CEF MARKET REVIEW
After a chaotic first quarter where equity closed-end funds (CEFs) dropped precipitously before rebounding nearly as quickly, the second quarter brought stability. For the quarter, CEFs had strong returns and narrowing discount valuations across nearly all asset classes. The fixed income rally boosted returns in levered taxable and municipal CEFs, which make up 60% of the net assets of the CEF universe. Energy and commodity CEFs, the two most beaten down categories over the past few years, were the big winners as investors returned to them in droves. Energy CEFs gained 25.15% on average in the quarter while commodity CEFs gained 18.63%.
Only 36 of the 539 CEFs we track had negative returns in the quarter, with the majority of negative performers having exposure to foreign equities. The U.K.’s surprise “Brexit” referendum vote on June 23 to leave the European Union (EU) led many foreign equity CEFs to go from solid gains to losses.
CEFs ended the quarter with an average discount of -5.08%, the narrowest valuation since June 2013 when fixed income CEFs were under extreme pressure following then Federal Reserve Chairman Ben Bernanke’s guidance to wind down its stimulus program. Since the market’s Fed-driven “Taper Tantrum” in 2013, CEFs have traded at discounts larger than -5% for 36 consecutive months, continuing their record run of cheap discount valuations. CEFs look poised to break that streak as CEF investors were not rattled by the U.K.’s Brexit vote outcome, a surprise event that would typically lead to sharply widening discounts. Following the vote, the S&P 500® dropped 3.59%. A decline of 3% or more has only happened 49 days in the last 10 years going back to June 2006 (see table below). In those 49 instances, CEF discounts widened 98 basis points on average, as skittish retail CEF investors rushed to the exits.
Post the Brexit vote on June 23, 2016, CEFs narrowed by 38 basis points, the second most narrowing ever, as investors used the opportunity to buy funds at lower prices instead of selling at even lower prices. This reaction may be attributed to the following:
Yields – With negative interest rate policies in Japan, the eurozone, Switzerland, Denmark, and Sweden, U.S. 10-year Treasuries at 1.47% are some of the highest yielding sovereigns. Equity, taxable fixed income, and municipal CEFs are yielding 7.71%, 8.46%, and 5.13%, respectively.
Mergers and Liquidations – There were only 539 CEFs at the end of the second quarter, 93 fewer since peaking at 632 in 2011 in the post global financial crisis world. Shrinking supply has led to narrower discounts.
Fed on Hold – Nearly all fixed income CEFs utilize leverage. With the Fed and market dialing back its rate hike expectations following Brexit, the cost of leverage actually dropped for many funds utilizing floating rate leverage, typically LIBOR plus spread, and fixed income rallied.
Institutional Ownership – Once dominated by retail investors, institutions have steadily increased allocations in recent years to CEFs as institutional ownership is now above 25%, a nearly 50% increase since 2010’s 17%. Institutions tend to be “stickier” investors, less likely to react emotionally to price volatility, unlike retail investors.
Activism – Many mergers and acquisitions have come to fruition over the years due to activist pressure on CEF boards. Over the past few years, we have seen new activists in the CEF space who have been pushing for more shareholder-friendly policies from boards, thus narrowing discounts.
New DOL Fiduciary Rule – The Department of Labor’s new Conflict Of Interest rule will make it difficult for new CEF IPOs to come to market. Historically, CEFs have been issued at 4-5% premiums from underwriting costs, sales loads, fees, and expenses. This model is less likely to continue in the future. With discounts prevailing in the current CEF market, putting a client into a new CEF at a premium when a comparable CEF is trading at a discount in the secondary market may not meet the new fiduciary requirement and may be a conflict of interest if the advisor is receiving a large commission for the transaction. As a result, we expect lower CEF issuance, which will keep supply down and push premium/discount valuations higher.
These factors combined lead us to believe that the discount narrowing trend will continue until CEFs move to premiums. This pattern has been the case in every CEF premium/discount cycle where discounts reached -8% since 1988.
Fixed income CEFs, both taxable and municipal, closed the quarter at -4.94% and -1.39%, respectively — levels not seen since mid-2013. Even at these levels, a strong case can be made for why fixed income CEFs should trade at narrow discounts or even premiums. Fixed income CEFs have extremely cheap borrowing costs, no redemptions or liquidity issues, yields that dwarf Treasuries, and active managers that actually generate alpha over the long term. Net asset value (NAV) total returns for fixed income CEFs (seen below) show strong outperformance over most timeframes. Only the one-year performance of domestic and foreign bond funds underperformed their benchmarks by a significant margin.
