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The dividends paid by the closed-end funds that comprise CEFL have been steady this year. The closed-end funds that comprise CEFL are trading at extremely large discounts to book value. The low price and high dividends combine to generate a 23.8% yield on an annualized monthly compounded basis. The discounts to book value and the possibility that the Federal Reserve may pause or even reverse its rate hike agenda makes CEFL attractive. My projection for the January 2016 the UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ) dividend is $0.2964. This is an increase from the $0.2718 monthly dividend paid in December 2015. However, it is a slight decline from the $0.3037 paid in October when all 30 of the components also contributed to the dividend. Of the 30 index components of CEFL, and YieldShares High Income ETF (NYSEARCA: YYY ), which is based on the same index and thus has the same components as CEFL, but without the 2X leverage, 29 now pay monthly. Only the Morgan Stanley Emerging Markets Domestic Debt Fund (NYSE: EDD ) now pays quarterly dividends in January, April, October, and July. Thus, EDD will be included in the January 2016 but was not in the December 2015 CEFL monthly dividend calculation. EDD did reduce its quarterly dividend to $0.22 from the previous $0.20. Somewhat offsetting this is the fact that Blackstone /GSO Strategic Credit Fund (NYSE: BGB ) will be paying two separate “monthly” dividends of $0.105 each with December 2015 ex-dates. Both of which will contribute to January 2016 CEFL dividend. The relative stability of the CEFL dividend may be surprising to those who assumed that the distributions from any instrument that had a 23.8% annualized compound yield, such as CEFL, would be experiencing declining distributions. The most bullish environment for the high dividend closed-end funds that mostly comprise the index upon which CEFL is based, generally occurs when the Federal Reserve reduces interest rates or is expected to do so. Now, there can be some hope, however slight, that the Federal Reserve actually reduces interest rates from current levels. There is one thing about the recent Federal Reserve decision to increase rates that can absolutely be construed as positive for those still constructive about the high dividend closed-end funds. Now, in contrast to before December 15, 2015, there is some possibility that the Federal Reserve will cut interest rates. Obviously, a zero interest rate policy meant no further rate cuts were possible, or at least that was thought to be the case before the European monetary authorities cut their deposit rate below zero. The dream by high dividend closed-end investors of a 2016 rate cut may not be as far-fetched as it seems. Since the 2008 financial crisis every central bank in a developed country that has tightened monetary policy had to reverse course and lower rates in response to weakening economic conditions. Most likely the December 15, 2015 Fed rate hike will not affect the economy much. However, with the markets in turmoil, weak economies worldwide and competitive devaluations popping up all over, it could be a colossal mistake. To be a mistake, the Fed rate hike in December 2015 would not have to be another 1931 when the Fed increased interest rates and made sure that there would be a depression or another 1937 (which is somehow remembered much more that the 1931 mistake). The 1937 mistake “only” halted the recovery and sent unemployment up from 14.18% in 1937 to 18.91% in 1938. In today’s hyperactive news and financial markets environment, for the December 2015 rate hike to be considered a “colossal mistake” an increase in the unemployment rate from the current 5.0% to 5.5% would be quite sufficient. One possible scenario that could occur as a consequence of the Federal Reserve decision to increase rates is that countries such as China would drastically devalue their currencies relative to the US dollar. China and other countries could make the not unreasonable argument that by raising rates the USA cannot complain about the value of the dollar since raising rates causes a currency to appreciate. A large enough increase in the value of the dollar could destroy many of the basic industries in the USA and could throw us into a recession. Even without a massive increase in the value of the dollar, the unemployment rate could increase for various other reasons. If the labor force participation rate, especially for prime working-age males ages 25-54, had followed its typical cyclical pattern, the unemployment rate would now be well