These CEF Sector Distributions Are Holding Up


This article was originally released a month ago – we continue to find value in these sectors and funds.

Many CEF commentators, us included, follow the unsavory journalistic practice of “if it bleeds, it leads”, at least with respect to distribution cuts, focusing on particularly sharp slashes and associated price crashes. In this article, we instead want to focus on the “bright side of life” for a change and discuss sectors whose distributions are holding up and whose earnings and yields are attractive.

Three sectors that we highlight are the non-agency residential mortgage, loan and emerging market external debt. Across these sectors, we like the Nuveen Mortgage and Income Fund (JLS), the Morgan Stanley Emerging Markets Debt Fund (MSD) and the Eaton Vance Senior Floating-Rate Fund (EFR). This top-down approach follows our strategic allocation framework on our service which incorporates sector dynamics when constructing a rational allocation profile.

Selecting Sectors With Stable Distributions

A pair of metrics we like to follow is the combination of sector covered yield and 3-year sector percent distribution change, which we plot below. Covered yield is the average sector current yield multiplied by the average sector distribution coverage and approximates the earnings yield of the sector. It is quite an effective metric because it is a combination of three key earnings and yield drivers: sector distributions, discount and coverage.

The second component – the distribution change metric – shows the distribution trend of the sector over the last few years. Sectors with relatively high figures are those that have been more resilient over the last few years under the broad-based pressure of ever-lower yields.

The green box in the chart below includes those sectors that have a high covered yield with relatively stable distributions over the last few years. In this article, we will focus on three sectors we find particularly attractive: non-agency residential mortgage sector, loans and external Emerging Market debt.

Source: Systematic Income Strategic Allocation Framework, Tiingo

Mortgage – RMBS

This non-agency residential mortgage sector does not exist on sites like CEFConnect. However, we have carved it out of the multi-sector and mortgage sectors to contain funds that specialize in non-agency residential mortgage securities.

The sector funds are:

  • Nuveen Mortgage and Income Fund (JLS)
  • Western Asset Mortgage Defined Opportunity Fund (DMO)
  • PIMCO Dynamic Credit Income Fund (PCI)
  • PIMCO Dynamic Income Fund (PDI)
  • PCM Fund (PCM)

This sector has a relatively low duration, making it more immune to large changes in interest rates. The other advantage of the sector is its more idiosyncratic performance – the sector has one of the lowest correlations to major asset classes as well as other sectors, making it a good diversifier in a broader portfolio.

On the fundamental side, the legacy portion of the sector has stabilized after the severe dislocation of the financial crisis. While the sector is priced much more fairly currently, offering fewer opportunities for strong capital gains, additional tailwinds include increasing prepayment speeds, strong forborne principal recoveries and cleanup calls. Separately, the sector provides an opportunity to invest in the household sector, whose balance sheet looks fairly strong as a result of a multi-year deleveraging.

One challenging aspect of the sector has been its tight average discount, which has grown to a premium of 10% on average. However, this is entirely due to the three PIMCO funds.

Source: Systematic Income CEF Tool

Within the sector, we like DMO and JLS, both of which have recently termed out. For more aggressive investors, DMO can serve as a cheaper version of PDI, with which it has had a strong historical return correlation. JLS has had a much more conservative profile and hence lower returns, but we think it still offers value for investors with a lower yield target.

EM External Debt

In the chart below, we plot distributions from the sector ETF benchmark, the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB). Although distributions have come down somewhat in the last few months, they are not a million miles away from the broad trend of the last few years.

Source: Systematic Income Strategic Allocation Framework, Tiingo

Emerging market high yield sovereign and corporate issuers continue to maintain a spread premium over US high yield despite stronger credit metrics. The other advantage of the sector is its baked-in diversification, as it includes sovereign, quasi-sovereign and corporate issuers across many different sectors and regions.

Source: Systematic Income Strategic Allocation Framework, Tiingo

Within the sector, we like the Morgan Stanley Emerging Markets Debt Fund (MSD), trading at an 8.2% discount and a 5.33% current yield. The fund has a below-average fee, strong coverage, sector-beating long-term NAV returns, the highest sector alpha and attractive absolute and relative discount valuation. The fund also has a share repurchase program in place where it has purchased shares at an average discount of 14.5%, which should also support the fund somewhat through sharp risk-off periods.

Loans

The trailing twelve-month distribution trend of the sector ETF is at a 5-year high, although momentum has slowed down in light of lower short-term rates which have put pressure on loan coupons. At the current level, however, loan yields are quite comparable to the high yield sector. However, since loan default rates have been historically lower while recoveries higher than those of high yield bonds, we think this makes the sector relatively more attractive in the corporate credit space.

Source: Systematic Income CEF Tool

Another attractive aspect of the loan CEF sector is that it generates about 2.5% over and above the underlying sector ETF, which is on the high side across the CEF space.

Source: Systematic Income CEF Tool

The sector continues to find disfavor with investors with continued outflows spurred on by lower short-term rates. Although its discount has recently narrowed to the average of other CEF sectors, it remains stubbornly wide. Better-than-expected corporate earnings, strong service sector numbers and a manufacturing lull which appears to be abating suggest that the credit cycle is not about to end.

Source: Systematic Income CEF Tool

Within the sector, we like the Eaton Vance Senior Floating-Rate Fund (EFR) trading at a 7% discount and a 7.32% current yield. The fund features strong historical NAV returns, below-average fee, wide discount and good risk control.

Conclusion

Despite of the grind lower in yields over the last few years, we can still spot some bright spots in the CEF space. Residential mortgages, external EM debt and loan distributions and yields have held up relatively well over the last few years. We think these sectors offer value among a depressed yield landscape.

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Disclosure: I am/we are long MSD, JLS, EFR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





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