CEF Weekly Review: Consequences Of Big Muni CEF Distribution Hikes

Aleksandra Zhilenkova 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 first week of June. 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 mostly strong week, outside of Utility and MLP sectors. Year-to-date all sectors outside of Agencies are in the green. Systematic Income Equity CEF sector discounts have finally come alive and started to trend tighter. However, a gap still remains between equity and fixed-income sector discounts. Systematic Income The median credit CEF sector is now tighter than its historic average which is due primarily to a number of expensive sectors such as loans. Systematic Income Market Themes A subscriber on the service asked about the implications of fixed-income CEFs distributing well above their net income. Recall that we have seen an absolute torrent of distribution raises (e.g. Invesco, Western Asset, BlackRock, Nuveen etc), often by the same manager over a short period of time. This has been concentrated in muni CEFs originally but has now spread to taxable CEFs as well with Nuveen hiking distributions once again this week by various amounts, many by high double-digit levels. A desire to tighten discounts is likely the main driver of the distribution hikes – there has already been a small tightening across both Invesco and Nuveen funds, something we would expect, all else equal. After all, optically, a 7-8% tax-free yield translates into a double-digit tax-equivalent yield for higher marginal rate taxpayers – above the historical track record of US stocks. For many investors, if you can get a higher “yield” than stocks with much less risk then why not? The second driver of discount tightening is simply because the fund is returning more of its assets at the NAV. If you don’t drip / buy more of the fund then the ROC, in effect, eliminates the discount. This is clear if you think about the extreme case of the fund returning all of the NAV immediately rather than gradually which is why funds that are terminating trade at negligible discounts. Another obvious outcome is that net income and distribution rate for many taxable CEFs are now miles apart. Historically, investors in fixed-income CEFs were told to pay attention to distribution coverage – low coverage meant the fund’s distribution was “unsustainable” and could be cut and vice-versa. With many funds hiking to a level where distribution is around 50% this analysis lever is now mostly irrelevant. At the very least, analysis will need to differentiate between managers who care about coverage and those (like Nuveen, Invesco, BlackRock etc.) who don’t. Another outcome is that NAVs will come under pressure with many funds having an additional annual headwind of 3-4% due to excess distributions. This could dissuade some investors from allocating to low coverage taxable funds despite the “juicy” yields. Perhaps a more important related consequence is that net income will trend lower as well. The lower the NAV the lower the amount of net income per share it can support. This means that the distribution rate will increase (because of the falling denominator), becoming ridiculous at some point. If the distribution is kept steady, we are only a few years away from double-digit yielding muni CEFs – a bizarre sight. This suggests that eventually the distributions of the very high-yielding funds will need to be cut. Another consequence is a lower tax basis and, hence, higher capital gains taxes than, perhaps, expected. ROC lowers the cost basis of the position so investors would have to take this into account to make sure they are managing their tax position wisely and not underestimating capital gains on sales. Market Commentary The CLO equity focused Carlyle Credit Income Fund (CCIF) had a call to discuss its Q1. Net investment income was $0.33 versus a total quarterly distribution of $0.315 ($0.105 per month). The aggregate portfolio weighted-average GAAP yield was 20.8% (cash-on-cash yield was 25.1%), which leaves some room for further distribution hikes. Based on Carlyle’s borrowers, EBITDA increased 8% during the quarter with only 2% of borrowers having interest coverage of less than 1x. CLO borrowers tend to be healthier than borrowers in the broader credit market given regulatory quality tests i.e. a limit on CCC borrowers in the portfolio etc. The weighted-average reinvestment period was 2.4 years which provides managers some time to take advantage of market volatility to reinvest repayments in new loans. This has not been working well given high loan prices but will kick in if we see a drawdown. The fund issued $4.5m of new shares via its at-the-market program. This is something that the other CLO CEFs do as well. In the current environment the fund is looking to do CLO resets which refinances CLO debt and extends the reinvestment period. As CLO debt spreads are quite tight this can be accretive to the NAV. CCIF has a higher cost of financing than the other CLO CEFs as many liabilities of the other CEFs were issued when interest rates were significantly lower. However, one source of alpha that CCIF has over the other funds is its ability to issue CLOs in the primary market rather than buy them in the secondary. This is what it did during the quarter and this could add up over time. Elsewhere in the CEF space, we’re seeing more CEF mergers, this time with the ClearBridge MLP CEFs EMO, CEM and CTR merging into EMO. Saba has been targeting the funds for a long time now. EMO is the second-largest position in Saba’s ETF of CEFs at 8% of the portfolio. The funds are also holding a tender offer for 50% of shares at a generous 100% of NAV. The discounts look to be fairly priced in the fund at around 3-4% – about half of the sector average, where you would expect them to be. After the tender offer record date, the discounts should widen back out to around 10%. Stance And Takeaways The Muni CEFs that hiked recently continue to trade at wide discounts but are now more likely to get additional demand and rally. Munis are also attractive for strategic reasons as well which we have discussed in a recent article. For this reason we added or increased positions across a number of muni CEFs, including NZF, MMU, NAD and others. Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

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