FGM: There’s a time to buy and there’s a time to hold (downgrade)

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We last covered revenue from the MFS Government Markets (NYSE:MGF) at the beginning of 2024, when we highlighted the benefits of the fund despite its unsustainable performance. The name is a closed-end fund that focuses on fixed funds income.

In our original paper, we were of the view that retail investors should buy MGF as a NAV accumulation play given the outlook for interest rates. CEF has had healthy results since:

The fund has achieved a total return of over 7% since our rating, driven mainly by the lower yield curve shift in recent months.

In today’s article, we’ll review FGM, its risk factors and composition, and outline why we don’t think the name offers an attractive entry point anymore.

Robust performance in 2024

full the product suite in the IG / Treasury space showed robust performance in 2024:

An investor can clearly see from the chart above when rates started to fall in 2024: June-July is when all the total return charts started moving strongly and coincides with the market pricing in the first Fed rate cut. As we stated in our original paper, MGF is a treasury and agency MBS bond play, so it is a turbo-charged version of the iShares 7-10 Year Treasury Bond ETF (IEF) and the iShares MBS ETF (MBB ). All three names are on the rise in 2024, but MGF has nearly doubled total revenue here.

Duration driven NAV growth

Despite the low 3.59% coupon of the underlying holdings, the fund has a duration of 6.13 years, which has driven gains:

A duration of 6 years means that for every 100 bps of rate cut, the fund earns +6% in NPV. This year saw a significant contraction of intermediate rates:

The 6-year tenor point of the yield curve fell by more than 100 basis points, accounting for the vast majority of gains in CEF. If the curve remains fairly stable for this duration point in the future, the fund will only end up reducing the return on the underlying holdings, with some lower gains from active management possible. The take home point for a retail investor is that MGF was a rate play rather than a dividend play and most of the curve is now moving backwards and investors should hold this fund instead of buy it.

While we recognize that further gains are possible down the road if the yield curve moves further down, we believe the market has priced in a very aggressive rate cut scenario and there is room for disappointment if the Fed is not as shocking as expected.

Composition of collateral – overweight Treasuries and MBS

CEF has remained a rates play through its collateral composition, which is overweight Treasuries and MBS bonds:

• Treasury: 64% of holdings
• Mortgage guarantor: 44% of holdings
• IG bonds: 8%
• Other: 10%
• Short positions: -26%

Please note that CEF takes a very active approach to its composition, using futures and other derivatives to make shorter-term plays on the shape of the yield curve and its movements. It currently has large positions in 2/5-year and 10-year Treasury futures.

However, the main takeaway for a retail investor is that CEF is a rates play. Only IG bonds have a credit component, with Treasuries and agency MBS representing pure rate plays. The fund will therefore be primarily driven by movements in interest rates.

Distribution is not supported

As we saw from the analysis above, the weighted average coupon of the underlying holdings is only 3.6%. However, the fund has a current distribution ratio of 7.4%. Where does the difference come from? You guessed it, from the return of capital:

As of the August 2024 payout date, over 50% of the distribution came from ROC, which checks out with the simple math done above. The fund is not leveraged, but takes active positions through futures contracts. Expect a distribution that is more or less in line with its cash flow from the underlying assets, with the rest built into the ROC. It’s unfortunate that the fund chooses to use such a high ROC figure, but the name is appealing during an easing cycle given its active approach to the markets.

What’s next for FGM?

The CEF will perform in a rate-tightening environment as the Fed eases rates. However, please note that nothing is linear and we believe that most of the yield curve movement is now behind us for this stage of the cycle. The yield curve is pricing in intermediate rates at 3.5% now, and with the Fed’s neutral rate at 2.75%, term premium theory says we’re at fair value. A sharp rise in unemployment and the possibility of a recession may further reduce rates, but we see these as holdovers for 2025. For now, we believe most of the year’s NPV build-up is behind us, and holders will only receive dividends for the next few months. 2025 could be a different story, but we may see a slight reversal here first in rates. We are therefore downgrading the name to ‘Hold’ from ‘Buy’ given the movement already embedded in the price.

Conclusion

MGF is a fixed income CEF. The fund is overweight Treasuries and MBS bonds with an intermediate duration of 6 years. Although the fund is unleveraged, the name uses futures contracts to take shorter-term positions, thus providing highly active management and additional potential for returns. CEF is up more than 7% from our Buy rating, helped by the significant reduction in intermediate rates in recent months. With most of the curve now moving backward, we see only limited upside for the rest of the year in CEF, with the potential for a slight reversal. We are therefore demoting the name to “Hold”.