Financial Advisors Panel The Fourth Annual Pristine CEF Conference in New York City October 29, 2014.
DISCUSSION WITH FINANCIAL ADVISORS – Webcast Replay
- Research and Portfolio Management Tips from CEF Specialists
- How to Manage a CEF Portfolio through Rising Rates
- Trading a CEFs for Relative Value Swaps vs. Market Timing
- Current Attractive CEFs
Panelists:
Note: The following is an edited summary of the transcript from the panel.
ELI: All right. I think we’ll just get started here. I’m Eli Eliasek, I’m the closed-end fund research analyst for Bank of America. Most of the speakers at the conference today have been portfolio managers at CEFs. You have also heard from closed-end fund analysts, like myself from the major wire-houses.
This panel includes closed-end fund analysts and portfolio managers of closed-end funds, so it offers a diverse span of perspectives. We have John Cole Scott, Executive VP of Closed-end Fund Advisors and a portfolio manager there, and Rob Shaker of Shaker Financial Services. Both of them run portfolios of closed-end funds. I have a few prepared questions for them and then we’ll open it up to questions from the audience.
I will ask each of you to offer a response to all questions. Let’s hear from John first. How do you first set up a portfolio of closed-end funds, what’s your process, and how do you manage that portfolio once it’s set up?
JCS: At our firm we specialize in closed-end fund and BDC research and trading. We currently have nine investment options available through a separately managed account process. We go about it, by breaking it down and analyzing different pieces inside of each model. We look at the underlying level of the CEFs holding data and the CEF related data. It’s really hard to own less than 3% to 4% allocation of a closed-end fund, in our opinion, and have alpha over other options that are out there. It’s hard to go over 10% allocations as well because there’s the idiosyncratic risk of fund sponsors and individual funds. In terms of analysis, we typically look at 3 pieces.
First, we look at the entry point or the pricing of the closed-end fund. Is it at a discount or a premium? We add to that what’s normal for that fund both currently and historically, long-short term, and what’s normal for the peer group. It is important to know, if a fund’s discount is widening, if that is a change specific to that fund or if it is a trend amongst other funds in its peer group.
We then do a lot of manager due diligence. We interview portfolio managers and publish them in our bi-monthly publication, the Scott Letter: The Closed-End Fund Report, my father started 23 years ago. We do a lot of just looking at the net asset value total return. In particular we look at 6-month and 12-month NAV TR numbers vs. peer funds because we feel that’s a great way to really sense how they’re doing after their cost.
The last piece we look at is dividend sustainability. We look at what’s plausible, we look at what data supports the distribution level, and we try to pivot around dividend cuts.
ROB: At Shaker Financial we also manage separately managed accounts. We manage them in a balanced fashion almost exclusively with closed-end funds. At the crux of what we do is something we call discount capture, and by that we mean we go out and try and buy a closed-end fund when it is artificially wide, historically lower than its historic average. If we buy there and then sell it once it narrows, we capture that amount of discount. So if we buy at 1% artificially wide, and sell it 1% artificially narrow, we’ve just made 2% above and beyond the normal NAV straight.
If you can imagine, if we take a balanced portfolio, continually do this with replacements, we can get the expected NAV return stream from a balanced portfolio but with this additive through discount capture.
ELI: Great. A lot of people are talking these days about what the impact rising interest rates is going to have on closed-end funds. I’d like to get your perspective on that.
ROB: Sure. I was thinking about it the other day. Someone was asking me about rising rates and if it has already been priced into the market. Of course my response was “I don’t know, what do you think?” The idea being that we’ve already had a huge pricing adjustment, at least in terms of discounts that started the taper tantrum of 2013. This concept that rates are going to rise has already really been built into the discount levels in closed-end funds. Has it been built into the bonds underlying within the closed-end fund? I’m not sure, but I can tell you this, if you look back, we see that a closed-end fund makes money two ways; the yield or the coupons they’re collecting and the pricing, the price in the actual bonds, the mark-to-market.
At Shaker Financial we are confident, especially when you talk about U.S. high-yield bond funds, short duration bond funds, that the coupon is going to outweigh any deleterious effect that you get from the mark-to-market. If you go back and you look through rising rate environments, even in 2013, high yield bond funds still have had positive NAV returns. Short duration senior loan funds still had positive NAV returns.
I think this concept that “Oh, don’t own a bond in a raising rate environment” leads to a lack of balance as they would say on CNBC. I think that, yes, you might have to be a little bit careful about your sector selection but I do not think that a raising right environment, if it even occurs, necessarily should mainly shy away from effective use of closed-end funds.
