FMD Capital Management

Exploiting Discount Arbitrage Opportunities in CEFs

Written by Michael Fabian, April 17th, 2014

The continuation in spread tightening for the vast majority of the fixed-income closed-end fund (CEF) universe has been an excellent theme for investors so far in 2014. Discounts are collapsing and premiums are widening at a break neck pace for many of the funds on our watch lists. However, that doesn’t mean you should sit tight, hang on to your existing funds, and wait for the next correction before you make changes. On the contrary I believe there are many opportunities to be unlocked through comparative analysis of funds within each respective asset class. Utilizing an arbitrage strategy to rotate to undervalued funds in relation to their respective net asset values (NAVs) should enhance your success during this ongoing spread compression.

Start by evaluating the average discount of every fund within your portfolio, and then compare them to what is available on your watch list; suddenly it’s easy to uncover pockets of strength and weakness. By reading the tea leaves you can identify funds that aren’t winning anyone’s popularity contest. Then go to work on performing your due diligence to ensure the fund in question doesn’t exhibit poor underlying portfolio performance or signs of under-earning its distribution policy.

Some funds have a way of recovering quicker than others on a price basis in the wake of a large correction.   Yet that doesn’t immediately translate into the NAV recovering quicker than another fund that hasn’t yet garnered the same amount of investor attention. For clients in our Dynamic CEF Portfolio, we monitor CEFs across multiple fund families, sectors, and asset classes to uncover transition opportunities with funds that portray better overall relative value characteristics.

For example, in the midst of the interest rate backup and subsequent underperformance in preferred stocks during 2013 we established a 10% position in the Flaherty and Crumrine Total Return Fund (FLC). Our investment thesis was twofold: to capitalize on the eventual stabilization and under valuation of the preferred stock complex and the consequent narrowing of the price discount to NAV.

Last week we decided to transition away from our holding in FLC due to the massive discount contraction and outperformance of preferred stocks over the last several months. FLC went from a discount of roughly 9% to a slight premium in a matter of 4 months, and that was on top of the 7% it returned in NAV. Furthermore, FLC is currently trading approximately 4% above its trailing twelve-month average discount.

The problem with selling a position that has performed better than the overall market is seeking out something to replace it with to maintain the portfolio’s balance and income stream. Instead of going to cash, other fixed-income opportunities, or selling out of preferred stocks altogether, we simply turned to a fund within the same family which hasn’t experienced the same magnitude of outperformance.

The Flaherty and Crumrine Dynamic Preferred and Income Fund (DFP) is a recent IPO that I have watched closely since its inception last year. DFP became an easy target for acquisition due to the confidence I already have in the management team. In addition, from a portfolio construction perspective the fund got a chance to invest its underlying assets at one of the most opportune moments for preferred stocks over the last several years.

In fact, DFP’s NAV gains have posted a marginal amount of outperformance over FLC’s so far year during the most recent ascent. The largest discernable difference is that we purchased DFP at an 8.5% discount, instead of the premium that we sold FLC for.

We started our position in DFP with just half of the net proceeds from the sale of FLC because I believe we could experience elevated CEF volatility sometime during the second or third quarter. I also like that DFP reports it’s NAV daily as opposed to weekly in the case of FLC. I think it’s also important to mention that DFP has both a lower expense ratio and a larger portfolio size when compared to FLC. However, both funds have nearly identical leverage ratios and distribution rates.

Many CEF investors prefer their CEFs to have longer operating histories to derive earnings and expected performance from. In this case, I am more focused on the composition of the portfolio and the management team’s history than trying to split hairs over a few pennies of UNII.

Overall we will be watching preferred stocks closely this year as they are one of the best performing asset classes next to high yield bonds for income investors. Just like any strategy, developing your game plan, and then implementing it decisively will always lead to a superior investment outcome.

Download our latest CEF special report: The Leveraged Income and Alpha Strategy.