For the second quarter, the Fund (Class A at NAV) returned 5.97%, outperforming the 1.49% gain of the composite benchmark. At quarter-end, the average weighted discount of the CEF holdings in the portfolio was -13.07% versus -13.04% in the prior quarter, widening by three basis points.
The Fund’s outperformance was due to its overweight positioning in energy, healthcare, and preferred shares and an increased position in NexPoint Credit Strategies Fund. We continue to remain overweight energy and healthcare as we believe that both energy and healthcare CEFs provide significant upside price appreciation after major sell-offs while also paying significant yields at double-digit discounts. We also expect to remain overweight CEF/BDC preferred shares as our analysis determines them to be low risk/high reward fixed income assets relative to other fixed income CEFs. Many CEFs have invested in longer-dated, lesser-quality fixed income to generate their yields as the yield curve has flattened, which we don’t see as attractive when compared to CEF/BDC preferred shares.
During the quarter, our equity exposure increased from 59.64% to 65.84% as we added a small amount to our equity holdings, but mostly because we saw strong gains in our equity positions. The main change was a decrease in fixed income exposure from 33.97% to 21.10% as we felt the fixed income rally was a bit long in the tooth for CEFs. We also took the opportunity to unload a chunk of our Oxford Lane Preferred Shares 7.5% (OXLCO) above par at $25.20 after building a position over the years for as low as $22.00. This also decreased our credit exposure significantly to Oxford Lane Capital as we continue to hold the higher 8.125% coupon preferred. We increased our cash position substantially in the quarter from 6.70% to 13.06% as we took profits in fixed income holdings that continued to rally and saw discounts narrow.
What Helped Performance
Energy — After six consecutive quarters of negative returns for energy stocks, the first quarter saw modest gains for energy as oil prices found a short-term bottom. The rally in energy and oil stocks continued in the second quarter, attributing 283 basis points of performance, nearly half the Fund’s quarterly return. Our two largest energy holdings, Salient Midstream & MLP Fund (SMM) and Tortoise Pipeline & Energy Fund (TTP), gained 44.71% and 29.17% respectively in the quarter. We continue to position the portfolio in deeply discounted MLP and energy infrastructure CEFs, which we believe can maintain distributions and should benefit from discount narrowing and stabilizing energy prices. With average discounts of energy CEFs of -7.49% and yields at 9.22%, we see plenty of room for discounts to continue to narrow while getting paid handsomely to wait.
NexPoint Credit Strategies Fund (NHF) — NHF has provided numerous trading and investment opportunities for the Fund over the past few years, whether it be through an alpha-generating spinoff or a massive position in American Airlines coming out of bankruptcy. We saw another opportunity in March as NHF had increased its exposure to distressed assets, senior loans, and CLO equity to nearly half the portfolio. Since many of these assets are illiquid and considered Level 3 for pricing, their values are not updated on a daily basis. NHF updates them on a monthly basis and as a result, there is a lag between underlying asset performance and NAV pricing. Because of our outsized positions in Oxford Lane preferred shares, we have become well versed in the leverage loan market. After seven consecutive months of losses for the leveraged loan market, March and April had their largest two-month gain since 2009, signaling a bottom in the market. We added to our position following a large markdown to NAV in March based on February performance. By the time NHF had adjusted its NAV for Level 3 assets on March 15 down 4.70%, the leveraged loan market had already erased losses for 2016. We added to the position which contributed 71 basis points to the Fund’s performance in the quarter on a gain of 22.29%.
What Hurt Performance
Preferred shares — Although they showed little correlation to the equity market and provided excellent risk-adjusted returns, our preferred share holdings underperformed taxable fixed income CEFs. With gains ranging from 2.71% to 5.56% in the quarter, our preferred shares underperformed average taxable fixed income CEF returns of 6.25%. Fixed income CEFs have been on a tear in 2016 as the Fed has remained on hold, the yield curve has flattened, and discounts have narrowed significantly. We have been repositioning our fixed income exposure into preferreds and cash as we believe the majority of fixed income CEFs are overbought and warrant a pullback.