JCS: We’ve been planning out our positioning for the rising rate environments for our clients. We did a couple of things. First, we now collect about 180 data points in every closed-end fund weekly. Since there’s lots of it from terms of leverage to cost of leverage, to the duration of leverage, to call schedules, maturity schedules. We’ve collected as much as we can to model out what’s currently out there as options for our clients.
We wrote an article, it was posted on our blog over summer, on how all closed-end funds did during the last similar rise in interest rates. Every major group was up. We saw U.S. equity funds did about the same as the SP 500 and sector funds were up 31% with an average yield increase of 5.7% over that time period. This was within the short period from 2004-2007 when interest rates last rose to 4%. Taxable bond funds still had a market price total return figure of 19.3%. They only actually saw an average of -2% loss in yield. Again, of course some subsectors had much larger losses in yield but the average taxable bond fund made reasonable money through a very challenging environment.
We also focus on BDCs which were up 32%. We’ve got lots of data to be able to pick the right ones as the sentiment changes, and even though we know there’s volatility in what’s going on, we feel very confident that the current is going to be very favorable for debt-based BDCs.
ELI: I’d like to hear a little bit about your perspective on how the portfolios are actually managed in terms of market timing versus relative value in closed-end funds.
JCS: We’ll raise cash from time to time. Usually it’s a client level decision. When we raise cash, it’s traditionally to keep the client around. We generally believe that the portfolio should be fully invested because that’s what we get paid to do.
First we decide which sectors we want exposure to. Then we decide which fund is performing above average, which fund is most likely to maintain or raise their dividend, and which fund is relatively attractive. Our trading, as you might get from Rob, is a little less than his. We generally own two-thirds of our portfolio less than one year. However, at the same time, we typically own things for at least a month.
ROB: We’re a little bit more active. The question of market timing, I don’t know how you feel out there but I would guess that 90% of you somewhat believe that you can’t really time the equity markets and win. For some reason, and I see this in closed-end funds, people seem to think that they can time the bond market and win. I think a lot of people have been hurt by that over the last year with the consensus being, “By December we’ll be at 3.5.”
If you think you’re going to market time with a closed-end fund, don’t buy it because the sheep mentality is the worst thing for closed-end funds. When everyone’s selling, there are no redemptions. Everyone’s selling, it widens, and you just lose if you sell. Your total return on a closed-end fund is NAV plus or minus what the discount is. If that discount widens 3% then you just lost 3%. It’s like the opposite of what we’re trying to do on a daily basis of the discount capture.
That being said, even though our individual positions are short term, our overall portfolio is pretty darn locked. We have about 20% margin, we run about 60% equity, 60% bonds every day. We end up there every day. It’s very hard to time the market and we don’t tell our clients that we have any special skills in that area. If we maintain the balance portfolio and use closed-end funds to get a little bit of that extra kick, that’s a better way of doing things than trying to tie it in our experience.
ELI: Great. Any particular sectors of the closed-end fund markets that you like?
JCS: As this conference is typically attended by investment professionals, you know this is not a recommendation of the following funds, just 3 ideas to consider further. Do your own due diligence as our opinions on a CEF can change at any point in the future. That said, we came up with three funds this morning looking over our universe data. Equity funds have recovered a bit from recent lows, but we still found some nice entry points. For example ZTR, a primarily US Equity CEF is at about a 10% discount. You get about 7-8% yield. It trades about $1.2 million a day and has had good NAV total return.
Again, is it perfect for everything? No, but it’s a relatively cheap, well performing closed-end fund. If you’ve been in this sector before you probably know the name. MLP’s are big at our firm because they’re relatively boring and the closed-end fund structure really adds a lot of benefits, you don’t deal with the extra K1’s, you’ve got professional management, there’s about 20%-25% leverage for almost all of them. Most of the closed-end fund versions of them are mid streams, which is funny, they’ve had a really rough year but people seem to, in my opinion again, forget they’re toll collectors. It doesn’t matter if oil is $50 a barrel or a $150 generally speaking, as long as oil is passed through the pipeline, the investment makes money.
Again, looking at the things we care about: NAV return and cheapness, EMO which is a nice solid CEF at ten and a half discount as of Friday’s close. Again, the yields aren’t as high here, 5.9%, but it’s pretty good for an MLP. It’s 86% return of capital, beneficial RoC, basically pass through return of capital which if you hold on to it for over a year is a more tax sensitive experience as long-term gains vs adding to your marginal bracket. Again, it’s only 20% leverage and it trades over $5 million a day.
The last one, RQI, came up when I was talking to a client that was being pitched an individual REIT by a financial planner; at 30% of an $800,000 portfolio, the individual REIT was yielding close to 3%. I told him about RQI, which is at about a 12% discount and yields 6-7%. It has 26% leverage, but also trades two and a half million dollars a day and is up over 20% year-to-date. Those are three of the things we like now. Again, they’re yieldy even on the equity side, and they’re attractive, so they are things to look into, things that we generally like.
