STI CEF: Unattractive Entry Point (Rating Downgrade) (NYSE:TSI)

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TCW Strategic Income Fund (NYSE:TSI) is a closed-end fixed income class fund managed by TCW Investment Management. We started covering the name last year when we assigned it a “Buy” rating. In our initial article, I highlighted how the fund had an overweight position in mortgage-backed securities, an asset class that we found to be very attractively priced at the time. TSI has delivered a very robust total return since our article:

CEF is up more than 20% since our article, almost matching the performance of the S&P 500, which is very unusual for a fixed income fund.

In today’s article, we’ll review TSI and its holdings and highlight why the fund no longer presents an attractive entry point given the narrowing of rates in the past months. However, we think CEF is attractive, but a name to hold at this stage of the cycle rather than take on.

Analytics

• AUM: $0.24 billion.
• Sharpness ratio: -0.17 (3Y).
• Std. Deviation: 6 (3Y).
• Yield: 4.66%.
• Premium/Discount to NAV: -2.6%.
• Z-Status: 3.
• Leverage ratio: 0%.
• Effective duration: 3 years
• Composition: Fixed Income Multi Assets

Collateral composition – still overweight MBS bonds

The fund continues to be overweight in both agency and non-agency MBS:

Mortgage-backed securities represent 46% of holdings, followed by corporate bonds at 19% and ABS at 14%. Notably, this CEF is mandated to hold common stock as well, but the stock only represents 3.9% of collateral at present.

When you look at the MBS allocation, you will see that Non-Agency is the largest position:

• Non-agency MBS: 45%
• Agency: 39%
• CMBS: 16%

Although non-agency MSB securities are not guaranteed by the US government, they still come with subordination credit enhancements and cash flow diversion provisions.

What’s interesting about this CEF is that it currently chooses not to run leverage. It has the ability to have a transmission ratio of up to 30%, but currently runs none. That’s a take, a conservative build, which hasn’t stopped it from generating a very high total return over the past year.

From a credit rating perspective, CEF focuses on investment grade names:

• AAA names 27%
• AA calls 7%
• Name 8%
• BBB names 19%
• BB name 12%
• B name 7%
• CCC names 6%
• CC and below 8%
• Not rated 5%
• residual is in cash

The composition of the fund highlights once again that rates are the main risk factor here, not credit spreads.

Discount to NAV – historically very tight

The fund has a very well-defined historical range for its discount to NAV:

CEF has seen its discount range from -10% to flat to NAV over the past decade. After posting an outstanding performance over the past year, the market has bid up the near-fixed discount, which is at the top of the range. We can see this from the discount z-statistic, which is currently at a high value of 3.11:

A Z-score is a statistical measurement of the relationship of a score to the mean of a group of scores. A Z-score can reveal to a trader whether a value is typical for a specified data set or atypical. Generally, a Z-score of -3.0 to 3.0 suggests that a stock is trading three standard deviations from the mean.

A large z-score means a relationship stretched in both directions. In our case, the z-stat shows that the discount reduction went too far too fast. Expect a mean reversion if rates start to rise again.

The yield curve has shifted lower

As outlined above in the “Analytics” section, the fund has a duration of 3 years. This translates into the fund’s profit and loss to be driven by the 3-year node on the yield curve:

In the last three months, we have seen less than 100 bps change for that tenor node. This was a huge move that helped price all the assets in the fund. Fixed income, especially Agency MBS, is very rate driven. The lower yield curve movement has given the fund a significant tailwind, taking into account both the increase in NPV and the reduction in the net asset value discount.

Significant movement down the curve is, in our view, stretched. The market is currently pricing in a terminal Fed Funds rate of 3%, which makes the middle portion of the curve very much toward the terminal rate. Through the term premium concept and the upward sloping yield curve, we would expect to have the intermediate tranche 50 to 75 bps wider than Fed Funds. We are currently here. So we don’t see much scope for further tightening here unless we have a severe recession.

A severe recession is not the base case right now, with the market priced for a soft landing. In a soft landing scenario, there will be no need to aggressively reduce rates. Thus, the future path implied by the current market for food funds is what is expected.

What’s next for TSI?

TSI is an actively managed fund and TCW will shift its allocations to capture profit-making asset classes as it aptly describes:

Its investment objective is to seek total investment returns, comprised of current income and capital appreciation. TSI has the ability to invest in a mix of fixed income and equity investments, including mortgage-backed securities, asset-backed securities, value and growth stocks, convertibles, high-yield bonds and equity investments in debt obligations guaranteed (CDO). TSI will shift and reallocate its investments on an opportunistic basis and may invest in other asset classes than those identified above.

In its current format, which is overweight IG MBS and corporate bonds, we think CEF has reached a good valuation point, helped by tighter rates and a narrow discount to NAV. The fund’s current price is no longer cheap and does not provide an attractive entry point. In fact, we feel that a cut of only 25 bps from September 2024 by the Fed and balanced language will actually disappoint some market participants, thus leaving room for a rate pullback, a negative for TSI.

Conclusion

STI is a fixed income CEF. The name is actively managed and has a multi-asset approach, but is currently overweight MBS bonds and corporate IGs. The fund is up more than 20% from our buy rating last year, helped by much lower rates over its 3-year duration and tighter spreads. CEF also saw its cut by more than 5%, moving it towards the top of its historical range. We no longer find the fund to be attractively priced for an entry point and are therefore downgrading the name to ‘Hold’.