CEF Weekly Review: PCF tries to convince shareholders

Welcome to another installment of our weekly CEF Market Review, where we discuss closed-end fund (“CEF”) market activity both from the bottom up – highlighting individual fund news and events – and from the top down – providing an overview of the wider market. We also try to provide some historical context as well as relevant themes that appear to be driving the markets or that investors should be aware of.

This update covers the period up to the second week of August. Be sure to check out our other weekly updates covering the business development company (“BDC”) as well as the preferred/baby bond markets for insights into the broader income space.

Market action

CEFs were mixed on the week as MLPs recovered from earlier in the month declines, but REITs struggled. To date, sectors with higher beta remain in the red while having a longer duration sectors like Munis are leading the way.

Unlike their BDC counterparts, CEFs fell only slightly in August.

The initial widening of discounts at the beginning of the month has been withdrawn.

Market Themes

High Income Fund (PCF) CEF seeks to solve the problem of CEF shareholders not attending shareholder meetings. This widespread reality makes it difficult for the CEF to institute any changes and makes it easier for activists to take over the fund (since the activist will surely vote their shares).

The idea PCF came up with is to increase the share of large information shareholders in their fund. They do this by holding a rights offering, which could allow shareholders with high information to add more shares. They then plan to make a tender offer for 90% of the number of shares issued in the rights offering if all of management’s proposals are adopted and 60% if not all are adopted.

At the current discount, the market price is almost the same as the rights offering price.

However, someone wanting to buy more shares in anticipation of the tender offer could not even buy that many shares in the secondary market without pushing the price much higher. This suggests that there could be decent participation in the rights offering.

As usual, though, many people won’t participate, and that’s the point. Voters with high information will oversubscribe and be overrepresented in shareholders even after the offer is completed. They are also the most likely to vote for all of the manager’s proposals to increase the tender offer to 90% of the newly issued shares. To be clear, the shares are fungible, so investors do not need to participate in the rights offering to participate in the tender offer.

In a sense, the manager bribes high-information voters with alpha at the expense of low-information voters. This is also a good result for PCF, not only because their proposals are likely to be adopted, but will also increase the fund (as only a maximum of 90% of the shares issued in the rights offer will be bought back). A secondary win for all shareholders is that this actually reduces management fees relative to the fund’s assets, as management fees are fixed.

One thing to keep in mind is NAV dilution, where NAV could fall by 7.5% if RO is fully subscribed, although it is likely to be less than that. This means there is less upside to the tender offer – closer to 4-7% maybe, not 12% as there might be less RO absorption.

One strategy is to wait for NAV dilution to be reported, which would drive the price down (to keep the discount at a double-digit level), buy the stock at that time, and then deliver in the tender offer.

Market Commentary

The two CEFs Western Asset IGI and GDO are seeking shareholder approval to convert to perpetual funds through a tender offer. As previously discussed, this comes straight from the Nuveen playbook and is the friendliest way to deal with termination. The main takeaway, as usual, is that shareholders should tender their shares. This is because the funds will very likely move to considerable discounts if they remain outstanding. Investors wishing to retain exposure to the funds could then buy the funds back from the market

CLO Equity CEF OCCI increased its distribution by nearly 10% to $0.115. This results in a yield of about 19%, roughly in line with OXLC and ECC. OCCI remains perhaps the most glaring example of the difference between yield and long-term returns. The total return on NAV since inception is 0.3% per annum – not far from zero.

In short, the fund has generated virtually no wealth for shareholders since inception, a far cry from its 19% return. This might be ok in a particularly dire economic scenario (eg March 2020) after a sharp fall in asset prices, but asset prices at the moment are still quite high, meaning that even in a favorable time frame, the fund did not provide any value. to the shareholders. This long-term “yield haircut” is important for shareholders to remember. Yield myopia can come at the cost of long-term wealth, as the two are not the same thing (although they are often presented as the same thing).

Position and aspects

This week, we reduced our allocation to the Western Asset Diversified Income (WDI) Fund and shifted capital to another type of CEF – Business Development Companies. This for three reasons.

On the one hand, while BDCs have narrowed significantly, falling an average of 8% in August, CEFs have almost fully recovered and the WDI is stable for the month.

Second, its valuation has steadily gotten richer over the past year or so, now trading at its richest level in 2.5 years in both absolute (left chart) and relative terms ( graph on the right).

Three, while BDC’s net investment income will decline as the Fed cuts rates, so will WDI’s. Its distributions rose alongside those of the Fed. And while nearly all BDCs in our coverage have significant excess net investment income, WDI’s distribution coverage is less than 100%, which could push the fund to reverse past distribution increases and make cuts .