CEF Weekly Review: CEF Reporting Could Has A Lot Of Room For Improvement

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 March. 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

Most CEF sector NAVs were up this week. The low-bar of an in-line PCE report soothed fears of a reacceleration in inflation and pushed up asset prices. February delivered a solid result with around a 1.5% total return, driven mostly by NAV gains.

CEF valuations remain wider of their historic average level.

Over the last year, we have seen a reversal of both wide credit spreads and wide discounts as credit CEF valuation has moved away from the very cheap lower / right-hand quadrant back towards the expensive upper / left-hand quadrant. Any further gains will likely be in discount tightening rather than credit spread compression.

Market Themes

Unlike the rest of the corporate space, CEF investors have to contend with a smorgasbord of fund-level reporting.

There are basically four levels of reporting that we tend to see in CEFs. The best are the monthly portfolio yield numbers that we see from BlackRock and First Trust. Yield is a much better indicator than net income because it includes pull-to-par from non-perpetual securities. Though there is a lot of focus on “cold hard cash”, the reality is that both distributions and net income numbers can be misleading. In 2021, net income overstated the earning capacity of most credit CEFs and in 2023 they understated them because of the flip in the price of bonds from typically over par in 2021 to below par in 2023.

The second-best type of reporting are monthly coverage numbers we get from the likes of PIMCO, Nuveen and others. These numbers are based off net income – not as good as actual portfolio yields – but not the end of the world if investors are aware which way they are biased.

Third best is the quarterly net income reporting that John Hancock and Western Asset do, which are obviously not as good as the monthly numbers.

And finally, there is the semi-annual reporting for the rest. From a regulatory perspective, funds only have to file semi-annual reports – something which will hopefully change some day because normal “companies” have to file quarterly results. CEFs are not companies in the same vein as, say, Walmart, however they are a type of company – typically, being a RIC or a registered investment company. BDCs, which are also RICs, do file quarterly results, so if BDCs can do it with non-transparent portfolios, surely, CEFs can do it as well given their public security holdings.

Semi-annual reports are particularly unhelpful in gauging important statistics like net income for several reasons. One, the reports themselves are published with an enormous lag. For example, the shareholder report for the Apollo Senior Floating Rate Fund (AFT) was just published at the end of February. This report covers the period till the end of December. This is already two months out of date.

Moreover, most CEFs have floating-rate exposure either on the asset side through floating-rate securities or on the liability side through floating-rate leverage instruments. In a period of shifting short-term rates such as the one we have had since the start of 2022, these changes show up in net income with a lag of 2–3 months because of the time it takes for them to update and accrue. In short, by the time we see the semi-annual shareholder report, the numbers could be 4–5 months out of date – practically useless for gauging important statistics like distribution coverage.

CEFs should be encouraged to move to a timely and, at least, quarterly release of key data. However, even when timely data is available, investors should adopt a forward-looking perspective on metrics like net income, translating the current and likely future trajectory of short-term rates to key fund metrics to ensure they are not surprised by negative developments that could have been foreseen.

Market Commentary

Loan CEF AFT released its annual shareholder report. Net investment income rose slightly over the second half of the year to $0.135 vs $0.137 distribution. The fund has had a great run so far this year with a 9% return, with most of that coming from discount tightening. Its portfolio is fairly unusual, with about a third in private credit, which gives it a BDC flavor. The discount has compressed to under 6% which is getting fairly rich. Its 5Y discount percentile is 88% meaning the discount has only been tighter 12% of the time. For the time being, it remains in the High Income Portfolio.

Overall, the two valuation stools of the CEF market – credit spreads and discounts remain mixed with credit spreads being very expensive and discounts being slightly cheap. If discounts tighten towards the expensive territory, it could make a lot of sense for investors to pare down their CEF allocation to wait for better entry points.