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Closed End Bond Funds Historical Discount Spreads


Guest MarkS
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from a risk standpoint these are very interesting. If you buy an unlevered bond fund for a 10% discount, you are insulating yourself nicely from a lot in terms of credit and duration risk (ie if you buy IG with duration of 5 or 6, you can have ~200 bps of rate rise, ceteris paribus, before your NAV is lower than what you paid, or if you buy HY you can take that much more in losses).

 

The problem is that as going concerns, these high fee vehicles pay a big percentage of their upside to the management companies AND many of them are levered so you don't get as big of a cushion on an asset value basis than the discounts would have you believe.

 

It's interesting that the equity market for vehicles with credit like risk (from lower risk IG and muni CEF's all the way to high risk BDC's) is telling us about credit and the economy...Someone has to be wrong.

 

I'm still on the sidelines, but have been meaning to compile a shopping list.

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I agree that closed end funds can be problematic.  But that not always the case. For example, Templeton Emerging Market Income (TEI), which I own, trades at a 16% discount, yields almost 8%, uses little to no leverage and has a modest expense profile - slightly more than 1%.  Generally speaking you guys are correct, but you're painting with a broad brush.

Thanks

Mark

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agreed, definitely generalizing...but 8% to invest in these places! I'd argue this is more equity like risk and the discount is more of an equity like discount ( a 10% discount for a US IG fund is a lot greater than a 16% discount for a Brazil Ghana Ecuador, hungary, Sri Lankan etc. bond fund).

whoa.GIF.14397ed07e7d90b6f4b418c5f7c5e48a.GIF

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I agree that closed end funds can be problematic.  But that not always the case. For example, Templeton Emerging Market Income (TEI), which I own, trades at a 16% discount, yields almost 8%, uses little to no leverage and has a modest expense profile - slightly more than 1%.  Generally speaking you guys are correct, but you're painting with a broad brush.

Thanks

Mark

 

I strongly recommend you read Stahl's latest paper.

http://www.horizonkinetics.com/docs/Your%20Bond%20Index%20is%20Not%20Immune%20to%20the%20ETF%20Bubble_FINAL.pdf

 

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I fell like chum in shark invested waters.  ☺ Seriously you guys are all very smart, far smarter than I am. I'll listen to all  of your opinions, and I appreciate them.  And if I'm wrong, I'll beg at your doors for gruel, and you can tell me "I told you so."  But here is why I putting on positions in some closed in funds. ( I am, however, spreading my money around.) This is just one chart amoung many that show the same thing from different perspectives.

http://quotes.morningstar.com/chart/cef/chart.action?t=TEI&region=usa&culture=en-US&productcode=COM&dataParams=%7B%22zoomKey%22%3A10%2C%22version%22%3A%22US%22%2C%22showNav%22%3Atrue%2C%22mainSettingId%22%3A%22main%22%2C%22navSettingId%22%3A%22nav%22%2C%22benchmarkSettingId%22%3A%22benchmark%22%2C%22sliderBgSettingId%22%3A%22sliderBg%22%2C%22volumeSettingId%22%3A%22volume%22%2C%22id%22%3A%22FCUSA00007%22%2C%22type%22%3A%22FC%22%2C%22name%22%3A%22XNYS%3ATEI%22%2C%22qsType%22%3A%22USA%3ATEI%22%2C%22baseCurrency%22%3A%22USD%22%2C%22defaultBenchmarks%22%3A%5B%22%24FOCA%24EB%24%24%7CEmerging%20Markets%20Bond%7CCA%5DFC%22%2C%22XIUSA000MC%7CBarclays%20US%20Agg%20Bond%20TR%20USD%7CXI%22%5D%2C%22startDay%22%3A%2209%2F23%2F1993%22%2C%22endDay%22%3A%2209%2F17%2F2015%22%2C%22chartWidth%22%3A955%7D

In the crash of 2008, we were facing Armageddon and the market priced things accordingly.  It seems to me that a lot of these fund are currently priced based on the fear of Armageddon. I tend to bet against fear. Sometimes I'm actually right.

Thanks Jay21, I'll check out TSI.

Thanks everyone.

Mark

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I agree that closed end funds can be problematic.  But that not always the case. For example, Templeton Emerging Market Income (TEI), which I own, trades at a 16% discount, yields almost 8%, uses little to no leverage and has a modest expense profile - slightly more than 1%.  Generally speaking you guys are correct, but you're painting with a broad brush.

Thanks

Mark

 

It's not that -- TEI is a decent fund with a decent manager and it looks cheep, I just don't get why I would want it.

