November Newsletter

Overview

In November, default fears returned with falling oil prices leading to concerns of energy companies struggling to repay debts. Additionally, many REITs saw declines later in the month with fears of rising rates making debts more expensive for these firms. Closed-end funds that focus on corporate bonds also struggled as a result of these risks and greater fears of lower liquidity.

BDCs outperformed the market broadly in November after entering oversold territory earlier in the year. In November, when the S&P 500 gained less than 1%, BDCs saw 6.4% gains, as measured by BDCS—the BDC ETN issued by UBS. Several high quality BDCs outperformed this, with some funds seeing higher premiums to NAV.

Macroeconomic data remains mixed in the United States, leading to more confusion and volatility in bond and equity markets. On the one hand, the BEA reported personal incomes rose by 0.4% in October, a sharp acceleration from September, and the CPI rose an annualized 2.5% in October; excluding food and energy, the CPI was also up 2.5% in October. On the other hand, personal consumption expenditure rose only 0.1% in October and GDP growth decelerated to 2.1%. While the CPI and personal income growth fueled speculation of a December interest rate hike, low PCE and GDP growth indicate American companies may continue to struggle to raise revenues and earnings.

1. REITs

Despite strong and improving funds from operations (FFO) in many cases, real estate investment trusts have been punished by the market throughout 2015. In November, many property REITs suffered capital losses despite many reporting steady or improving FFO:

Additionally, occupancy rates have held or risen for the best performing REITs and new investments indicate the likelihood of continued rising dividends. The fears of an interest rate hike have caused these funds to see capital outflows both in November and for most of 2015.

Exceptional strong performer DLR benefited from high investor expectations throughout October, when the company's stock rose 13.2% before reporting Q3 FFO of $1.32 that was 5 cents above expectations. The company also reported $33 million in annualized rental sales and $21 million in annualized rental renewals in the quarter. Combined, those represent 7.7% of the company’s total FFO. On the negative side, DLR reported lower sequential revenue growth with occupancy rates and cap rates stagnating even as debt loads have risen.

2. BDCs

This year has been tough on higher yield investments including mREITs, MLPs, bond funds and BDCs, for many reasons including higher yield expectations from investors potentially from interest rate and credit cycle concerns, oil prices, and general market volatility. 

Many of these investments hit a low in late September, along with the general markets, and then rallied through October. However, BDCs have rallied much more than the others during November for a few reasons including a positive earnings season. More importantly, many companies reported higher investment yields and the potential for a strong Q4 including portfolio growth and pricing. BDCs with recent repayments and/or leverage capacity will likely take advantage of the uptick in credit spreads.  I am expecting a certain amount of tax-loss related selling in December followed by a rebound similar to 2014. There is a good chance that BDCs will report a strong Q4, that could lead to a sustained rally in 2016.

3. CEFs

High yield and corporate bond focused closed-end funds began to see some market price recovery in early November, but more recent concerns about interest rates continue to plague the CEF universe. Of the funds we track, only two (ETW and CII) have a positive YTD performance excluding dividends, due to their investment strategies. ETW is a buy-write fund that uses a covered-call strategy to provide high income to investors while maintaining exposure to equities. This equity exposure has caused the fund to lose 2.8% of its value in November.

Similarly, BlackRock’s CII invests in stocks and sells calls to boost distributions. This fund has maintained its dividend for three years—although that dividend was funded partly by a return of capital in 2014. With largely horizontal performance in 2015, a covered-call strategy has easily outperformed the S&P 500. We expect a covered-call strategy to continue to outperform the market, even though a brief and shallow end-of-year rally in equities may already be beginning.

Finally, funds with high yield corporate debt exposure have seen varying net asset value declines as stock prices fell apace, with discounts steepening for most funds to 52-week lows; in some cases, discounts have reached their lowest points since 2008. At the same time, some funds have become more dependent on ROC to fund distributions. In addition, some funds have extended their duration exposure as low yields on corporate bonds make it difficult for them to cover distributions. Others have cut dividends. The performance of these funds is likely to change markedly in 2016 if interest rates rise.

The Bloomberg USD High Yield Corporate Bond Index lost 1.8% of its value in November, and is only 1.5% above its lowest point in early October. 

Despite a recent recovery in pockets of the CEF universe, it appears that the market is continuing to anticipate further declines in the high yield universe in the short term, whether due to interest rate exposure, lower liquidity, or rising default risks.