above 5.0%. The headline U-3 unemployment only counts those actively seeking work as in the labor force and unemployed. As we pointed out in ” Disability’s Disabling Impact On The Labor Market ” historically labor force participation has behaved cyclically in the midst of a slightly declining trend. Participation tends to fall during recessions and rise during recoveries as job prospects improve. But in the current economic cycle the participation rate fell during the recession and continued falling throughout the recovery to date. Dubious and fraudulent disability claims have vastly increased the number of those collecting disability with commensurate decreases in labor force participation and the unemployment rate. A segment on CBS “60 Minutes” last season quoted employees of the Social Security Administration and administrative law judges who asserted that lawyers are recruiting millions of people to make fraudulent disability claims. One such judge said “if the American public knew what was going on in our system half would be outraged and the other half would apply for benefits”. In response to the rising tide of fraudulent disability claims and the resulting depletion of the disability trust fund, reforms have recently been enacted. In the deal that transferred $300 billion from the social security trust fund to the disability fund which otherwise would have been exhausted in 2016, Congress required that disability claims now involve input from doctors. This only makes a difference in the ten states that did not require medical input for disability claims. However, those were the ten states where the highways were filled with billboards from law firms soliciting clients to file disability claims. It could be Janet Yellen’s bad luck that labor force participation and the unemployment rate increases as fraudulent disability claims diminish. There is also the possibility that the regular consequences of higher rates push a still fragile economy over the edge. Higher LIBOR and T-bill rates increase the interest rates on every adjustable rate mortgage, business loan and most credit cards. While lower oil prices help consumers, oil industry workers are losing their jobs. In addition to the job losses in the oilfield and related industries, lower oil and gas prices reduce income for many. Every one of the 3.3 billion barrels of oil produced in the United States results in income to some American either directly to land and lease owners from royalties, distributions from royalty trusts or profits to corporations. The $60 decline in oil prices has reduced income to those Americans by $200 billion As the hedges that gave some oil companies some relief from the collapse in oil prices run off, many of the weaker firms are facing financial distress. This reduces the wealth of those who own shares or bonds in these companies. Any or all of these factors combined with weak world-wide economic conditions, could result in higher unemployment rates. While an increase in the unemployment rate would signify to the general public that the rate hike was a mistake, an inversion of the yield curve in response to the increase in short-term rates by the Federal Reserve could indicate to Janet Yellen that a 1937 type mistake had been made. I think Janet Yellen’s greatest fear is being responsible for another 1937. Most agree that the premature Federal Reserve tightening in 1937 worsened the depression. There were a large number of influential voices advocating against the rate hike. These included Paul Krugman, Larry Summers, Austan Goolsbee and the International Monetary Fund. Those within and without the Federal Reserve who opposed the rate hike would have a powerful “I told you so” if raising rates does have severe negative consequences. This could prompt the Federal Reserve to adopt a new policy, similar to that of Japan during most of the last 20 years. This new policy would be to say that the new “normal” policy is that interest rates are only increased in response to clear and unambiguous evidence that the economy is overheating and that inflation is getting out of hand. The enormous discount to book value for many closed-end funds decreased somewhat from last month. Last month, all 30 of the index components of the UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ), and the YieldShares High Income ETF (NYSEARCA: YYY ), which is based on the same index and thus has the same components as CEFL, but without the 2X leverage, traded at discounts to book value. They are trading at even deeper discounts to book value now. From the inception of CEFL until four months