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(This report was issued to members of Yield Hunting on March 28th.)
To add or not to add, that is the question.
The answer is not so simple, unfortunately. I often circumvent the answer when I get questions from members that as “should I buy fund XYZ?
Timing the market is a fool’s errand. The answer to the above question depends on a myriad of variables. This makes it impossible to give a one-size-fits-all answer.
However, some thoughts to think about.
1) Buy the NAV, not the discount!
As I have said for many years, the NAV holds all the information you need to assess the quality of the fund and its many factors. While some discounts are very attractive at the moment, if the NAV is in decline, it doesn’t matter.
The margin of safety is wide of a reason. NAVs are in decline as both spreads widen out and interest rates go up. On top of all that, we have fund flows out of the space forcing bond funds to bet net sellers in a market that is cheaper than it has been outside of two small windows (Q42018, March 2020) going back 5 years.
If you buy a fund that has a wide discount but the NAV is in free fall, the discount doesn’t really matter. Sure, you are getting a few percent of extra cushion and some additional yield, but that could be wiped out quickly in a falling NAV environment like we are in.
Look for funds that are positioned correctly in this environment. We’ve highlighted funds that have “bucked the trend” and will do so again this week. In the meantime, it may be better to hide out in other areas of the fixed income markets like BDCs that have a positive correlation to rates.
2) Don’t use a single variable to try and solve a 19-variable problem!
One thing I see is that investors (and the media) attempt to draw an exact parallel to a past time period. For instance, previous tightening environments.
The problem is that not all markets are the same. In fact, they are rarely even close to being the same.
We can draw intelligent conclusions and speculate based on historical records but that doesn’t mean what has happened will happen again.
3) Focus on the income, not the total return!
Think about why you buy fixed income assets. Is it for capital appreciation or the yield? For many investors, it is both and there’s nothing wrong with that. However, for others, they are looking for a solid income play in this low-yield world.
Investors need to always have a goal for each asset they purchase. Is it a long-term income stream they are buying? Is it an opportunistic capital gain via the discount tightening? Is it a shorter-term total return play?
Investors who don’t know why they are buying an asset, need to re-evaluate their strategy.
Most investors purchase CEFs as a replacement for individual bonds and bond mutual funds that no longer provide the yield they need to achieve their retirement income hurdle. In other words, they have a specific income target that they want to achieve and individual bonds and bond funds aren’t going to get them to that goal. They use CEFs in order to ‘juice’ that yield and produce the income they require to maintain their standard of living and make their retirement plans work.
If income is your objective, then the noise surrounding the market value movement is irrelevant. While it doesn’t feel good to see your market value go down, investigate why it is in decline. As I wrote in the March 23rd Morning Note:
The move lower in CEF values (and mutual fund values) YTD, is primarily driven by the higher move in rates. Remember that bond prices move inversely to interest rates. So as rates rise, bond prices fall. But the fall in values isn’t because of an increase in credit risk (i.e. risk of bankruptcy). The fall in bond portfolios is being driven by higher inflation driving up interest rates.
This isn’t a permanent impairment of your capital- simply a re-valuation. That re-valuation will not last forever. Eventually, rates will fall and bond values will move back higher.
4) Long-Term should think counter-cyclically!
I have discussed the concept of counter-cyclical investing strategies before. This is where you are going against the grain and investing in the most out-of-favor category and sub-sector.
The rationale is simple: By the time you make a change to go to the areas of the market that have the best upward momentum, you are likely going to be too late.
Second, pulling back from the CEF market when discounts are tight and adding when they are wide is how you produce that “CEF Alpha” that we all hope to achieve. There are asset managers who have built their whole careers on producing that alpha. Rob Shaker over at Shaker Financial comes to mind. They are extremely tactical CEF investors looking to capture some discount tightening and then they move on to another play.
The question is, when do you buy?
5) The discount doesn’t have to narrow- the way you want!
Building off that last section, one of the things we have to assess is why there is a discount in the first place. Is it macro-driven? i.e. higher volatility, rising rates, geopolitical events, recession, wider spreads, etc,
Or is it micro? The fund cut the distribution. Management is doing a poor job. Rights offerings are diluting shareholders. Etc.
The first issue I have with discount narrowing is that it can be ‘good’ discount tightening or ‘bad’ discount tightening. Good discount tightening is when the price moves higher toward the NAV. Bad discount tightening is when the price goes down but the NAV falls faster.
Bad discount tightening often happens in a bear market or correction with investors anticipating NAV declines in the near future. Bonds are an illiquid area of the market and can be ‘delayed’ days or longer for their prices to reflect the real market environment. Often we see volatility in the markets and the NAVs of a bond CEF barely budge. But then days later, we see it decline more significantly.
So a widening discount in a highly volatile market can simply be the market anticipating the NAV decline. That is an important concept that is often overlooked.
Takeaways
All this to say that I don’t think we are at the place where I would be adding significantly to my CEF portfolio. Even looking out a year or more, the prospects are still relatively ‘normal’ in terms of the total return potential. However, risks remain high and the recession word is being thrown around with the yield curve flattening dramatically.
For those that are risk-averse, I would be a bit more defensive here than I normally would simply to preserve capital and wait for a better entry point. The risk-takers, as I’ve been noting, could stick their necks out here and attempt to bottom feed off some of these beaten-down funds.
The variance of outcomes here is extremely wide. If we go into a recession, the first three months of the year will look like a pipe dream relative to the losses we are likely to see. However, if the recession talk is overblown, the upside risk here is far greater than the downside and we could see 20%+ returns in short order.
Each individual investor needs to decide what is an appropriate allocation to CEFs at the moment. I, for one, added a bit in the heightened volatility a few weeks ago which turned out to be a bit too early. I also trimmed other positions which have held up.
Rotational trades are about all I am doing now as I attempt to both hunker down and capture opportunities in funds that I think are oversold on a temporary basis.
I don’t know what the future holds but investors need to understand their own risk tolerance and make choices based on that level of acceptance.
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