While most investors would likely believe that it’s tougher to uncover relative value in deeply discounted closed-end funds, in my opinion the hardest part of managing a CEF portfolio is knowing when to cut bait and move on. The truth is that there is no clear formula for measuring valuation, meaning that although a fund may be trading marginally above its historical spread to NAV, that doesn’t necessarily mean it’s richly valued.
There is always that active management and underlying portfolio construction component that you simply can’t rule out. In the current environment, most taxable fixed income CEFs have relied heavily on a high yield bonds, which up until just recently have caused virtually all portfolios to under perform.
In fact, it’s rare to see a longer duration high quality fixed-income component to a CEF these days since the spread between the yield to maturity of the individual issues and leverage borrowing costs simply isn’t wide enough to cover a fund’s distribution policy.
A perfect example of this type of portfolio construction and relentless retail investor enthusiasm is the DoubleLine Opportunistic Credit Fund (DBL). The fund actually has a prospectus rule for maintaining an equal balance between quality and credit, which during the first quarter correction have allowed it to emerge virtually unscathed. During the months that have followed, high yield has risen significantly alongside virtually all other risk assets.
With Treasury yields remaining low, this has further bolstered the underlying portfolio performance of the fund.
The one problem is that investor interest has been so strong, DBL has almost completely decoupled from its underlying portfolio. Just this past week, it traded to an all-time high of 17.38% premium to its net asset value. While that trait alone isn’t enough to declare the fund overvalued, that exorbitant premium is over two full years of dividend payouts.
Furthermore, while the underlying portfolio performance has been good on a relative basis, it also is rather conservative to make up that large spread in a reasonable time frame.To close the gap, the 10-year Treasury yield would either have to go to 1%, or we would have to see a huge round of pre-pays at par from the deeply discounted non-agency MBS within the portfolio.
Two scenarios that aren’t outside the realm of possibility, but are further out on the likelihood spectrum.
For those reasons, last Friday we stepped aside from our last piece of DBL for investors within our Dynamic CEF Income Portfolio.
From a strategy perspective, we are diversifying out to larger multi-sector CEFs that carry a lot more flexibility than DBL. We originally purchased the fund at a slight discount, which allowed us to capture a large double digit gain on top of the last few years of income. From our perspective, if we rotate those proceeds into a well-managed CEF trading at an attractive discount, we came out ahead.
Learn more about how we select holdings and construct our Dynamic CEF Income Portfolio here.
The post There is No Perfect Formula For Measuring CEF Valuations appeared first on FMD Capital Management.