ago, there were always some component closed-end funds trading at premiums to book value. Four months ago, two of the components were trading at premiums to book value. On a weighted average basis, the closed-end funds that comprise CEFL are trading at a 12.84% discount to book value as of November 20, 2015 as compared to 13.41% a month ago. Closed-end funds typically trade at either discounts or premiums to book value. On balance, there is a slight bias towards discounts. Because of significant changes in the composition of the index, comparisons of aggregate discounts to book value from previous years are not very meaningful. In attempting to find an explanation for the extreme discount to book values that the closed-end funds that comprise CEFL and YYY are trading at, I considered two possible factors. One concern with many closed-end funds is that their dividends include a significant amount of return of capital. I ran regression analysis to determine if there was any correlation between the proportion of the dividend paid by a closed-end fund that represents a return of capital and the discount to book value that the closed-end fund is trading at. For the 30 closed-end funds that comprise the index CEFL is based on, there was no statistically significant relationship. For many securities other than closed-end funds, such as common stocks, discounts or premiums to book values are logically based on the business prospects for companies. Thus, Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) trades at significant premium to book value, while Peabody Energy (NYSE: BTU ) trades at a significant discount to book value, reflecting differing market perceptions of the future prospects for those companies. Google trades at approximately 5X book value while BTU trades at about one-fifth of book value. In my article: mREITs Impacted By Enormous Price To Book Swing – MORL Yielding 27.6%, I discussed the large discounts to book value that mREITs such as American Capital Agency Corp. (NASDAQ: AGNC ) are trading at. The logic behind mREITs such as AGNC trading at significant discounts to book value is primarily based on the possible impacts of higher future interest rates. Whether one agrees or disagrees with the magnitudes of the discounts or premiums to book for securities such as Google, Peabody and AGNC, there are facts and logic related to each company’s business prospects that could possibly explain or justify changes in the premiums or discounts that have occurred in those stocks. There are no such facts or changes in market forecasts of business prospects that can possibly explain or justify changes in the premiums or discounts that have occurred in the closed-end funds that comprise CEFL. For closed-end funds, changes in the premiums or discounts to book value should be solely based on the value that investors place on the relative advantages and disadvantages of the closed-end fund structure, rather than the differing market perceptions of the future prospects for the securities in the closed-end funds’ portfolios. Investors in closed-end funds could purchase the securities held by a closed-end fund themselves. In most cases, there are also open-end funds available to investors that have risk, return and expense characteristics similar to any given closed-end fund. Changes in market perceptions of the prospects of the securities that comprise the portfolios of closed-end funds cannot logically explain or justify any change in the magnitudes of the discounts or premiums to book for the closed-end funds. Any such changes in market perceptions of the prospects of the securities in the portfolio should be reflected in the prices of the portfolio securities themselves. Thus, the ratio of the price of the closed-end fund to its book value should not be related to the expectations of the prospects for the portfolio securities held by the closed-end fund. If investors value the advantages of diversification, management and possibly lower transaction costs associated with owning a closed-end fund rather than owning the individual securities that comprise the closed-end fund’s portfolio more than the fees and expenses, which are the primary negative aspect of closed-end funds, then the closed-end fund will trade at a premium to book value. Conversely, if investors feel that the fees and expenses of the closed-end fund outweigh the advantages of diversification, management and possibly lower transaction cost associated with owning a closed-end fund, it will trade at a discount to book value. The trade-offs between the advantages and disadvantages associated with