CEF Weekly Review: PCF tries to attract shareholders’ interest

Welcome to another edition of our weekly CEF Market Report, where we discuss closed-end fund (“CEF”) market activity from both the bottom-up – highlighting individual fund news and events – and the top-down – providing an overview of the broader market. We also try to provide some historical context and the relevant themes that seem to be driving the markets or that investors should keep an eye on.

This update covers the period through the second week of August. Be sure to check out our other weekly updates on the Business Development Company (“BDC”) as well as the preferred stock/baby bond markets for perspectives on the broader income space.

Market action

CEFs have seen a mixed picture this week as MLP funds recovered their declines at the start of the month, but REIT funds have struggled. Month-to-date, higher beta sectors remain in the red, while longer duration sectors Sectors like Munis are at the forefront.

Unlike their BDC counterparts, CEFs recorded only a slight decline overall in August.

The initial expansion of discounts at the beginning of the month has been reversed.

Market topics

The CEF High Income Securities Fund (PCF) seeks to solve the problem of CEF shareholders' non-participation in shareholder meetings. This widespread reality makes it difficult for CEFs to make changes and makes it easier for activists to take over the fund (since the activist will certainly vote on their shares).

The idea of ​​PCF is to increase the share of well-informed shareholders in their fund. They do this through a rights issue, which could give well-informed shareholders the opportunity to acquire more shares. They then plan to launch a takeover offer for 90% of the shares issued in the rights issue if all management proposals are accepted, and for 60% if not all proposals are accepted.

At the current discount, the market price roughly corresponds to the rights issue price.

However, someone who wants to buy a lot more shares ahead of the tender offer would be unlikely to be able to buy that many shares on the secondary market without driving the price up significantly, suggesting that there could be a decent level of participation in the rights issue.

As usual, however, many people will not participate, and that is the point. Well-informed voters will subscribe more, and they will continue to be over-represented among shareholders after the tender offer closes. They are also the ones most likely to vote for any proposals by the manager to increase the tender offer to 90% of newly issued shares. To be clear, shares are fungible, so investors do not need to participate in the rights issue to participate in the tender offer.

In a sense, the manager is bribing well-informed voters with alpha at the expense of poorly informed voters. This is also a good outcome for PCF, not only because their proposals are likely to be accepted, but also because they make the fund grow (since only a maximum of 90% of the shares issued in the rights offering will be repurchased). Another benefit for all shareholders is that this actually lowers management fees relative to fund assets, since management fees are fixed.

One thing to consider is NAV dilution. NAV could fall by 7.5% if the RO is fully subscribed, but it will probably be less. This means the takeover offer has less upside potential – perhaps more like 4-7%, not 12%, as the RO could be less drawn down.

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

Market commentary

The two Western Asset Term CEFs, IGI and GDO, are following shareholder approval to convert to perpetual funds with a tender offer. As mentioned, this is straight out of the Nuveen playbook and is the most shareholder-friendly way to deal with terminations. The key takeaway, as always, is that shareholders should tender their shares. Because if the funds remain in circulation, they will most likely exit at significant discounts. Investors who want to maintain their exposure to the funds could then buy the funds back in the market.

CLO Equity CEF OCCI increased its distribution by nearly 10% to $0.115. That represents a yield of around 19%, roughly in line with OXLC and ECC. OCCI remains perhaps the most stark example of the difference between yield and long-term returns. Its total net asset value return since inception is 0.3% per year – not far from zero.

In short, the fund has created virtually no wealth for shareholders since the beginning, a far cry from its 19% return. That might be fine in a particularly dire economic scenario (e.g. March 2020) following a sharp decline in asset prices, but asset prices are still quite high right now, meaning the fund hasn't created any value for shareholders even over a benign period. This longer-term “return discount” is something shareholders should keep an eye on. Return myopia can come at the expense of long-term wealth, as the two are not the same thing (although they are often portrayed as the same).

Attitude and insights

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

On the one hand, although BDCs declined significantly, falling by an average of around 8% in August, CEFs recovered almost completely and the WDI remained unchanged for the month.

Second, the stock's valuation has risen steadily over the past year and it is currently trading at its highest level in 2.5 years in both absolute (left chart) and relative (right chart) terms.

Third, while BDCs' net investment income will fall if the Fed cuts rates, so will WDI, whose distributions have risen in tandem with the Fed's. And while nearly all of the BDCs we cover have significant excess net investment income, WDI's distribution coverage is less than 100%, which could force the fund to reverse its past distribution increases and make cuts.