FMD Capital Management

Closed End Fund Discounts Tighten – So What Are You Selling?

Written by Michael Fabian, May 23rd, 2014

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.

Margin of Safety

The style of our management gives us the levity to further reduce the size of our existing holdings if the tightening trend continues. The one saving grace is that we already have enough of our portfolio exposed to credit related securities that are resting on healthy gains.  Yet it’s important to point out that from a portfolio management perspective, we haven’t begun selling in droves quite yet.  However, our portfolio does carry roughly a 10% cash position as a volatility and opportunity buffer.

Furthermore, I could even see that quickly reaching as high as 25% if excess premiums develop.   Carrying at least some margin of cash at this stage of the game is important because discount expansion opportunities can occur quickly.  Having room to make acquisitions without disturbing existing positions is always a prudent course of action.

Carrying concentrated positions also gives us the ability to reduce the size of our holdings to lessen the volatility and drawdown if credit conditions change rapidly.  There are a few funds such as the PIMCO Dynamic Income Fund (PDI) or the PIMCO Dynamic Credit Income Fund (PCI) that I would grapple with selling completely due to the strong expertise of management.  Nonetheless, if the herd begins to stampede, some defensive actions must be taken.

If you find yourself in the same boat, I would encourage you to speculate on how best to taper your CEF holdings while still maintaining overall portfolio balance and exposure to funds you favor the most.  Meanwhile, remain steadfast by spending time analyzing funds you don’t yet own but would like to.  I have my eye on funds such as the NexPoint Credit Strategies Fund (NHF) and the Western Asset Mortgage Opportunities Fund (DMO) for future acquisitions given the right opportunity.

Keep in mind that conditions won’t change overnight, but developing a plan now and then implementing it decisively can produce excellent results.  When the time comes, it can go a long way to ensuring you lock in gains and have plenty of capital to put to work when new opportunities present themselves.

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