closed-end funds relative to the securities that comprise the portfolios of the closed-end funds are rational reasons for the closed-end funds to trade at discounts or premiums to book value. However, it is not rational for the discount or premium to be influenced by expectations of future returns on the securities that comprise the portfolios of the closed-end funds. If the market thinks that the securities in a closed-end fund’s portfolio will decline, and thus the net asset or book value of the closed-end fund will decline, there is no reason why the premium or discount that the closed-end fund is trading at should change. Some closed-end funds employ limited amounts of leverage. As investment companies, closed-end funds cannot have more than 33% leverage and most employ less, if any. That a closed-end fund does or does not employ a relatively small amount of leverage should not impact the premium or discount that the closed-end fund is trading at. Leverage is the easiest characteristic of a security to offset. Thus, if an investor was interested in a security but did not like the fact that the security employed 20% leverage, the investor could offset that leverage by combing that security with a risk-free asset. For example, if you had $10,000 to invest and you liked a closed-end fund but were unhappy with the 20% leverage, investing $8,000 in the closed-end fund and $2,000 in a risk-free asset will result in the same risk/return profile as investing $10,000 in the same closed-end fund, if that fund did not employ any leverage. Likewise, if you liked a closed-end fund but would rather that fund employed more leverage, you can buy that fund on margin and get in the same risk/return profile as investing in the fund if it had more leverage. Thus, leverage or lack of leverage should not influence the premium or discount that the closed-end fund is trading at since any leverage in a closed-end fund can be offset by an investor. There should be some limits as to how far away from book value a closed-end fund should trade. If a closed-end fund is trading at a sufficiently high premium to book value, an arbitrage opportunity could exist. Buying the securities in the closed-end fund’s portfolio and simultaneously selling the closed-end fund should generate a profitable arbitrage. Likewise if a closed-end fund is trading at a large enough discount, buying the closed-end fund and selling the securities that comprise the portfolio, it could generate arbitrage profits. These types of arbitrage would be risk arbitrage as opposed to riskless arbitrage. In riskless arbitrage, one buys a security or commodity and simultaneously sells something that is the equivalent of what you sold. An example of riskless arbitrage would be after a merger had been approved in which the acquirer is issuing one share of its stock for two shares of the company being acquired, you simultaneously buy two shares of the company being acquired for a total cost less than a share of the acquirer. This would essentially lock in a profit that would be realized when the merger closed and the values converged. Attempting to take advantage of the discount to book value being irrationally wide for a closed-end fund would be an example of risk arbitrage since there is no terminal event that will make the value of what you buy converge with what you sell. It may be irrational for a closed-end fund to trade at a 10% discount to book value. However, there is always the possibility that it could go to a 15% discount. As Keynes famously said, “The market can stay irrational longer than you can stay solvent.” Closed-end funds do not usually provide convenient opportunities for explicit risk arbitrage transactions where one security is bought and the other security is shorted. Retail investors usually cannot use the proceeds from selling some securities short to buy other securities. Hedge funds and institutions that may be able to use the proceeds from selling some securities short to buy others might find closed-end funds, and especially some of the securities that comprise the portfolios of the closed-end funds, not liquid enough to trade in. Even market participants who are able to use the proceeds from selling some securities short to buy others might be dissuaded from buying closed-end funds and shorting the securities in the closed-end funds’ portfolio, because of the fees and expenses charged by the closed-end funds. However, if the discount to book value is large enough, the fees and expenses charged by the closed-end funds could be offset by the discount to book value and thus generate a positive