ROB: I would like to incorporate all your disclaimers into what I say. As you can imagine we don’t usually have long-term positions. Yet in this period bond funds look great and especially certain sectors. I think with senior loan funds you have this period in which they were deep discounts, came back to premiums, hung out at premiums for over a year or two, and now have been widening back out to deep discounts.
It all depends what you’re looking for. If you’re looking for something that’s better than cash, you have senior loans; they’re going to pay much better than cash, and they have a potential for about 5% to 6% narrowing. That’s even in a raising rate environment. Then there are shorter duration funds. We like things that are short duration as part of our overall portfolios.
We’re also big fans of high yield. It’s one of those groups that seem to have become something people like to talk about on CNBC or any type of financial network. I heard an earlier panelist say due to all the restructuring and refinancing that the default horizon is now 2017, 2018. Okay, defaults are pushed off. High yields in general do better in a raising rate environment than investment grade or anything else.
I don’t know why, all of a sudden, there’s a large issue about the high yield. We don’t feel there is and we find them to be very attractive at their current positions. We like the best of both worlds. There are a couple of guys, I guess I can say BLW and ISD, who are both attractively wide discounts, and in our world they’re the best of both worlds. They’re short duration, high yield bond funds. That’s some pretty good protection. I’m not smart enough to tell you that rates are going to rise. I am smart enough to tell you everybody says they are and that sometime by 2016 they’re probably going to be higher.
Even if they don’t rise, the risk there is more default risk. If you see default risks, you might want to move away from the high yield sector if that’s how you are, but we foresee steady growth. I haven’t heard much to make me nervous about the effectiveness of high yield. We’re focusing on sectors we like, and currently we like senior loan and high yield funds.
ELI: Thanks Rob. We met earlier before the panel and they told me they were looking forward to some challenging questions for the audience. So, I think we’ll open it up and see if there are any questions from them.
Q: This question is about the effect of the rising rates on bond funds. I have a really naive question about rising rates. Okay, so rates rise and bond fund managers, it’s their job to balance their portfolios. So, they’re selling things at good prices, waiting for maturities. There’s a lot of issuance and higher coupons. What’s the big deal with rising rates? I express that in the most naive way I could. It doesn’t relate to changes in prices. It relates to just the fact that the managers are balancing.
ROB: I agree a hundred percent, but of course I can’t say that back to the clients when they call all panicked. A lot of what you say is absolutely true because in the long run, you take the high yields. If rates rise then you will get the same quality at 9% yield. People are going to trade in these bonds, and they’re going to get better bonds. So over time the effect of rising rates won’t be that dramatic.
The problem will come in 2018. Goodness gracious guys don’t buy bonds in 2017, 2018. The panic in 2013 happened because the rise in rates was unexpected and sudden. Once again, it goes down to the fact of what’s built-in and priced into the market. So, what I would tell my clients is, “You can have raising rates widen up over here at the end of it. Absent default, this fund is going to make this much money off their coupons as everything comes to duration. You’re going to end up here after default.”
What happens when rates rise steadily? Everything’s fine, no one even notices it. There’s a little mark-to-market all coming off the NAV. What happens when all of a sudden it jumps? Now you turn negative for the time being because the price is in the mark-to-market and the accounting they have to do after 2008 is going to show up in that NAV statement. But once again, absent default you’re still going to wind up in the same spot.
JCS: As a student of history I look to see where some of the best places to be last time were, in case the current takes us the same place this time around. For example emerging market bond funds did well last time around; they had a total return of 35%. Yields came down but they had a great market price total return that was about that of the S&P 500, and it was a fixed income exposure. High yield bond funds had a total return of 23%, yields did come down over the period. But again, people sometimes forget, closed-end funds are priced at the market. Your performance is the price you paid plus the dividend payments received. We don’t like the yield to go down, who does? But if we can understand the backdrop of the level is very important.
The other grouping that went down less, as you might suspect, is multi-sector bond funds, because the manager could pick his positions through the changing bond environment. Like senior loan and high yield funds, debt-based BDCs also did very well through the last rising rate environment.
As we look at the volatility of closed-end funds our ability to navigate the short-term discount volatility, that’s why we get paid to do our job. I know the volatility is considered a risk, but when I explain it to our clients, I say, “It’s the NAV volatility that, in my opinion, is the risk. It’s the market price volatility which will help us give clients alpha. It gives us the opportunity to sell potentially higher to NAV and buy lower to NAV than is normal for a fund. We love to do relative value swamping across our closed-end fund portfolios.
