CEF MARKET REVIEW
Closed-end funds turned in another stellar quarter following the strong gains of the second quarter. The main difference between the strong gains in both quarters was the size of the discounts. Discounts narrowed a considerable 1.11% in the second quarter, compared with a scant 0.05% in the third quarter. For the CEF industry as a whole, the average weighted discount was -5.03% at third quarter-end. Since discount narrowing contributed little to the quarter’s strong returns, CEFs earned their gains the old fashioned way — through solid NAV performance.
The 36-month streak of discounts below -5% snapped during the quarter, peaking at -4.35% before retreating back below -5% at quarter-end, as the prospect of the Federal Reserve hiking interest rates in 2016 appeared likely, and uncertainty surrounding the potential outcome of the U.S. presidential election weighed on the market. Municipal and taxable fixed income funds, which had been the leaders of narrowing discounts since the start of the year, made an about-face in September as commentary from Federal Reserve members signaled a more hawkish tone supporting a rate hike before the end of 2016. Although the Fed did not move in September, the stage has been set for a December hike with the Fed futures market pricing in more than a 60% probability that the Fed will hike. Domestic and municipal fixed income funds saw weak performance into the end of the quarter as investors trimmed or exited their positions.
“CAVEAT EMPTOR” — MUNICIPAL BOND CEFs
In the third quarter, municipal bonds especially suffered weak underlying performance as yields approached historical lows before pulling back, and cost leverage continued to rise for many municipalities utilizing floating rate leverage through tender option bonds (TOBs) or variable rate preferred securities (VRPs). With the prices for TOBs and VRPs typically linked to the SIFMA Municipal Swap Index plus a fixed spread, we are seeing a sharp increase in the cost of these securities.
The steep rise is a direct result of Fed tightening and new money market regulations that require a floating net asset value (NAV) for institutional prime and tax-exempt money market funds instead of setting the share price at $1. Massive outflows by investors from prime and tax-exempt money market funds have put increasing pressure on the 3-month LIBOR and the SIFMA Municipal Swap Index. Because the yields of the underlying securities in taxable fixed income funds are substantially higher than municipal bonds in the current market, thus providing a much steeper yield curve, the sharp rise in the LIBOR has not affected the performance as notably as it has with municipal CEFs. Some high quality municipal CEFs perceived as "safe" are barely earning 1% net income when the cost of leverage and fund fees are taken into account.
When you add in the fact that more than four out of five municipal CEFs are levered over 20%, the combination of higher leverage costs with a higher probability of a selloff in municipal bonds from their historically low rates could lead to worse performance than during the Fed-induced “taper tantrum” in 2013 when municipal CEFs dropped an average of -13.15% from May 21 through the end of December that year. In that instance, leverage costs remained unchanged, and the yield curve for AAA-rated muni bonds had a bear level-steepening as the longer end of the curve sold off between 1.04% in 7-year bonds to a high of 1.31% in 20-year bonds. The difference between now and then is that yields today are substantially lower on the long end of the curve than they were in 2013 and leverage costs have been rising sharply, which does not bode well for the future performance of CEFs that invest in municipal bonds.
For the third quarter, the Fund (Class A at NAV) returned 5.56%, outperforming the 3.35% gain of the composite benchmark. At quarter-end, the average weighted discount of the CEF holdings in the portfolio was -12.49% versus -13.07% at the end of the prior quarter, narrowing by 0.58%. The outperformance was attributed to continued strong performance in MLP and Technology CEFs along with a rally in foreign equity CEFs. Only one position, Adams Natural Resources Fund (PEO), contributed negatively to the Fund’s performance in the quarter as PEO dropped 0.38%. All other holdings made positive contributions to performance in the quarter.
During the quarter, we decreased our equity exposure from 65.84% to 46.71% as both the discount narrowing trend and the equity market rally stalled. We increased our fixed income exposure from 21.10% to 32.76%, by adding preferred shares and baby bonds. Our CEF fixed income exposure remained near historical lows for the Fund as narrow discounts, the rising cost of leverage, flat yield curve, expected dividend cuts, and narrow fund strategies made half the fixed income funds in the CEF universe uninvestable in the current market. We increased our cash position for the second consecutive quarter, from 13.06% to 20.53%, as we realized gains and repositioned our portfolio for what we expect will be a volatile fourth quarter due to the election and the high probability of a holiday rate hike by the Fed.
