The Fed’s turn to rate hikes in 2022 after a lengthy pause drove down asset prices across the board and pushed up volatility. Now that the hiking cycle looks to be complete, and market participants are expecting cuts, market valuations across both fixed-income and equity sectors have returned to expensive levels.
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In other words, market beta is unlikely to deliver similar gains as over the past year or so. For this reason, it makes sense to turn to alternative sources of return or alpha which can top up portfolio performance this year. In this article, we review four types of alpha strategies designed to deliver returns beyond the beta of the broader CEF market.
Interval CEFs
An interval fund is a type of, usually private, fund that provides liquidity with periodic buybacks rather than through secondary market trading. There are a couple of unusual public CEFs however that behave like interval funds and buy back their shares periodically. This includes funds like the RiverNorth Capital and Income Fund (RSF) and the BlackRock Enhanced Government Fund (EGF). RSF provides a quarterly buy-back of 5% of outstanding shares at the NAV, while EGF buys back 5% of shares annually at a 2% discount.
Roughly, half the shares are submitted in these buybacks which effectively doubles the buyback rate, i.e. if you submit all your shares, and half of all shares are submitted the fund buys 10% of your shares not 5%. This strategy makes sense when 1) the fund is not a basket case and 2) the frequency of the buybacks and level of discount are attractive enough. Both of these are true of RSF and not true of EGF. EGF has lost money on a 5Y total NAV basis, while RSF has returned 5.3% per annum – very respectable for a multi-sector fund.
RSF has a fairly unusual allocation with its portfolio in small-business loans via Square, BDC notes and SPACs. A key point is that the fund’s NAV held up well through various tough periods, including COVID and 2022.
The RSF discount has recently widened, which now makes the strategy fairly compelling.
Systematic Income CEF Tool
With RSF trading at an 8% discount, selling back shares works out to additional value of around 3-4% per annum (8.5% discount x 4 times per year x 10% of shares redeemed). One thing to watch out for is you’d want to participate in the fund’s rights offerings as well and oversubscribe, which can generate even more alpha. RSF has a current yield of 11%.
Term CEFs
The Nuveen Preferred & Income Term Fund (JPI) has been our go-to term CEF, and it has performed as expected, with Nuveen going through their usual extension request / tender offer pattern. The discount of the fund has narrowed to a tight level, generating an additional performance tailwind for investors.
At this point, there are fewer compelling opportunities than usual from a pull-to-NAV perspective.
Systematic Income CEF Tool
Among the term CEF population, the Western Asset High Yield Defined Opportunity Fund (HYI) looks reasonably compelling with a scheduled termination date in Sep-2025 and a 5% discount (equivalent to a 3.9% pull-to-NAV yield). The fund carries no leverage, has a modest duration of 3.3 and a current yield of 9.9%.
Its valuation is trading at the High-Yield CEF average level, which offers an asymmetrically positive profile. If the fund indeed terminates, the upside of the performance tailwind from discount compression to zero is very appealing. And if the fund tries to turn itself into a perpetual fund (without offering an opportunity to get out at the NAV), the downside discount widening should be limited as it’s already trading at the sector average level.
Systematic Income CEF Tool
Investor Flows
Floating-rate assets like bank or private loans have been very much in demand ever since the Fed started to hike rates. As short-term rates moved higher, loan coupons increased, which allowed loan CEFs to hike distributions, which generated strong demand from the investor base. Demand has been so strong that loan CEF discounts have rarely been higher. The median loan CEF is trading at a discount of just 0.8% – a rare sight.
Systematic Income CEF Tool
Such rich valuations are easily explained by past performance, but are somewhat puzzling as they totally disregard likely future performance. Specifically, net income is very likely to fall significantly over the next couple of years in the base scenario that the Fed delivers rate cuts in response to continued deflation and a further slowdown in the economy.
One part of the CEF market that has been left behind are limited duration CEFs. These funds hold the combination of shorter-dated corporate bonds and loans. Although the base yields of these funds (i.e. the 2-3Y Treasury yield) is lower than the base yield of loans (i.e. the 3-month rate), it has the advantage of being largely locked in for a couple of years. On the other hand, the net income of loan CEFs will fall pretty much immediately on the first Fed cut.
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The two funds that look interesting in the sector are BGH and SDHY whose valuations have remained wide, with the latter being somewhat lower-beta due to a higher-quality portfolio and lower leverage. BGH and SDHY trade at current yields of 8.8% and 8.5% respectively.
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Relative Value
Relative value CEF rotations remain an important part of our allocation strategy for two basic reasons. One, there are many CEF families boasting funds with fairly similar portfolios. And two, CEF valuations can be all over the place with little regard to the fundamental differences between funds. This is particularly the case as far as management fees are concerned. The general rule of thumb is that for two CEFs with similar portfolios, the one with the lower management fee should trade at a tighter discount, all else equal.
This is why we continue to favor the Flaherty & Crumrine Preferred Income Opportunity Fund (PFO). Its advisory fee of around 0.57% – low by credit CEF standards. Though its fee is not the lowest in the Flaherty suite, the combination of its widest discount in the suite (and sector) and modest fee combines for the highest level of net income in the suite, which is likely to only increase once the Fed starts to cut rates.
Another interesting relationship to flag up is between the two Saba-managed CEFs – BRW and SABA. The two funds don’t have identical portfolios, but they’re similar with holdings across CEFs, private funds and first-lien loans. SABA has a significantly lower management fee and so should eventually trade at a tighter discount than BRW, so tactically, SABA is a decent bet here. SABA has a current yield of 9%.
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Takeaways
With market valuations back to expensive levels, CEF investors may be thinking about other opportunities besides the beta provided by their portfolios to boost returns in their portfolios. We highlight four alpha strategies CEF investors can use in their portfolios. In the current environment, we see most alpha potential in interval funds, leaning against investor flows as well as relative value opportunities.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