ELI: Since closed-end funds are closed-end capital, they really have to wait for the bonds and the portfolio to mature or be called in order to have new cash to put to work at those higher yields. Just selling the bonds at the higher yields, basically selling the bonds for loss and putting it to work at a higher yield, it’s almost kind of a wash. So, really a fact that you want to look at is the maturity schedule in the underlying portfolio.
Q: Okay. I’m interested in your respective thoughts about where the discounts will be by year end and then 2015.
ROB: The munis I’ll leave completely to John because we don’t use municipal bond funds. First of all there’s tax loss selling. I believe that the biggest week for tax loss selling is Thanksgiving week. This is because there are a lot of big houses that basically tell their people, “As soon as you get your tax loss selling done you can go out for Thanksgiving holiday.” You see so much pressure, especially early Wednesday morning. It’s a good time to buy.
You’ll have that followed by the January effect. I don’t think equity funds are going anywhere. They’re pretty solid. You’ll have a lot of deep discounts for your traditional large cap. Plus there’ll be some sector, possibly healthcare that might be going up to a premium for a while. On average you should be sitting there at about an 8 or 9 discount. For taxable bonds, as long as people can say publicly that they don’t want to have a balanced portfolio, that they would rather be all-equity, and that instead of bonds they’re going to have dividend paying equities, as long as they continue to do that, there’s going to be a little bit less demand on the bond side and discounts might stay.
I don’t think that’s going to last through the next year, though it might. It is good to have balance. That’s traditionally what we’ve done. It has helped us through periods of slight correction. If they stay down here, it’ll be pretty attractive to a couple of activists if they don’t come back. But I would think that those pressures should really only be moving to a sort of nice tail wind to the bonds.
JCS: Ok, so these are forward looking educated guesses. I think that the normal range for the municipal bonds is 3% to 5% discounts and as I said earlier, it’s currently wider than a 2 standard deviation event for munis. That tells me there is opportunity for my clients. Taxes are not going down, in my opinion. One of the questions that we think about for the bond side of our portfolios is what will the pace of change for the interest rates be.
It’s not going to be perfect because this is the Fed we’re talking about. The pace of change is going to be a big part of this, but as rates rise and bonds become due and new money is put to work, they’re going to be putting it to work at higher levels. People are going to be fearful of bonds even though they might forget that many bond fund sectors generally do well in rising rate environments. Honestly, dislocations are where we always have a chance to make great decisions and alpha for our clients. We see this current discount level as temporary. There will be an eventual shift back to normal levels, within -2 to -3%.
ELI: I would say I’m a little more pessimistic on the outlook for discounts on the muni funds, mainly because what’s driven the discount so far is this fear for rising rates that everyone’s seemingly been calling for. Until that fear subsides my view is that those deep discounts will linger for some time. That’s not to say that there’s not a value in those funds. The fact is that you can buy a muni fund on an average 8% discount. There are discounts of 13% in some funds, which is attractive.
JCS: I’d add that on a one year basis, the average national muni is at 19% NAV total return. Again, as Eli says, it’s still an 8 discount. If you think about when is the best time to invest in closed-end funds, it’s when you are going against the market. If everyone agrees with you you’re probably at the wrong side of a closed-end fund trade. To be able to get good NAV performance and relative cheapness is, in our opinion, the best of both worlds.
ELI: I think that should wrap it up. I’ll let John and Rob just have a few closing remarks.
JCS: I’ll be very brief. A panel earlier talked about liquidity for closed-end funds. I’m telling you as a business that only buys closed-end funds and hope to be a bigger business over time, we’ve thought about this. When investing in closed-end funds, as you get larger, liquidity can become an issue, however, there are about 5-6 traders in the U.S. that can help you work through this hurdle. Once one of our traders, with WallachBeth Capital, he bought a quarter of the daily trade volume on the offer for a PIMCO bond fund.
Yes, there’s less liquidity in closed-end funds, but there are relationships available to assist you. As you grow, feel free to reach out to me if you want to be introduced to the folks we know. There’s ways to trade these things more efficiently and be a better buyer of these funds.
ROB: Just remember that total return on a closed-end fund investment is the NAV movement plus or minus the change of discount. It’s just one more thing that you should be thinking about. Other than that, I’m Robert Shaker and if you ever have a question or want to chat about a specific situation or scenario, it’s what we do. We talk closed-end funds. Thanks for coming.
Disclosure: The views and opinions herein are as of the date of publication and are subject to change at any time based upon market movements or other conditions. None of the information contained herein should be constructed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed. Data, unless otherwise stated comes from the October 24, 2014 issue of our CEF Universe service. Some of the opinions expressed are not those of Closed-End Fund Advisors.
cefadvisors 
Comments are closed.