CEF Weekly Review: Why Some Managed Distribution Funds Keep Cutting Distributions
This article was first published to Systematic Income subscribers and free trials on August 20.
Welcome to another installment of our weekly CEF market review where we discuss CEF market activity both from the bottom up – highlighting individual fund news and events – as well as top-down – providing an overview of the wider market. We also try to provide historical context as well as relevant themes that seem to be driving the markets or that investors should be aware of.
This update covers the period up to the third week of August. Be sure to check out our other weekly updates covering the BDC as well as the preferred/baby bond markets for insights across the entire income space.
The 4-week CEF rally came to a halt this week as all but two sectors (CMBS and MLP) ended in the red, with only the CMBS sector enjoying a tighter discount.
Month-to-date, the CEF space is up less than 1% overall, with Munis underperforming.
Year-to-date, the CEF sector has once again exited double-digit losing territory, although it is still around 8% off its recent low in June.
Discounts bounced off their stickies, widening about 1%. Fixed income CEF haircuts are back in fair value territory, while equity CEF haircuts remain expensive, overall.
One of the things that many investors like about CEFs is the relative predictability of distributions. The funds with the most predictable distributions are those that have formula-managed distribution policies that are usually set at a percentage of last month’s net asset value or a rolling period, typically covering the last 12 months. For example, all of CEF Allspring (formerly Wells-Fargo) tracks this rolling 12-month NAV MDP.
The following chart shows the distributions (blue line) of the Wells Fargo Multi-Sector Income Fund (ERC) along with its 12-month moving average net asset value. ERC had a 9% multiplier on its 12-month average net asset value (which recently dropped to 8%) in calculating its annualized distributions.
Given the trajectory of NAVs, what happens is that higher NAVs from 12 months ago drop out of the 12 month lookback and are replaced by new lower recent NAVs, driving down the average and also leads to a lower distribution.
This is why ERC has teamed up with its four counterparts Allspring to once again reduce its distribution.
For CEFs with formula-based CDMs, this dynamic allows investors to not only predict the next distribution, but also get an idea of how the distribution will move in the future by comparing the current net asset value to that from 12 months ago. And since relative CEF valuations also tend to follow their distributions, investors can also get an idea of the impact the distribution will have on valuations. We highlight which funds have formula CDMs on our service.
The Guggenheim Strategic Opportunities Fund (GOF) has released its report to shareholders. The fund combines various credit sectors with equity holdings – much like a lower-beta version of the PIMCO Global StocksPLUS & Income Fund (PGP). GOF is attracting a lot of interest due to its 12.8% payout ratio.
The new shareholder report tells us that over the past year, the fund has earned approximately $0.066 per month and distributed $0.1821 per month, which equates to a distribution coverage of 36%. Net profit was also down about 16% year-on-year.
GOF’s historical total returns are somewhat worse than those of the hybrid sector, so the fund has no secret alpha sauce to justify its high premium. Obviously, taking into account its premium, the price’s total return will be even worse since each dollar of the price only holds about $0.80 of the net asset value.
The valuation of the fund is close to the maximum differential compared to the hybrid sector, which currently makes it very expensive. In our view, investors have more attractive options in the sector, such as Tri-Continental Corp. (TY) or Franklin Universal Trust (FT) with better historical returns and better valuation.
Position and takeaways
Before the start of the week, we downgraded a number of CEFs. Specifically, we removed 5 CEF holdings from Buy to Hold and one from Strong Buy to Buy. Our view was simply a reflection of the valuations offered to investors.
Specifically, by the end of last week, credit spreads had fallen from 6% to 4.2%, while the average CEF haircut narrowed from 7% to less than 3%. Against the backdrop of slowing leading indicators and the Fed being happy to drag the economy into recession in order to keep inflation under control, that seemed expensive.
We have been steadily adding risk to our income portfolios due to increasingly attractive valuations this year, but have only made relative value rotations since the June valuation trough. We continue to assign buy ratings to a number of funds that continue to benefit from the Fed’s steady rate hike path. For example, the Apollo Tactical Income Fund (AIF), the Ares Dynamic Credit Allocation Fund (ARDC) and the Western Asset Diversified Income Fund (WDI) have all increased their distributions this year and are expected to continue to increase them in the future. next year as rising short-term rates filter through their net income profile. These funds continue to trade at decent valuations.