What Helped Performance
Eagle Point Credit Baby Bond – In August, the Fund was able to purchase a large position in Eagle Point’s 7% 12/31/20 (ECCZ) baby bond at below par, making it the largest position in the portfolio, and replacing the Oxford Lane Capital 7.50% preferred shares that we sold in the prior quarter. The new position gained 4.39% from its purchase date through the end of the quarter, generating a gain of 0.35% for the Fund. The new CEF baby bond is rated A- by Egan Jones, which makes it attractive to institutions like insurance companies which are unable to buy unrated preferred shares and baby bonds issued by 1940 Act companies. As a baby bond, ECCZ must maintain a 300% asset coverage ratio, which puts it higher in the company’s capital structure than a preferred stock, which must maintain 200% asset coverage ratio. As a result of the investment grade rating, strong asset coverage ratio covenant, and 7% yield, we expect ECCZ to trade at or above par unlike some of its unrated peers as institutions continue to demand high quality income products with substantial yield.
MLPs – Our MLP CEF holdings continued to drive outsized returns in the Fund. Tortoise Pipeline & Energy Fund (TTP) and Salient Midstream & MLP Fund (SMM) gained 16.15% and 15.36% in the quarter, respectively. Both funds were the best performers of the quarter and continue to trade at substantial discounts to their NAV and peer MLP funds. With oil trading in the high $40s a barrel, natural gas in a bull market, and OPEC agreeing to set production limits, the price of oil and natural gas appears less likely to revisit their lows of the first quarter of 2016. These developments bode well for the continued recovery in energy assets as defaults work their way through the market and the best operators rise to the top.
What Hurt Performance
Preferred Shares –From a total return perspective, our preferred share holdings lagged as they gained between 1.56% and 4.64% in the quarter while the Fund gained 5.56%. From a risk-adjusted return perspective, they performed as expected in a market that is increasingly looking less safe. We continue to prefer the solid fixed coupons of the preferred share and baby bond market for CEFs than fixed income CEFs as the underlying fundamentals and leverage characteristics of fixed income CEFs are unattractive to us. Preferred shares have pulled forward gains as all of our preferred holdings currently trade above par. Because they are trading above par, we analyze the probability of the shares getting called and may trim some of our preferred positions when we see fit.
Cash – Entering the quarter with the portfolio at 13.06% cash instead of fully invested detracted from gains in the quarter. We also increased our cash holdings towards the end of the quarter, which proved prudent as gains stalled out in the CEF universe. Uncertainty surrounding the presidential election, a potential Fed rate hike, and declining earnings per share coupled with narrow discounts in CEFs gave us cause for concern. We expect to maintain a higher level of cash than normal as we are positioning the Fund for expected investment and trading opportunities following the election, the Fed’s December meeting, and tax-loss selling season.
Following the 2012 U.S. election, the S&P 500® Index sold off as investors rebalanced portfolios based on the makeup of the new Congress and President Obama’s victory. The selloff was even more pronounced for the CEF industry, which widened from a small discount of -0.86% to -4.55% in the aftermath of the election results. In that election, the incumbent president, Obama, was running against Mitt Romney, a businessman-turned-politician with governing experience, and widely considered a moderate Republican. For many, that election was viewed as a traditional matchup, and the CEF market still sold off significantly as CEF investors tend to spook easily.
The current election cycle is far from traditional: The first female candidate running on a progressive platform is up against a businessman with no political experience running as an “outsider candidate” looking to change Washington D.C. Both candidates have the lowest favorability ratings ever entering the election with wildly differing views on how to govern. Add in the possibility that the Republican majority in the Senate and House may actually be in play and the results on November 8 could spark more market volatility than in 2012.
With average discounts at around -5%, slightly wider than the long-term average of -3.67% dating back to 1988, CEFs are no longer as cheap as they were during the last three years. Historically, CEFs have gone through cycles where they reached double-digit discounts and then traded to premiums. With the market near all-time highs, bond yields near historic lows, the Federal Reserve raising rates, election uncertainty, and tax-loss selling season soon upon us, the tradition of discounts heading to premiums before heading back to double-digit discounts may be in jeopardy.
CEF investors typically skew older, more risk-averse, and more novice than investors in stocks and open-end funds. Even though two-thirds of CEFs are fixed income, many investors in the space falsely perceive them as less risky. The fact that CEFs have narrowed heading into this uncertainty reveals the complacency of CEF investors who follow price trends instead of analyzing individual CEFs and the CEF market as a whole. Since tax-loss season coincides with the election and the December Fed meeting, as the complacent retail investor panics (often their modus operandi in situations such as these), we will be watching for opportunities to purchase new positions or add to existing positions.