CEF Market Weekly Review: How Underperforming Funds End Up At High Premiums

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 last week of August. 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

CEFs had a good week as nearly all sectors enjoyed higher NAVs while discount action was mixed. Higher-beta Convertible and equity-linked sectors outperformed. Performance over August, however, was broadly negative and nearly shaved off the positive performance accrued over July.

Year-to-date, the CEF space is up over 4% in aggregate.

Over the past year equity-linked CEFs (red and purple lines) have outperformed their fixed-income counterparts however they have lagged the S&P 500 in both total price and total NAV terms.

The average CEF sector discount remains quite a bit wider of its longer-term average level. Despite supportive underlying markets, distribution cuts have taken their toll and reduced investor sentiment for the product.

Market Themes

Recent price action in the CEF market, once again, highlights an interesting phenomenon that we’ve touched on a few times. Underperforming funds that don’t mind overdistributing tend to end up with high premiums. This is because the NAVs of these funds tend to deflate especially quickly (as a result of both underperformance and overdistribution) which mechanically pushes up the distribution rate.

The high distribution rate attracts low-information investors who then push up the fund’s premium. At some point the rubber hits the road and the fund makes a large distribution cut, likely locking in permanent economic losses for holders.

We saw this very clearly in the Brookfield Real Assets Income Fund (RA) last week. After keeping the distribution flat since inception at the end of 2016, the fund bit the bullet and cut the distribution by over 40%. Cue the premium collapse from 15% to a discount of 12% – a price drop of 24%.

The situation is obviously bizarre. We have a mostly fixed-income fund (at this point almost entirely fixed-income, at the end of 2022 it was about 20% in equities) with a net NAV income of around 5.2%. By holding a fund with a 15% premium investors are basically saying – no no I think the fund’s NAV net income of around 5.2% is too juicy and I am happy to reduce that to 4.5% by paying a 15% premium.

It goes without saying that 5.2% is not exactly a stretch – that’s where TBills are trading now. And, of course, the fund’s premium was there because of the high distribution rate of the fund – 16.2% before the cut.

Sometimes funds can make up the differential between their high distribution rate and lower net income with alpha however this gap is just too large for RA and it doesn’t look like it has been able to generate any positive alpha at all.

Its last shareholder report shows it outperformed the HY corporate bond index by a small margin since inception however this doesn’t adjust for its leverage nor for the fact that it also holds equities – both of these suggest that its alpha has been negative since inception.

The key lesson here is to keep in mind Stein’s Law – if something is unsustainable it will stop. High-premium CEFs that have kept their distributions at a very high level despite consistent underperformance pose a significant danger to investors. The eventual distribution cut will likely deliver a permanent economic loss to investors, one that could be very difficult to climb out of.

Market Commentary

Hancock preferred CEFs (HPI, HPF, HPS) released quarterly net income figures. The Hancock suite of preferred CEFs (HPI, HPF, and HPS) is the only one in the sector that hasn’t seen distribution cuts over the past couple of years.

This is why they continue to trade at puzzlingly high valuations – all three funds trade at premiums vs. the median preferred CEF trading at a double-digit discount.

Obviously, investors interpret the lack of distribution cuts as some sort of secret sauce which has allowed the funds to maintain their net income despite rising leverage costs. The reality is different – the net income of HPI has fallen by over 27% since the end of 2021. Current coverage is sub-70%.

Another Hancock fund PDT recently cut the distribution by 15% and has enjoyed a sharp widening in the discount. The other 3 funds should not be far behind.

Stance And Takeaways

The CEF space remains mixed in its valuations. Credit spreads are fairly tight (unattractive) while discounts are fairly wide (attractive). This environment suggests that the CEF wrapper remains compelling only for funds holding higher-quality assets which is where we focus our attention now.