January Newsletter

I've begun looking at high yield investments through the lens of their 52 week low; as these begin to trade more and more as a group on a reflection of macro expectations--i.e. the FOMC's rate decisions, oil prices, Chinese growth, etc.--it makes more sense to first categorize them according to how much they're off their 52-week low and then make purchasing decisions accordingly.

This isn't to say that simply buying those shares that are nearest their 52-week low is the best decision. For instance, many BDCs nearer their 52-week low (MCC, GBDC, SLRC) are substantially worse buys than others that are far above their 52-week low. Likewise, highly volatile CEFs like PHK can come close to their 52-week lows at a given point, then quickly bounce back but all the while my buy/sell position remains the same. Thus l use the 52-week low metric as a starting point for selecting funds, and then look at dividend coverage, portfolio composition, duration of holdings, sector exposure, and other fundamentals before making my purchasing decision.

The BofA Merril Lynch High Yield Master II Option-Adjusted Spread has skyrocketed to its highest point since 2011 and far above its inter-recession average between 2001 and 2008.

What does this mean for corporate bond CEFs? Two things:

1. New high yield (and investment grade) corporate bond issues pay a higher coupon. Income investors interested in clipping coupons and collecting dividend payments over a long period will be rewarded with higher income if they buy new issues. This applies for CEFs as much as individual investors.

The significance of this is clear: funds with more dry powder will have better dividend coverage. Funds that have been deleveraging, lowering duration, and cutting dividends in recent years (several Pimco funds, as well as NCV and NCZ) will be best positioned to do this, although the distribution-to-NAV ratio for some (PHK, NCV, NCZ) is unsustainably high and thus should be avoided.

2. Holdings will fall in mark-to-market NAV. In other words, the sticker price for a bond CEF is likely to go down in the short-term. This means there is likely to be market price volatility as long as the yields on corporate bonds go up. The way this works is as follows:

Step 1. Corporate bond NAV goes down

Step 2. CEFs see their cumulative NAV go down

Step 3. Markets see CEF NAVs go down, sell off, making market price go down

Step 4. Discounts to NAV expand, creating buying opportunities

If a fund is well managed and not overly levered or have too high of a distribution, this trend is extremely good for holders and buyers of bond CEFs, and is an opportunity to buy more. 

However, timing is important, which is why I went 100% into cash in November and only in mid-January began making small purchases of some corporate bond CEFs. I will discuss this in a future SeekingAlpha article, but I will say now that I purchased the following: PDI, PFL, PFN, PTY, PCN, NIE. I am eyeing other CEFs but am waiting for future FOMC meetings and how they impact junk bond yields.

Real estate investment trusts have been hit hard on market jitters. This is largely the result of expectations of a worsening economy or the possibility of an outright recession. 

While I do not fear these outcomes and see a strong economy relative to the recent past, I do expect more market volatility as the yields on these remain relatively low. I am looking at purchasing OHI, O, LXP, DLR, and HPT when they hit my price targets.

To say BDCs have been disappointing would be an understatement. Market fears of a worsening macroeconomic environment, fears of defaults triggered by the fall in oil, fears that the strong dollar will hurt GDP growth, and fears that the Fed will keep raising rates are hurting these names broadly.

I remain on the sidelines until we see posted Q1 and possibly Q2 GDP figures before considering adding BDCs to my portfolio.