Welcome to another installment of our CEF Market Weekly Review, where we discuss closed-end fund ("CEF") market activity from both the bottom-up - highlighting individual fund news and events - as well as the top-down - providing an overview of the broader market. We also try to provide some historical context as well as the relevant themes that look to be driving markets or that investors ought to be mindful of.
This update covers the period through the third week of May. Be sure to check out our other weekly updates covering the business development company ("BDC") as well as the preferreds/baby bond markets for perspectives across the broader income space.
Market Action
It was a positive week for CEFs with all sectors registering positive total NAV returns. Discounts were mixed. Month-to-date, all sectors are solidly in the green with REIT and Utility sectors in the lead.
Discount behavior remains divergent between fixed-income and equity-linked sectors. Discount weakness is particularly evident in covered call and EM equity sectors.
Market Themes
CEF discount changes tell us a good deal about the drivers of the CEF market. For example, early in 2022 just as short-term rates moved higher, loan CEF discounts widened sharply, often trading at double-digit levels through 2022 and wider than the discount of muni CEFs. This is despite the fact that the rise in short-term rates would benefit loan and hurt municipal CEF net income generation.
Loan CEF discounts remained near double-digit levels (and wider than those of muni CEFs) through 2022 when they started to move significantly tighter, now trading at very tight levels and much tighter than muni CEF discount levels. This is despite the fact that the next sizable move in short-term rates is nearly guaranteed to be lower rather than higher, benefiting muni and hurting loan CEF net income generation.
What this tells us is that discounts behave in a rearview mirror rather than a forward-looking manner. In other words, most investors are making allocation decisions based on things like distribution changes and returns without understanding how these are expected to evolve over time in response to fairly predictable changes in short-term rates.
Leading up to 2022, short-term rates were low, a situation that benefited CEFs with fixed-rate assets. However, with the policy rate at zero, the next sizable move in 2022 was going to be higher with nearly certain probability. In other words, muni CEFs were skating on thin ice while loan CEFs were poised to benefit. Despite this, the market was punishing loan CEFs and rewarding muni CEFs, clearly ignoring the likely change in fortunes of these two sectors. The same situation is happening now but in reverse. For this reason we favor muni CEF over loan CEF allocation for new capital allocation.
Market Commentary
CLO Equity CEF NAVs have been updated through April. CCIF has had a nice run since it was highlighted with the discount tightening and the price at the year-to-date high. At this point it’s less compelling for two reasons. One, it’s trading at a premium of around 4% - that’s still below that of OXLC and ECC but that makes sense given its higher leverage cost.
And two, its total NAV return so far this year has been somewhat lackluster - it’s only ahead of the basket case OCCI in the sector. It’s possible it’s taking a defensive approach with its portfolio and if that’s the case we will know more on the next drawdown.
OXLC boosted its distribution by 12.5% to $0.09. This works out to a current yield of over 20% on both NAV and price. OXLC likes to have the highest yield across this niche sub-sector so the move is not a total surprise.
In an environment of higher-for-longer (with respect to short-term rates), the fund is positioned well. A leveraged CLO equity fund has two levels of assets and liabilities. Within the CLO it has floating-rate assets (i.e. loans) and floating-rate liabilities (i.e. CLO Debt) for a net long floating-rate profile.
It then leverages this CLO portfolio with fixed-rate liabilities (both bonds and preferreds). Funds in this sub-sector issued their liabilities in the last 2-3 years when long-term rates were lower which is now providing a benefit for their net asset position. For example, OXLC has bonds and term preferreds with mostly coupons of 6-7% (one bond has a coupon of 5%!) but yields of 8-9%. In other words, its net income is benefiting by around 2% on its leveraged assets (about a third of total assets) because of the favorable timing of the issuance of its bonds and preferreds.
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