 

Say that discount disappears in a year. TEI's 3year average discount is something like 4%, so say in a year you get +12% ± change in NAV + 8% yield. So, that's 20% and then maybe 7% a year afterwords. Okay, that's not horrible, but I think I agree with the others that it is equity like risk in the NAV and if the discount takes more time to converge to an average value, then the return is looking just okay (2year ~= 15%/year; 3 years 12% year, etc). The longer it takes, the more the return will convert to the underlying returns of the portfolio.

 

Mostly, it doesn't scream "free money!" to me, it screams "free nickels!"

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TheAIGUY - everything that you said is correct. However, I would add two things.  First, you guys are focusing on the example I used instead of the point that I was attempting to make. Specifically that closed end funds in general have been taken out behind the wood shed. You don't like TEI? Great! But that doesn't mean that you can't find a closed end fund more to your liking. Second, if you look at the attached multi year chart previously posted, you will see that the NAV of TEI  has significantly declined relative to its history.  In fact its not far from its 2008 low. Your numbers assume that the NAV will not revert to the mean over time.  That may or may not be true. If the NAV reverts to near it's mean you're going to get an additional boast to your hypothetical returns.

Thanks

Mark

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TheAIGUY - everything that you said is correct. However, I would add two things.  First, you guys are focusing on the example I used instead of the point that I was attempting to make. Specifically that closed end funds in general have been taken out behind the wood shed. You don't like TEI? Great! But that doesn't mean that you can't find a closed end fund more to your liking. Second, if you look at the attached multi year chart previously posted, you will see that the NAV of TEI  has significantly declined relative to its history.  In fact its not far from its 2008 low. Your numbers assume that the NAV will not revert to the mean over time.  That may or may not be true. If the NAV reverts to near it's mean you're going to get an additional boast to your hypothetical returns.

Thanks

Mark

 

You're right -- I'm assuming the NAV won't revert to the mean. But why would I assume that? I don't really have a view on the underlying, I think the attractive bit is the discount. If I had a way to arbitrage that discount in a shortish period of time, It would be interesting. Equally, if I found the underlying fund interesting, that would be attractive.

 

Personally, I don't see any CEF's where I'd want to only the underlying portfolio. However, If you're interested, there is an activist CEF (special equity fund -- ticker:SPE) that tries to spur liquidation events that's run by a value guy (I think they're called "bulldog"?). There are a couple of other funds that specialize in this, FWIW

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I am thinking of HTR.  It is run by brookfield which is a huge plus in my mind.  According to yahoo finance since inception in 1990 it has more or less kept up with the SP500, I think the S&P beat it by a fraction of a percent but regardless it has held it's own and validated the investment over the long term.  There is a 15% discount to NAV which is not fantastic but not bad.

 

So I guess you buy with the intention that you get S&P like returns + a one time bonus of 10-15% as it re-prices closer to NAV.

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I am thinking of HTR.  It is run by brookfield which is a huge plus in my mind.  According to yahoo finance since inception in 1990 it has more or less kept up with the SP500, I think the S&P beat it by a fraction of a percent but regardless it has held it's own and validated the investment over the long term.  There is a 15% discount to NAV which is not fantastic but not bad.

 

So I guess you buy with the intention that you get S&P like returns + a one time bonus of 10-15% as it re-prices closer to NAV.

 

Or you increase your compounding power by 10-15% over the long-term life of the investment. This would be much more helpful than a 10-15% one-time boost.

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I am thinking of HTR.  It is run by brookfield which is a huge plus in my mind.  According to yahoo finance since inception in 1990 it has more or less kept up with the SP500, I think the S&P beat it by a fraction of a percent but regardless it has held it's own and validated the investment over the long term.  There is a 15% discount to NAV which is not fantastic but not bad.

 

So I guess you buy with the intention that you get S&P like returns + a one time bonus of 10-15% as it re-prices closer to NAV.

 

Or you increase your compounding power by 10-15% over the long-term life of the investment. This would be much more helpful than a 10-15% one-time boost.

 

 

well, it's also a levereed bond portfolio of CCC rated MBSs. How do you feel about owning a basket of that at a 15% discount to NAV?

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I am thinking of HTR.  It is run by brookfield which is a huge plus in my mind.  According to yahoo finance since inception in 1990 it has more or less kept up with the SP500, I think the S&P beat it by a fraction of a percent but regardless it has held it's own and validated the investment over the long term.  There is a 15% discount to NAV which is not fantastic but not bad.

 

So I guess you buy with the intention that you get S&P like returns + a one time bonus of 10-15% as it re-prices closer to NAV.

 

Or you increase your compounding power by 10-15% over the long-term life of the investment. This would be much more helpful than a 10-15% one-time boost.

 

 

well, it's also a levereed bond portfolio of CCC rated MBSs. How do you feel about owning a basket of that at a 15% discount to NAV?

