CEF Weekly Review: Invesco Succumbs To Peer Pressure

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 February. 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

All but one (i.e. MLPs) CEF sector rallied this week, buoyed by strong macro numbers and despite Powell all but taking a March cut off the table. The CEF space finished January at a respectable return of around 1.5% for the average sector. That entire rally was due to discount tightening as NAVs were flat.

Equity and fixed-income CEF sector discounts remain divergent with the equity sector valuation rally having stalled.

Market Themes

Invesco has come out this year with guns blazing on the CEF front. It hiked the dividends of its Muni CEFs by 10-23%. The company is clearly piggy-backing onto what Nuveen and BlackRock have done, something we discussed in previous Weeklies.

This is signaled not just by the out-of-cycle hikes but also by the reasons mentioned which were to tighten the discounts and support market liquidity. The latter reason is pretty much made up but they couldn’t just have one reason so they added liquidity too.

There was some confusion after the previous Nuveen and BlackRock Muni CEF hikes and whether there was some magic increase in net income. Of course there wasn’t and we could see that by a sharp drop in coverage for the funds that hiked.

As far as hikes being able to tighten discounts, the evidence is flimsy at best. If we have a look at a chart of hikes vs. discounts there is not a very strong relationship i.e. Muni CEFs that hiked sharply last year are trading at only a slightly tighter discount than funds that have not. And now with most of the sector having gone through these hikes, the actual impact of the hike on the discount is immaterial.

If anything, the hikes actually make it difficult for the funds to sustain the distribution and will lead to a descending distribution coverage. This also means that we shouldn’t expect hikes for these funds once leverage costs actually do come down over the next couple of years.

The best way to gauge the impact of the distribution on a given fund’s valuation is to track the distribution (blue line) against its valuation differential to the sector (green line) which we do in the chart below for the Nuveen Quality Municipal Income Fund (NAD). We see that while NAD appears to have enjoyed a relative discount tightening after its hike, it is nothing to write home about, being around just 1% or so. Moreover, the fund continues to trade at a wider discount than the sector average.

The chart below looks at the broader Muni CEF sector. The evidence that distribution hikes have made a big difference is not obvious. The chart is noisy with little clear relationship except for funds that trade at wider discounts. Here we see that CEFs that sharply hiked distributions (those in the top third of the chart) only enjoy slightly tighter discounts than CEFs that cut the distribution. Moreover, CEFs that hiked actually trade at wider discounts than funds whose distribution did not change very much.

Market Commentary

There was a line in the commentariat regarding the Nuveen Preferred and Income Term Fund (JPI) which said something like transforming it into a perpetual fund takes some risk off the table with regard to asset valuations. It’s not at all clear what this is supposed to mean but, interpreting it literally, it’s wrong. Turning JPI into a perpetual fund doesn’t do anything with regard to its assets – the fund simply carries on with its assets intact. Risk does not go up or down – it doesn’t change because nothing happens to the assets.

The PIMCO Dynamic Income Strategy Fund (PDX) – the previous Energy focused PIMCO CEF – is struggling to adjust its holdings in line with a more “income” profile of its other taxable funds. Recall that the fund’s investment mandate changed from 80+% Energy to 25+% Energy.

The sticking point is its large private equity position in Venture Global which makes up 21% of the NAV due to sizable markups. The White House has delayed a decision on the company’s LNG project which would be the largest in the country once built. It’s possible that the review could be made after the election. This makes the tactical case for the fund more difficult.

Stance And Takeaways

In line with the above, we downscaled our allocation to PDX given the uncertainty around its holdings and the timing of its full conversion to a primarily credit fund. We are also looking to add to our JPI allocation as the discount has now widened out to around 4%. Given how tight credit spreads are, there is some risk of a drop in preferreds prices, however. A JPI discount closer to 5% would be a decent amount of margin of safety in this case.

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