(This report was issued to members of Yield Hunting on Feb 15th. All data herein is from that date.)
I’ve been discussing this for months but I thought it would be best to get my thoughts and the facts down in one full report to reiterate how higher interest rates affect closed-end funds (“CEFs’).
The biggest takeaway from this report is that most of the downside in CEFs comes in the time period leading up to the first hike, not during the actual hiking period (which presumably starts in March).
Distributions are likely to go down as interest expense, the cost of the borrowing to create the leverage, increases. While some of that is offset by the fund’s ability to reinvest maturing bonds and low-duration securities into longer-duration, higher-coupon assets, it is typically not enough to offset the higher interest costs.
We would expect distributions to be cut from 4.5% on the low end to as much as 9-10% on the higher end, primarily in municipal CEFs. In the grand scheme of things, this is NOT the end of the world. Distribution cuts in this realm have been standard for the last 20 years.
NAVs tend to rise strongly following the first hike, which I do think will occur again this year as the unknown becomes more known. I also believe that the Fed will be far more dovish than the market thinks and that they won’t correct the market in lower probability cases if they do need to hike more than 3 or 4 times.
Rising Rate Environment Periods
In the last two decades we have really only had two periods of rising rate environments:
- 2004-2006 [17 hikes]
- 2015-2018 [9 hikes]
In 2004, the first hike was June 30, 2004. In 2015, it was December 16, 2015.
In both rising rate environments, we knew well in advance that a hike was coming. In the case of the latest [starting 2015] we were pricing in a rate hike as early as late 2013.
In May 2013, Fed Chair Ben Bernanke simply stated that the Fed would start tapering asset purchases at some future date, which sent a negative shock to the market and caused bond investors to run for the exits and unload their bond positions.
As a result, the 10-year yield went from about 2% on the day before that announcement to over 3% by that same December. That move in the rates is what is referred to as the Taper Tantrum.
CEF discounts widened dramatically from extremely tight levels in 2012 to wide levels by the start of 2014. They kept continuing to widen as the market moved from the cessation of Quantitative Easing to the anticipation of the first rate hike. This, of course, worried investors.
The data shows that most of the discount widening occurs before the first hike. This was certainly the case in the last period with most widening occurring well before the first rate hike in December 2015. In fact, that first rate hike in December 2015 was very close to the nadir or widest points for average discounts across CEFs.
That was certainly the case in taxable and municipal bond CEFs.
Going through a few examples, we can see that play out. Below are some larger, more liquid funds that were around back in 2012-2013. You can see that for the first third of 2012, discounts (“valuations”) were very tight. Taxable bond CEFs were actually around the top decile in terms of valuation meaning that, going back to 1996, they were only tighter 10% of the time or less.
But by the end of 2015, discounts had swapped and were in the bottom 10% for valuations with discounts tighter over 90% of the time. That is a massive switch in a relatively short amount of time- three years.
As important, NAVs suffered from negative drag from higher rates- or the expectations of higher rates. In the six months before the first rate hike, taxable bond CEF NAVs were down about 5%. That is roughly what they are down now in the current higher rate expectation period.
However, following both the first hike in 2015 and going back to the first hike in 2004, NAVs were up 11.1% and 10.8%, respectively, in taxables. And prices generally outperformed NAVs causing some discount tightening.
The following is from Mike Taggart, formerly head of CEF research at Morningstar. He notes that prior to the first hike, discounts tend to widen. After the first hike, they tend to tighten up.
So are we heading for a tighter discount environment over the next six months? It’s certainly possible.
Inflation Expectations Will Be Key
I do think if the Fed decides to go with a quarter-point move in March, instead of the now more popular half-point increase, it would signal a bit more of a dovish take and methodical, steady approach.
In 2018, the Fed clearly raised too quickly and Powell, who was Fed Chair during that period as he is today, will likely have learned from that mistake. The Fed will need to watch the long-end of the curve very closely. That will dictate how far they can go in raising rates.
Right now, the long-end is sitting at 2.0%. That is just 8 hikes in total (at a quarter point per hike). So, in my opinion, there is very little need to go 2 that quickly. Right now, economists are jumping all over each other to increase their full 2022 PCE inflation levels.
But if you strip out Covid-sensitive areas of the CPI report, inflation would be just 2.5%. That doesn’t signal to me that they need to go 7 times this year.
And Economists are continuing to downgrade this year’s GDP growth forecasts. It is rare for the long-end of the yield curve to continue to move higher when GDP growth estimates are being revised downward.
The yield curve is now expected to invert within the next 18 months, perhaps sooner if the recent decline in the spread between 10s and 2s continues.
The market agrees with the options treasury market forecasting an inversion about one year out.
With everyone focusing on the Fed Futures market, few are paying attention to the OIS Fed Funds forward curve. This shows that the market actually expects the Fed to start cutting rates as soon as late next year, as the tightening cycle “overshots.”
Also, the ISM price index within both the services and manufacturing surveys appear to have peaked and inflation is likely peaked as well.
With inflation expectations and the hard data peaking, it is plausible that inflation will start to head lower and the ‘fears of the market’ on ever higher and permanent inflation will subside. It won’t happen overnight but it will likely occur over the subsequent weeks and months.
Sentiment is key. Investors trade based on expectations (the rumor) and not the current data (the news). When the current data becomes the news and rumor no longer dominates, the market’s unknown becomes known and risk assets get bid up.
I think that date will start on March 15th when the Fed meeting commences and we have the known-known of how much the Fed will move on the first hike.
Once that occurs, I think NAVs and discounts will start to produce some nice returns for CEF investors.
Do you buy now or buy then?
Impossible to know but I am waiting a bit more time before buying wholesale. I still own a bunch of CEFs and am just slightly under my longer-term target allocation to them. That is mostly because I was mispositioned for the Fed pivot.
I had noted to members that I wanted to buy for the January Effect and then sell in mid-February based on the Fed moving in the June meeting. But within 3 weeks time, the Fed pivoted to a March meeting and a decent shot at that meeting being a 50 bps move. That hit discounts relatively hard and funds flew out of the fixed income space causing spreads to widen and NAVs to come down.