 

I'd feel alright about it. Here's the deal, we all recognize that markets are mostly efficient, but that there are some inefficiencies. But the market has deemed the value of these CCC MBS at one value, and then at the same time said if you buy them as a package you get 15% off. I can't imagine it will work out in every situation, but it doesn't seem hard to beat the market when you're buying everything the market has available at double-digit discounts.

 

My main problem with these things is the active management. You can't look at them and say you're simply buying assets cheaply relative to the market. You have to trust that the active management isn't going to burn through the benefit of that 10-15%. That's a harder question, but my guess is that anyone who carefully selected a handful of CEFs trading at 10+% discounts would have no problem handily beating the market.

 

I haven't looked at the actual numbers to know if has been proven or not, but it's hard to come up with a scenario with the active managers of all of these funds just destroying the 10-15% value year-in and year-out.

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HTR in Jan 11, 1990 was $3.41 adjusted for dividends.  Today it is 21.71.  So it is 6.36x where it started at.  It probably IPO'd at no discount to NAV so if you standardized nav discount it is up about 7.4x.

 

SPY, from Jan 11 1990 to today is up about 6.78x.  So SPY beat HTR strictly speaking but by a small margin.  Compared to the NAV adjusted value HTR beat SPY.  If you standardized the PE on SPY (because I think it is a higher PE today than Jan 1990) then HTR beat by an even larger margin.

 

So they have proven they can at least match the market.

 

I think the average CEF, however, significantly under performs so I won't be buying baskets.

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I am thinking of HTR.  It is run by brookfield which is a huge plus in my mind.  According to yahoo finance since inception in 1990 it has more or less kept up with the SP500, I think the S&P beat it by a fraction of a percent but regardless it has held it's own and validated the investment over the long term.  There is a 15% discount to NAV which is not fantastic but not bad.

 

So I guess you buy with the intention that you get S&P like returns + a one time bonus of 10-15% as it re-prices closer to NAV.

 

 

 

Or you increase your compounding power by 10-15% over the long-term life of the investment. This would be much more helpful than a 10-15% one-time boost.

 

 

well, it's also a levereed bond portfolio of CCC rated MBSs. How do you feel about owning a basket of that at a 15% discount to NAV?

 

I'd feel alright about it. Here's the deal, we all recognize that markets are mostly efficient, but that there are some inefficiencies. But the market has deemed the value of these CCC MBS at one value, and then at the same time said if you buy them as a package you get 15% off. I can't imagine it will work out in every situation, but it doesn't seem hard to beat the market when you're buying everything the market has available at double-digit discounts.

 

My main problem with these things is the active management. You can't look at them and say you're simply buying assets cheaply relative to the market. You have to trust that the active management isn't going to burn through the benefit of that 10-15%. That's a harder question, but my guess is that anyone who carefully selected a handful of CEFs trading at 10+% discounts would have no problem handily beating the market.

 

I haven't looked at the actual numbers to know if has been proven or not, but it's hard to come up with a scenario with the active managers of all of these funds just destroying the 10-15% value year-in and year-out.

 

So Rivernorth, a fund manager who does CEF strategies and works with Oaktree and double line, look like they've been able to beat an appropriate benchmark by about 2% gross of fees over the last several years (all of this, of course, gets eaten up in their management fee).

 

That's seems about right, though, b/c you could imagine that not all of that 10-15% discount is a real discount. Some of that probably reflects fee structure, but the underlying assets are often illiquid, and CEFs them selves are illiquid and more risky than an unleveled version of the portfolio, so presumably some of that discount is a liquidity premium and a haircut for management rather than a misspricing per se.

 

I still think there's some alpha there (2% a year sounds reasonable to me), but I don't know if its enough to overcome the frictional costs of investing (taxes really) and there's not a huge margin of safety there.

 

 

Edit

If you capitalize a 1% management fee as a liability (with a 10% discount rate) and add that to the nav, you get something like a 10% discount as fair value

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HTR in Jan 11, 1990 was $3.41 adjusted for dividends.  Today it is 21.71.  So it is 6.36x where it started at.  It probably IPO'd at no discount to NAV so if you standardized nav discount it is up about 7.4x.

 

SPY, from Jan 11 1990 to today is up about 6.78x.  So SPY beat HTR strictly speaking but by a small margin.  Compared to the NAV adjusted value HTR beat SPY.  If you standardized the PE on SPY (because I think it is a higher PE today than Jan 1990) then HTR beat by an even larger margin.

 

So they have proven they can at least match the market.

 

I think the average CEF, however, significantly under performs so I won't be buying baskets.

 

Management at HTR has only been around since 2006-2007 (it was unclear to me reading it), but your point about its performance stands as its been roughly kept up with the S&P over that time. I don't think its reasonable to standardize on PE, though, that presumes quite a bit. You could also standardize on interest rates and push its performance down, or consider taxes, in which case it looks a lot worse, etc.

 

Management, strategy and fees seem fine, though.

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