CEF Weekly Review: Why Rising Leverage Costs Aren’t To Blame For Low Yields
This article was first published to Systematic Income subscribers and free trials on September 18.
Welcome to another installment of our weekly CEF Market Review where we discuss closed-end fund (“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 September. 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.
It was another tough week for the CEF space as an upside inflation surprise pushed nearly all income assets lower. All CEF sectors recorded lower NAVs and most also recorded higher discounts. Since the start of the month, all sectors have posted negative total returns, with Munis leading the way lower given the recent reversal in Treasury yields.
So far, September is looking worse than August. The two months together have largely offset the rally we saw in July.
The CEF space has returned to its May level and is around 4% off its recent low in June.
Fixed income discounts have become attractive, while CEF equity discounts remain expensive.
Movements this year in both credit spreads and CEF credit discounts have been interesting. As shown in the chart below, from December of last year until around April, the evolution of CEF prices was mainly driven by widening discounts (y-axis). From April to June, on the other hand, price developments were mainly driven by widening credit spreads, although discounts tightened somewhat. Since then we have seen a small recovery (June to August) as credit spreads and haircuts tightened, followed by a period where credit spreads remained relatively flat while haircuts widened .
In our view, current credit spreads appear too tight relative to CEF haircuts, so we expect spreads to widen over the medium term or haircuts to tighten. Between these two scenarios, we believe that wider credit spreads are the most likely outcome.
There was a discussion on the service about whether the rising leverage costs of many CEFs are to blame for their poor performance this year. As a case study, we can use the PIMCO Dynamic Income Opportunities Fund (PDO).
There’s a lazy refrain we come across from time to time that goes something like because PDO uses repos for borrowing and repos carry a variable rate interest burden the recent rise in short-term rates increases the cost of fund leverage and this largely explains the year-to-date performance of a fund like PDO.
This kind of comment is the typical type of argument you tend to see. The problem is that he approaches things backwards. Basically, he looks at the performance of a fund like PDO and then notices that it has variable rate liabilities and jumps to the conclusion that it is the fact that its interest charges have increased that must explain its negative performance since the beginning of the year.
This kind of thing may seem convincing because the argument is directionally correct, i.e., all other things being equal, an increase in interest charges will lead to a decline in the yields of the total net asset value of the fund. However, if we look closer, we will notice that the real impact of higher leverage costs cannot even come close to explaining the moves in most credit CEFs we have seen this year.
For example, PDO interest expense increased by about 3% this year (about 2% actually fueled interest expense). The fund’s liabilities are a little less than its total equity and the period we are talking about is around 8/12 of the year. In other words, the impact of increased fund liabilities is approximately 2% higher liability cost x 1 (liability amount to net asset value) x 8/12 = 1.3 %. The fund’s total price return this year is -19% and its total net asset value return is -15%.
Thus, the argument that rising interest charges explain much of the price/NAV total return is wrong by more than an order of magnitude. So what explains the performance of the PDO? Well, a lot of the price performance is due to the widening of the discount. The rest is due to higher credit spreads and higher Treasury yields.
Coming back to interest expense, keep in mind that in addition to floating rate liabilities, a fund such as PDO also has floating rate assets such as loans, non-agency MBS and ABS for roughly the same amount as its repo, resulting in little or no impact on its earnings or NAV from changes in short-term rates. The key takeaway here is that investors should look outside of repo cost to explain CEF’s performance this year.
There is an opinion in the commentary that because the RiverNorth CEF (OPP) is overweight in non-agency MBS, it has significantly underperformed this year as MBS durations have increased due to higher rates.
First, it’s important to point out that an increase in duration due to higher rates (this happens because mortgage holders become much less likely to refinance), also called convexity, is an effect second order to explain price movements. To say that convexity is responsible for lower MBS prices is like saying that what explains why a car travels 50 miles in an hour is the fact that it has accelerated slightly on its journey before stopping rather than just the fact that she averaged 50 mph on the journey.
Second, much of what the OPP lists as non-agency mortgages in its report are not, in fact, residential mortgage-backed securities, but rather asset-backed securities (e.g. Upstart securitizations), home equity loans (eg New Century securities), CLOs (eg Octagon securities) and student loans (eg SOFI securities).
Finally, most of the non-agency MBS sector is variable rate and therefore its duration could not increase much. What explains the total return of a fund like OPP this year is the exposure to the duration of its other assets, the increase in credit spreads as well as the widening of CEF haircuts (OPP holds CEF in its wallet). Overall, we consider the non-agency MBS space to be attractive in this environment.
There were a number of CLO Equity CEF NAV updates in August. OXLC NAV was up 6% in August (about 17% below year-end level), ECC NAV was up 4.4% (about 15% below year-end level) year), OCCI NAV increased by 5% (it is 17% below year-end level), EIC NAV increased by about 2% (it is 13% below year-end level) ‘year).
CLO Equity CEF premiums have deflated somewhat on both sides by the price decline and the most recent rise in NAV. So far, NAVs are estimated to be slightly lower in September.
Having moderate but not exorbitant volatility is a good thing for these funds. Moderate volatility allows them to reinvest loan repayments in loans priced below face value and (in most cases) profit from maturity or eventual redemption at par, while exorbitant volatility typically causes them to deleverage, which, in turn, causes them to lock in economic losses. . As long as volatility remains subdued and defaults remain low, these funds can profit.
So far, as our CEF tool shows, total net asset value returns for these funds have done quite well this year compared to the double-digit numbers we’re seeing in many other credit sectors.
The 2 Apollo Credit CEFs increased distributions – AIF by 13% and AFT by 11%. This is the third increase for the AIF this year. AIF earned $0.085 on average in the first half and is now distributing $0.11. That’s a big difference, but the fund is just looking ahead given the lag with which short-term rates are passed on to income, the fund’s reporting lag when we find out the fund’s income level and the fact that short-term rates will continue to rise. . AIF remains in the high income portfolio.
Location and takeaways
We did not chase the June-August rally to the upside and now that it has largely reversed, we are looking to add more CEF exposure to our income portfolios. A number of CEFs are within 1-3% of their lows for the year, including DMO, WDI, FINS and PTA. The first two funds have significant exposure to floating rate/non-agency MBS and the latter two have a higher quality tilt – two characteristics we find attractive in the current environment.