Europe – Our small exposure to Europe contributed negatively to the Fund as the surprise results of Britain’s referendum to leave the EU sent European equities plummeting. The New Germany Fund (GF) and First Trust Dynamic Europe Equity Income Fund (FDEU) had gains of 1.83% and 2.03% respectively for the quarter, heading into the vote on June 23. After trading down sharply swinging to losses of -10%, the two funds rebounded to close the quarter down -3.08% and -2.02%, respectively. With more uncertainty in the region now that Britain has taken the unprecedented move to leave the EU, we expect volatility to continue and we will manage our exposure accordingly.
Portfolio Holdings and Positioning
We continue to remain overweight CEF/BDC preferred shares (17.91%), energy CEFs (12.89%), and healthcare CEFs (11.69%). The preferred shares are low beta and help offset the higher beta energy and healthcare CEFs in the portfolio. An opportunity to unload a large chunk of our top holding arose in the quarter as we trimmed OXLCO from 10.10% to 3.47%. OXLCO would be callable at $25 on June 30, 2016 and with the parent fund (OXLC) breaching their asset coverage ratio in consecutive quarters; we saw it as an opportunity to sell shares above par to avoid getting called away at a lower price. As it turns out, OXLC was the buyer of our shares at $25.20, per their June announcement. If the preferreds trade back below $25, we may look to add shares once again and repeat our strategy. We are also looking to diversify our exposure in preferreds. Since launching the Fund in 2012, the Oxford Lane preferreds have generated the highest risk-adjusted return.
After a strong rally in energy CEFs in the quarter, they remain well off their highs. The Fund is positioned to take advantage of more upside appreciation, specifically in MLP and infrastructure CEFs. After numerous dividend cuts in energy stocks and CEFs, distributions appear to be stable with a possible return to dividend growth if oil continues to trade between $40 and $50. Above $50, MLP CEFs will be off to the races as most utilize some form of leverage to the high yielding asset.
We also remain bullish healthcare as the sector continues to provide both revenue and EPS growth. In a world where investors and economists keep pointing to revenue and earnings declines for stocks over the past few quarters, healthcare continues to show steady growth in both. Additionally, it is arguably the cheapest defensive sector. With expensive valuations for utilities, consumer staples, and telecom as investors chase yield in defensives names, healthcare has been the forgotten sector. Much has been made about the upcoming election due to comments made on the campaign trail by U.S. presidential candidates regarding healthcare pricing, but the reality is nothing will be done without the support of Congress. We see an attractive risk/reward proposition for healthcare heading into the election and after, as the sector has been beaten down, especially biotech.
We believe CEFs are poised to continue their discount narrowing trend and break through the -5% average for the first time in three years. As contrarian investors, we will continue to trim our positions as discounts narrow and head towards premiums. We may be “exiting the party” early but we espouse the old adage “nothing good happens after midnight.” With presidential elections four months away and numerous questions swirling around Brexit and the future of the EU, we expect volatility to pick up in the market, providing CEF price dislocations which are often more exaggerated than the underlying NAVs.
Activists have continued to be a major driver of narrowing discounts in CEFs but as discounts have narrowed substantially in fixed income CEFs, the opportunities for large upside gains for activists appear to be few. Activists often focus on fixed income CEFs because the underlying assets typically have less volatility, can be easier to hedge, and may provide more capital preservation during a long drawn out proxy fight. With only 11% of fixed income CEFs trading at discounts below -10%, activists may need to transition to more traditional, passive CEF investors, leave the CEF space in search of other activist opportunities, or reallocate to equity CEFs. Equity CEFs are still trading at substantial discounts, with 54% still trading at discounts below -10%. If activists can stomach the volatility of their NAVs, there are numerous equity funds that are vulnerable to shareholder activism.
We believe the best opportunities in the CEF market are currently in equities due the large disparity between equity and fixed income premium/discount valuations. Additionally, equity CEFs are yielding 7.71%, which is well above Treasuries and the S&P 500, and should drive income investors into the space. With our large cash position, we plan on deploying capital if we see sharp pullbacks in the CEF space over the coming months. If a pullback doesn’t come, we are content with our positioning and will continue to “drive with the brake on.”