Closed End Fund Discounts Tighten; So What Are You Selling?
Michael Fabian: It’s been a great year so far for investors in fixed-income closed end funds; with interest rates trending marginally lower it appears upward price momentum could surely continue. But for those that endured the turmoil in mid-2013 that experience should act as a staunch reminder of just how quickly trends can change. After all, I have found that most closed-end fund (CEF) investors are total return driven, despite what they might claim about holding them strictly for income. Interestingly, the question I get asked the most is not when to buy, but when to sell. So as we find ourselves at opposite ends of the spectrum from what I wrote about almost one year ago, I’m pondering what lies ahead for CEF prices in the near future.
Cycling through my watch list of roughly 50 CEFs its clear the “easy money” has already been made. Nearly every fund is trading well above their respective trailing twelve month premium or discount levels. However, that indicator alone doesn’t characterize a fund as overvalued. With so many different individual strategies and underlying assets, the most important part of evaluating and managing a portfolio of CEFs is staying intimately familiar with how it could react to changes in the impending market environment.
The message I communicated last year touted the opportunities available due to widespread interest rate fluctuation and shaky retail investor angst in the CEF marketplace. This year I’m more compelled to highlight the potential pitfalls that could lie ahead in the credit markets. Namely the excesses that have built up in high yield bonds as a result of the 2013 interest rate rise.
Nearly every sector of the high yield debt market, as measured by a bond’s relative yield spread to U.S. Treasuries, is dangerously close to the lowest levels since the beginning of the financial crisis. And while a reversion to the mean in the credit cycle doesn’t have to happen for quite some time, it’s obvious the opportunity for price appreciation has significantly diminished. Moreover, the volatility in high yield has been subdued for quite some time as investors have moved away from long-duration interest rate sensitive securities into yield-bearing credit-sensitive securities.
Most investors would probably counter my argument for an eventual correction in credit with the fact that default rates remain at all-time lows. Yet waiting for the consequent spike in default rates to become reality before making meaningful portfolio changes to balance quality and credit will likely have undesirable consequences.
As a result, for clients in our Dynamic CEF Income portfolio, I’m largely avoiding new positions in funds that rely on high yield corporate bond strategies both domestic and internationally. Seeing as though the CEF complex as whole depends largely on high yield securities due to the nature of exploiting leverage in an attempt to generate a meaningful yield spread. It’s clear I have my work cut out for me when investigating new positions.