carry for a long closed-end fund — short the fund’s portfolio position. This would be especially true for closed-end funds that specialize in securities that generate higher income, such as those in the index upon which CEFL and its unleveraged counterpart YYY are based. An example of the discount to book value more than offsetting the fees and expenses would be a hypothetical closed-end fund whose portfolio securities yielded 10% before expenses. Most income-oriented closed-end funds have expense ratios lower than 1%. Shorting $100 worth of the securities that comprise the fund would require payments of $10 representing 10% annually to those who the securities were borrowed from. The $100 proceeds from the short sale could be used to acquire $100 of the closed-end fund. If the closed-end fund was trading at a 14% discount, $100 of the fund would represent 100/.86 = $116.28 worth of the securities in the fund. These securities yield 10%, so the gross income from the fund position would be $11.63. The net income, assuming a 1% expense ratio, would be $10.63. Thus, even after expenses and fees, an account long the closed-end fund would generate higher income than the portfolio securities while it waited for the discount to narrow to realize the risk arbitrage profit. While explicit risk arbitrage where the portfolio securities are shorted and the proceeds are employed to buy the closed-end fund might not occur in significant quantities to narrow the discount to book value, implicit arbitrage should eventually have an impact. Implicit risk arbitrage would occur as investors holding or wanting to hold securities with similar risk/return characteristics as a closed-end fund or the portfolios held by the closed-end fund shift from other securities to the closed-end fund. Institutional investors who had portfolios that contained securities similar to or identical to those held in a close-end fund could improve their risk/return profile by shifting out of securities in the closed-end fund to the closed-end fund, if the discount to book value for the closed-end fund was large enough. Retail investors could switch from securities held in portfolios of close-end fund to the closed-end fund and improve their risk/return profile if the discount to book value for the closed-end fund was large enough. More important, investors could shift out open-end mutual funds into closed-end mutual funds with similar objectives and portfolios. Open-end mutual funds are sold and redeemed at net asset value. Thus, there is never any discount or premium to book value for an open-end mutual fund. Advantages for investors in no-load mutual funds are that there are no transactions costs and the funds can always be redeemed at net asset or book value. Closed-end funds usually require some brokerage commission to buy and sell them, and there is risk that the closed-end fund will fluctuate due to changes in the premium or discount to net asset value in addition to fluctuation in the portfolio securities. The advantages of no-load open-end mutual funds are somewhat offset by the lower fees and expenses that closed-end funds usually have. When closed-end funds are trading at large discounts to book value, investors can significantly increase their returns by switching from open-end funds to closed-end funds that have similar assets but are selling at discounts to net asset value and typically have lower fees and expenses. When an investor redeems an open-end fund at net asset value, the open-end fund sells portfolio securities to fund the redemption. That would tend to lower the market prices of those portfolio securities. If the investor uses the proceeds from the redemption of the open-end fund to buy shares in a closed-end fund that holds similar portfolio securities, the net effect would be to put downward pressure on the market prices of the portfolio securities and upward pressure of the market prices of the closed-end funds. Thus, the discount to book value for the closed-end funds will tend to decline. This large discount to net asset value alone is still a good reason to be constructive on CEFL. It should be noted that saying CEFL components are now trading at a deeper discount to the net asset value of the closed-end funds that comprise the index does not mean that CEFL does not always trade at a level close to its own net asset value. Since CEFL is exchangeable at the holders’ option at indicative or net asset value, its market price will not deviate significantly from the net asset value. The net asset value or indicative value of CEFL is determined by the market prices of the