February Newsletter

The bottom line for February: much ado about nothing.

In the first two weeks of the month, fears were mounting and the big bad "R" word (recession, of course) was being whispered both in the halls of investment banks and in the popular press. I was quite astounded to hear both investment bankers and lay investors talk seriously about a looming recession. Seeing red on Bloomberg terminals, analysts couldn't help but be convinced something terrible was around the corner.

I didn't for once think a recession was nearby, so when the month ended with a surprise 1% GDP revision from the BEA, I was unsurprised. My viewpoint was also rewarded in my own personal high yield portfolio, which was down as much as 3% in mid-February, causing me to increase my purchases of both diversified high yield and investment grade bond CEFs and one equity CEF--NIE, which remains one of my favorite funds in the market. I ended February up YTD for the first time, without even accounting for dividend payouts.

From a chart standpoint, February was the month of intense fear ending in intense relief, resulting in a U-curve for high yield asset classes.

All asset classes mirrored SPY for February, which ended the month up 0.71%. That sounds better than high yield, but its YTD volatility has been worse than high yield bonds and REITs.

2016’s performance and the U-curve of February tell us some interesting things about market attitudes to each of these asset classes, and the future of high yield sectors broadly in an increasingly uncertain interest rate environment.

High Yield Debt

The fact that corporate defaults are still rising, but high yield bonds are not falling significantly in price. In part, this isn’t too surprising, since high yield spreads have risen tremendously in the past year and are at their highest point since 2011 and far above their pre-crisis average, as discussed in last month’s note.

Seeing this trend, I argued last month that well-managed bond closed-end funds will benefit from higher yields on bonds while falling NAVs will become a less pressing concern for funds with low portfolio duration and little leverage. This is why I spent February buying some Pimco bond CEFs, and I’m happy with the purchases.

Looking at the CEF world, we see that plenty of names are still not far from their 52-week low and attractive yields with relatively low risk are still being offered by the market. Although the lows of the February are over, opportunity still exists in both buy-write CEFs and bond CEFs, with high discounts and sustainable payouts. This should embolden investors to double down, ignore the “recession” criers, and enjoy a high sustainable income stream. While I was very negative about high yield in late 2015, I am just as confident now that buying and holding select, well-managed high yield CEFs will deliver alpha for 2016.

REITs

Some property REITs have seen intense, ridiculous sell-offs in 2016, reaching 52-week lows in the middle of February. This was a clear buying opportunity, and the earnings results of some property REITs showed strong FFO growth and sustainable dividend payouts. While some REITs guided for disappointing FFO growth in 2016, there is still growth. Occupancy rates also appear high and growth is also in the cards for the best REITs. Finally, low price-to-FFO multiples at DLR, HPT, HCP, and LXP despite low risk profiles in these companies relative to other REITs makes for a lot of opportunities to buy income. As with bond CEFs, REITs enjoyed bargain prices in February as fear overcame investors.

BDCs

We are nearing the end of the BDC earnings season, and the results are not terribly surprising. High-quality BDCs like MAIN, ARCC, TCAP, HTGC, and FSIC saw strong NAV resilience, NII increases, and/or strong stock performance. Others, like PNNT, PSEC, MCC, and FSC had lackluster performance and some NAV declines. Although February was not a bad month for BDCs, especially for those who remember the fiendish declines of 2014 and 2015, the market has continued to punish poor BDCs with huge discounts to NAV. Value investors are being fooled into buying assets at a discount in the fallacious belief that the assets are ridiculously undervalued. This is an old argument and it doesn’t work any more now than it did in 2014. For instance, when PSEC was trading at a 15% discount people said it was a silly underpricing. Now that the discount is 37.5%, several SeekingAlpha writers are again arguing the discount is silly. But it isn’t. PSEC’s NAV has fallen by 10% over the last few quarters and there are still overpriced CLOs in the portfolio.

The dynamics in the BDC market are a learning opportunity: buying assets at discounts does not equal prudent investing, as those who bought MAIN at a premium have outperformed just about any other BDC investor. There are other things to look at, especially with BDCs, including fee structure, management incentives, portfolio construction, and other issues.

With that in mind, I see little reason to buy BDCs right now, even MAIN. The yields are lower than many investment grade bond CEFs whose debt portfolios include higher quality, larger companies less likely to go into non-accrual or default. When MAIN and FSIC yield over 10% including specials, I will buy both funds. Until then, I remain on the sidelines in the BDC world.