Saturday, 24 September 2016
Last updated 1 day ago
Jul 29 2014 | 9:33am ET
By Steve Mason
Portfolio Manager, Collins Capital Investments
In an environment where many asset classes seem expensive by historical standards, it is tough to find compelling investment opportunities that offer attractive risk/reward profiles. This is especially true in the fixed income world where yields in many areas are at record lows. As long-term investors in hedge funds, we have always liked managers who scoured the investment universe looking for the best and most differentiated ideas, particularly in frothy market environments. Similarly, we have always kept an eye out for one-off opportunities and thoroughly analyzed the best way to get exposure to them.
One of the most attractive buying opportunities over the past several months has been heavily discounted fixed income closed-end funds (CEFs). We believe this is one of the few areas of the fixed income market where you are being properly compensated for the risk. CEFs are investment companies registered under the 1940 Act and actually predate open-end mutual funds. There are several hundred CEFs and, in fact, roughly 1 in 5 securities on the New York Stock Exchange are CEFs. Unlike open-end mutual funds or exchange-traded funds (ETFs), investors do not purchase or redeem directly from a CEF, rather they buy or sell fund shares on an exchange similar to a company stock. This feature is key to CEFs and the opportunities they occasionally present. The price a CEF trades at is independent of its NAV and all CEFs trade with a discount or premium to its underlying value (i.e. NAV). Prices of CEFs are driven by supply and demand, or more aptly, fear and greed, as the CEF market is one that is driven by retail investors. This dynamic creates periods of forced selling where you may be able to buy assets for literally 10-20% discounts.
This is exactly what happened to fixed income focused CEFs in the summer of 2013 when initial fears of an early end to quantitative easing created a selloff in Treasuries. Nervous retail investors started to dump CEFs in droves, irrespective of the fact that many areas of fixed income bounced back relatively quickly. This drove discounts on many funds to the double-digits, despite often trading at premiums only months prior. Outside of a brief period in 2008, discounts had never been as attractive. What also stood out was the fact that broader market performance was positive. The S&P 500 and the Barclays US Corporate High Yield Index were up in 2013. The chart in Figure 1 below shows how CEFs traded versus the S&P 500. The largest underperformance of CEFs vs the S&P 500 occurred in 2013, despite the fact that markets were up. It is one thing to witness selling in CEFs when the underlying holdings were going down, but in this case, they were often times going up. In addition, CEFs were one of the few areas that had losses in 2013 so investors were selling them for tax loss harvesting purposes, putting further pressure on prices.
CEF Underperformance in 2013
[Source: Bloomberg; First Trust Composite CEF Total Return Index vs S&P 500 TR -- The green areas show periods of CEF underperformance vs the S&P 500. It reached extreme levels in Q3, 2014, despite positive market performance.]
Indiscriminate selling usually creates opportunity and that is exactly what occurred here. By the end of 2013, over 90% of all CEFs were trading at a discount. Given the diverse nature of CEFs, it is possible to create a portfolio of funds across high yield, municipal bonds, emerging market credit and other areas of fixed income, to balance out subsector risk. Factors such as the absolute level of the discount versus the historical discount, liquidity, leverage and yield, are all important considerations when narrowing the universe. With proper construction, it is possible to create a portfolio of CEFs that have a low double-digit discount that potentially could pay high single-digit yields while you wait for the discounts to narrow.
CEFs have had a good run this year. While there has been some discount tightening, most notably in municipal bond funds, the majority of the gains are due to the rally in credit markets. While the risk reward has diminished in some sectors, there have been opportunities to deploy capital into other situations with a more favorable return profile. We do expect discounts to contract further this year as other investors become attracted to the yields that have been hard to find in others areas of the fixed income universe.
Steve Mason is the Portfolio Manager at Collins Capital Investments, LLC. Prior to joining Collins Capital, Mr. Mason worked with Banc of America Securities’ Financial Sponsor Group where he executed private equity leveraged finance transactions. Mr. Mason began his career with Weil Gotshal & Manges LLP, a leading international law firm, focusing on merger and acquisition, securities and corporate transactions. He graduated summa cum laude with a B.A. from Virginia Tech where he was a member of Phi Beta Kappa and a Commonwealth Scholar. Mr. Mason received his J.D. degree from the University of North Carolina at Chapel Hill School of Law.