closed-end funds that comprise the index upon which CEFL is based. My constructive view on CEFL stems not only from the wide discount to book value of the closed-end funds, but also from the very large dividends paid by CEFL. One troubling aspect of CEFL is the significant amount of the dividends paid by the closed-end funds that comprise CEFL that consists of return of capital. My calculation using available data indicates that 25.1% of the January 2016 CEFL dividend will consist of return of capital. However, there does not seem to be any statistically significant relationship between return of capital and the discounts to book value that the individual closed-end funds trade at. My calculation projects an January 2016 dividend of $0.2964. For the three months ending January 2016, the total projected dividends are $0.8247. The annualized dividends would be $3.2988. This is a 21.5% simple annualized yield with CEFL priced at $15.33. On a monthly compounded basis, the effective annualized yield is 23.8%. Aside from the fact that with a yield above 20%, even without reinvesting or compounding, you get back your initial investment in only five years and still have your original investment shares intact. If someone thought that over the next five years markets and interest rates would remain relatively stable, and thus CEFL would continue to yield 23.8% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $290,489 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $23,800 initial annual rate to $69,136 annually. CEFL component as of December 18, 2015 Name Ticker Weight Price NAV price/NAV ex-div dividend frequency contribution return of capital First Trust Intermediate Duration Prf.& Income Fd FPF 4.86 21.18 23.29 0.9094 12/1/2015 0.1625 m 0.0114 MFS Charter Income Trust MCR 4.52 7.78 8.95 0.8693 12/15/2015 0.06191 m 0.0110 0.0213 Eaton Vance Limited Duration Income Fund EVV 4.51 12.55 14.33 0.8758 12/9/2015 0.1017 m 0.0112 0.0154 Eaton Vance Tax-Managed Diversified Equity Income Fund ETY 4.5 11.17 11.94 0.9355 12/21/2015 0.0843 m 0.0104 0.0073 Eaton Vance Tax-Managed Global Diversified Equity Income Fund EXG 4.49 8.79 9.74 0.9025 12/21/2015 0.0813 m 0.0127 0.075 Blackrock Corporate High Yield Fund HYT 4.4 9.85 11.08 0.8890 12/10/2015 0.001152 m 0.0002 0.07 Prudential Global Short Duration High Yield Fundd GHY 4.39 13.96 16.12 0.8660 12/16/2015 0.11 m 0.0106 Alpine Total Dynamic Dividend AOD 4.33 7.59 9.19 0.8259 11/18/2015 0.0575 m 0.0100 Alpine Global Premier Properties Fund AWP 4.3 5.73 6.97 0.8221 11/18/2015 0.05 m 0.0115 0.03 Western Asset Emerging Markets Debt Fund ESD 4.3 13.84 16.38 0.8449 12/16/2015 0.105 m 0.0100 0.0104 PIMCO Dynamic Credit Income Fund PCI 4.28 17.99 20.8 0.8649 12/17/2015 0.23 m 0.0167 Doubleline Income Solutions DSL 4.27 16.54 18.16 0.9108 12/16/2015 0.237 m 0.0187 Clough Global Opportunities Fund GLO 4.25 10.33 12.48 0.8277 12/16/2015 0.1 m 0.0126 0.1 ING Global Equity Dividend & Premium Opportunity Fund IGD 4.06 6.96 8.06 0.8635 12/1/2015 0.076 m 0.0136 0.0084 BlackRock International Growth and Income Trust BGY 3.85 6.05 6.86 0.8819 12/16/2015 0.049 m 0.0095 0.0434 Prudential Short Duration High Yield Fd ISD 3.53 14.75 16.45 0.8967 12/16/2015 0.11 m 0.0080 GAMCO Global Gold Natural Resources & Income Trust GGN 3.5 4.65 5.18 0.8977 12/9/2015 0.07 m 0.0161 Aberdeen Asia-Pacific Income Fund FAX 3.42 4.53 5.46 0.8297 12/29/2015 0.035 m 0.0081 0.0175 Morgan Stanley Emerging Markets Domestic Debt Fund EDD 3.31 6.74 8.16 0.8260 12/16/2015 0.2 q 0.0300 MFS Multimarket Income Trust MMT 2.98 5.54 6.44 0.8602 12/15/2015 0.04452 m 0.0073 0.0151 Calamos Global Dynamic Income Fund CHW 2.95 7.09 8.42 0.8420 12/8/2015 0.07 m 0.0089 0.0658 Blackstone /GSO Strategic Credit Fund BGB 2.67 13.59 15.43 0.8808 12/29/2015 0.21 m 0.0126 0.0012 Blackrock Multi-Sector Income BIT 2.15 15.65 18.35 0.8529 12/10/2015 0.1167 m 0.0049 Western Asset High Income Fund II HIX 2.07 6.37 6.94 0.9179 12/16/2015 0.069 m 0.0069 0.0006 Wells Fargo Advantage Multi Sector Income Fund ERC 1.73 11.21 13.15 0.8525 12/11/2015 0.0967 m 0.0046 0.0283 Allianzgi Convertible & Income Fund NCV 1.73 5.4 6.18 0.8738 12/9/2015 0.065 m 0.0064 Wells Fargo Advantage Income Opportunities Fund EAD 1.36 7.45 8.26 0.9019 12/11/2015 0.068 m 0.0038 Nuveen Preferred Income Opportunities Fund JPC 1.28 8.95 10.06 0.8897 12/11/2015 0.067 m 0.0029 Allianzgi Convertible & Income Fund II NCZ 1.06 4.82 5.49 0.8780 12/9/2015 0.0575 m 0.0039 Invesco Dynamic Credit Opportunities Fund VTA 0.97 10.42 12.04 0.8654 12/9/2015 0.075 m 0.0021 Scalper1 News
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