CEF Specialist

4 Contrarian Income Funds

By Steven Pikelny | 08-06-13 | 06:00 AM | Email Article
As interest rates spiked over the past few months, many fixed-income sectors were
hit hard. Investors poured out of mutual funds and exchange-traded funds; even
Vanguard saw its first net outflows in 20 years. With fixed income leaning out of favor
(or, at least less in-favor than it was earlier this year), many investors argue that
certain sectors of the bond market are now oversold. Municipal bonds, in particular,
look increasingly attractive with their spread over longer-term U.S. Treasuries
increasing drastically in the wake of Detroit's publicized insolvency.
In light of these fears, it can be difficult to go against the grain. As we recently
pointed out, availability bias (the tendency to weight recent impressions--such as a
large price drop--more heavily than boring data points, for example) can be hard to
overcome. But without making sweeping, absolute statements about sector valuation,
the concurrent sell-off in fixed-income closed-end funds has given rise to some
slightly less ambiguous deals. Valuing an entire asset class is difficult; valuing a CEF
that invests in that asset class but is trading at a large discount, is less difficult.
What's more, opportunistic investors looking to take advantage of attractive
valuations without taking on as much market risk might want to consider hedging
their exposure, as we discussed at the end of this article.
With this in mind, let's take a look at four out-of-favor CEFs (three muni funds and
one emerging-markets debt fund) that look attractive on a sector-agnostic basis.
BlackRock Municipal Income Investment Quality (BAF)
For investors who expect rates to remain low, BAF is a good option. The fund has
very little call exposure (less than 3% of assets will mature or become callable in the
next five years), which means that reinvestment risk in a low rate environment is
minimal. BAF's biggest risk is its sensitivity to increasing interest rates, which is
amplified by a relatively high leverage ratio (total assets/net assets) of 1.69. The
portfolio's resulting effective duration of 10.7 years is fairly long on an absolute basis,
although this is hardly unusual for leveraged-muni CEFs. In terms of credit quality,
97% of assets are rated A or higher, giving it one of the highest credit-quality profiles
of any muni CEF.
Aside from the risk associated with its long duration, the fundamentals of the fund
are sound. It does have some slight exposure to Detroit, but this consists of insured
water and sewer debt, which has an increased margin of safety over the uninsured
city general-obligation debt. Nevertheless, the discount has widened to 11.7% after
shares traded at net asset value as recently as January. On a three-year statistical
basis, BAF is one of the most undervalued CEFs, with a z-score of 2.9 for the period
(in other words, its current discount is close to three standard deviations lower than
its three-year average discount). The widened discount boosts the distribution rate by
75 basis points to 6.5% at share price.
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Two High-Yield Municipal CEFs
More aggressive muni investors might want to venture into the high-yield muni
space. While many of these funds look pretty junky from a credit-quality perspective,
it's important to keep in mind that municipal portfolios do not equate with a similarly
rated corporate high-yield fund. Rating agencies look at the two classes of bonds with
different criteria, and corporate bonds historically have exhibited much higher default
rates than munis with the same credit ratings.
Among the high-yield muni group, PIMCO Municipal Income (PMF) stands out
mostly for its 7.9% distribution rate at share price. The fund achieves this by
investing in a low-credit-quality portfolio (about 40% of assets are rated below BBB
or are nonrated) with a leverage ratio of 1.68. At a 4.4% premium, it is trading well
below its 17.1% three-year average premium. But considering that PIMCO has held
on to its auction-rate preferred shares (ARPS) for leveraging this fund, the small
premium is somewhat justifiable: The fund's ARPS allow for much cheaper leverage
financing, for now. This gives it a cost advantage over its peers, many of whom have
refinanced with more expensive forms of leverage.
Nuveen Municipal High Income Opportunity (NMZ) is another good option in the high-
yield muni category, currently trading at a 6.2% discount (its widest since 2008). To
be sure, it has advantages and disadvantages compared with PMF. On the plus side,
Nuveen devotes more resources toward its municipal research operation than does
PIMCO. While the Nuveen research team employs nearly two dozen credit analysts to
parse through the muni universe, PIMCO's team only contains six analysts. This
means that Nuveen can spend more time finding value among the junk and spread its
bets over a greater number of securities. On the negative side, it appears that NMZ is
taking on more risk to generate less income: 61% of assets are rated below
investment grade or are nonrated bonds, and its effective duration of 13.3 years is
longer than PMF's 9.3 years. Meanwhile, its distribution rate at share price is 20 basis
points lower than PMF's.
Nevertheless, the amount of unrated debt in each portfolio makes it difficult to
conclusively say which fund is truly taking on more credit risk.
Morgan Stanley Emerging Markets Domestic (EDD)
Finally, for investors avoiding the muni game all together, EDD presents another
interesting opportunity. This fund focuses exclusively on emerging-markets debt
denominated in local currencies. Like Nuveen Diversified Currency Opportunities
(JGT) (which we highlight here), this fund's share price took a hit when interest rates
spiked and concern over the global "reach for yield" ending gained speed. This means
that even though the fund does not take on much explicit interest-rate risk (the
portfolio has a duration of 5.2 years), its exposure against the U.S. dollar still can be
problematic if the currency markets move against the portfolio. In addition, the fund
also takes on some credit risk, with a little less than one third of assets either
nonrated or BB.
The portfolio is tilted mainly toward Latin America and Eastern Europe, with exposure
to Brazil, Turkey, Russia, and Mexico comprising 57% of assets. Although some of
the portfolio was positioned in corporate bonds, 90% was invested in sovereign debt.
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In addition, the fund leverages its portfolio 1.24 times and uses currency forwards to
gain extra currency exposure (its biggest position here was against the Japanese
yen).
Overall, the fund is trading at a 13.3% discount, which is well below its three-year
average discount of 8.0% and brings the distribution rate at share price up to 7.1%.
It's worth reiterating that these funds are not for everyone. If you don't want long
interest-rate exposure, for example, buying a leveraged long-duration fund might be
a bad idea, despite the discount. But for those taking contrarian viewpoints, or
looking to hedge their market exposure, these funds can be good instruments.
Steven Pikelny is a fund analyst at Morningstar.
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