreds as part of their overall leverage, which helps to boost income as short-term rates rise. It’s a third hike for the trio this year, although the first hike only offset the odd distribution cut the funds had in Q1. Overall, BSL is a reasonable option in the loan CEF space and one that makes sense for tax-loss rotations. The Guggenheim Taxable Municipal Bond & Investment Grade Debt Trust (GBAB) looked like it released a semi-annual report; however, it was only an amendment of the previously issued one. GBAB is the only one of the three taxable muni funds that doesn’t appear to disclose income on a monthly basis which makes it difficult to follow. It’s also the only fund in the sector that has not cut its distribution this year. However, just because it hasn’t cut its distribution doesn’t mean we don’t know what’s happened to its income.

Even before looking at the report we can say with nearly 100% certainty that its net income has fallen this year for two reasons – cost of leverage has gone up (absent either fixed-rate leverage instruments or previously acquired interest rate hedges) and the need to deleverage due to a sharp drop in the NAV.

These two net income drivers, combined with fixed-rate assets, means net income has to fall. Clearly not all CEFs have fallen prey to these dynamics – Western Asset Mortgage Opportunity Fund (DMO) is one that is clear on both counts as discussed previously – but nearly all other leveraged funds have.

We’ll know more when the actual report comes out however we do have the GBAB monthly Section 19s which show how much ROC is being distributed. The level of ROC has risen from under 20% to over 30% this year which pretty much jibes with what’s been happening with the other two taxable muni CEFs. GBAB has the highest valuation in the sector – in fact it’s the only fund trading at a premium – which should change once it cuts.

Stance and Takeaways

We are seeing quite a bit of weakness in CEF discounts – in contrast to stable or higher NAVs. Discounts have widened around 2% in the last couple of weeks. This could be due to tax-loss selling but assuming the money is just rotated around the CEF market we shouldn’t be seeing a lot of discount weakness in aggregate. This suggests that it’s likely investors are pulling money out of the space. Individual funds that are worth a look are MFS High Yield Municipal Trust (CMU), Western Asset Mortgage Opportunity Fund (DMO), Angel Oak Financial Strategies Income Term Trust (FINS), and PGIM Global High Yield Fund (GHY).

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.