Tax swapping

The bond sell off of the last few months has created some mark to market losses that may be suitable for some tax loss harvesting, but there is still a portfolio need for income, although not explicitly needed to be tax free. Based on research I've reviewed it feels like there is still relative value in municipal especially compared to other sectors of US fixed income. Some reasons for sticking with muni exposure (for income) include * Detroit headline fears - compared to the Meredith Whitney scare of a few years ago, the Detroit headlines have not caused as severe of a selloff, but they are pretty strong. There are a handful of troubled issuers (Puerto Rico, Chicago, many Michigan cities, etc.) but overall the broader muni obligors are ever so slowly getting better, despite ratings downgrades being slightly tilted to the downside. * Munis relative to duration matched Treasuries are offering more value, given the tax advantages, especially if one is in higher tax state and looks for local funds. Even if one sticks with national funds high tax states like NY/CA tend to be 25-30% of most national funds holdings. Muni's relative to strong corporates are positioned the same way. * If one sticks to the shorter end -- noting that munis are a long duration sector -- there is enough steepness to the curve that perhaps some gains can be picked up from rolldown. * There is tremendous fear of rate rises, but if they do not happen on schedule, there can be money to be had from wearing some of this duration risk. * There is some risk to this, but if one believes that short rates may continue to stay pinned even if tapering starts happening, then levered muni CEF's, trading at discounts, may be particularly attractive as swap vehicles. There are 200+ muni CEF's available. I will filter the candidate universe based on these screens * Current market distribution yield + Discount to NAV greater than 13 (which is the average) This provides some measure of safety (from the discount, as well as some yield) * Expense ratio of less than 110 bps. The Bloomberg is not reliable for this, so this will have to reconfirmed a couple of different ways, both from run rates (on CEFConnect, as well as from the actual filings) Again wide dispersion here, and given that its tough to add value here, why pay up? * Market cap greater than 100mm. Probably colinear with the ER screen, but there is enough illiquidity in CEF space that prowling the very bottom is not needed. * A filter on 90 day volatility, which is a reasonable proxy for duration given the hit that bonds have taken in the last few months. We'll exclude vehicles whose NAV volatility was greater than 9% annualized over the last 90 days. These filters result in a small subset (about 5%) of the vehicles: AFB, MQT, EOT, VKI, VKQ, VPV, IQI, VGM, PMO, MHF Right off the bat, we'll kick out VPV as its a state specific vehicle that is not germane to our needs. Ideally I'm looking for a portfolio with a duration near 7-8 that is investment grade and avoids Puerto Rico, Illinois, Michigan cities, Chicago, Hawaii, and Guam. In addition I'd like dividend coverage of the fund to be high, and I'd like to avoid a situation where there is a high average bond price combined with call exposure. In addition I'd like positive UNII to provide a buffer for div cuts -- which removes MHF.

Blackrock Credit Allocation Trust IV (BTZ) - Reasonable Value

Blackrock Credit Allocation Trust IV (BTZ) is a closed end fund that has recently undergone a variety of changes, and seems to offer reasonable value at prevailing prices.  It is suitable for low risk, low return type of appetites.

First, a little backstory: during the 2006 timeframe Blackrock launched four different preferred funds to great investor demand, raising close to 2 billion in assets.  Unfortunately the timing was poor as investing in financial sector capital securities, prior to the credit crunch, turned out to be disastrous.  Dividends were terminated and firms went bankrupt, so capital was permanently impaired.  As markets began healing in 2009, Blackrock and the fund's board altered their mandate.  The investment policy was shifted to a (primarily US oriented) credit allocation strategy, with guidelines, but not rules, suggesting 50% investment grade bonds, 30% high yield bonds/loans, and 20% capital securities (preferred etc.).  In addition to keeping most of its holdings (80%+) in credit oriented assets, the fund focuses (above 50% holdings) on investment grade issuers.  For further portfolio detail check the sponsor’s site at http://www.blackrock.wallst.com/public/fund/profile.asp?symbol=BTZ.

In addition to expanding their hunting grounds of eligible holdings, a new portfolio management team was installed in 2011.  The new team does not seem to be either a significant plus or minus, as far as I can observe from the outside.  When comparing the mgmt. team’s NAV performance to peers (in a couple of different categories) it looks as if they are middle of the road, if skill is demonstrated solely by short term recent returns.  In any case, it’s difficult to assess this dimension of the fund with the short history we have.  I’ve compared BTZ price & NAV performance versus a passive proxy basket of ETFs (50% LQD, 30% JNK, 20% PFF) and both the beta (1.26) and outperformance (about 30% more over 5 yrs.) makes sense as they are driven by the CEF leverage of ~30%.  Whenever hiring active management, it makes sense to compare to passive alternatives.

During 2012, Blackrock began cleaning up the various Closed End Funds they had outstanding, and moved to consolidate the four similar mandates into one fund.  In theory this would improve liquidity, reduce expenses, and perhaps tighten up the persistent discount to NAV the funds had become afflicted with.  It is difficult for sponsors to raise assets for closed end vehicles when their existing lineup cannot command prices close to NAV, so this should be a move that works for both end investors and the manager.  These funds were PSY, PSW, and BPP which were to be rolled into BTZ, at NAV after any undistributed net investment income (UNII) was paid out.  The merger was closed early in December, and in late December, the annual reports were finalized and released.

For closed end bond funds that are held primarily for their income, it is important that the underlying portfolio held by the fund generate enough income to support the distributions.  Many CEFs that trade at a discount to NAV are not so “cheap” once a projected dividend cut is impounded into the valuation.  For BTZ, calculating the net investment income (NII), going forward, requires some adjustment since no pro-forma projections were provided before/after the merger with her sister funds.  So to estimate the fund earnings and distribution coverage we will add up all the prior four funds trailing 12m NII, subtract the 1H of the year, adjust for the merger shares, strip out the UNII, and then calculate the “earned yield” assuming that the last six months cash flow a reasonable basis for a projection. 

	PSW	PSY	BPP	BTZ	New BTZ	comment
2012 NII (in 1000s)	7109	31100	14031	48604	100844
1H12 NII	3664	15767	7116	24638	51185	subtract
DIV (in 1000s)	7652	29898	14046	48700	100296
UNII						distributed
adj. shrs (in 1000)	7679	32712	15867	51828	108086	merger adj
2H earn					0.9189	annualized
current div				0.0785	0.9420	x12
earnings at this px				13.75	6.68%	px on 12/27
distrib at same px					6.85%

The point of all calculations was to determine how well covered the current distribution is.  As of right now, the portfolio is under earning the payout. I don’t think it’s concerning since the potential merger synergies have yet to be captured (lower expenses from one fund rather than four) and most funds can tolerate a small amount of under earning, if they have routine trading activity that leads to profits.  Blackrock has a history in this product lineup of adjusting distributions to match earnings, so it’s unlikely a large mismatch would be permitted for a length of time.  My view based on the pro-forma analysis is that the 6.85% current yield is adequately supported, and the downside is a .2c/mo. cut, which puts the fund at the earned yield of 6.68%.  Note that the most recent distributions are classed as partly returns of capital (ROC), but that can be explained by the UNII buffers being wiped out by the merger.  The unification forced all four funds to distribute accumulated UNII prior to closing.

Let’s take a look at the current discount of -9.50% versus net asset value.  BTZ has historically traded at an average discount of -10.12% since release, as advisors who were burned by recommending them once, as well as end investors, stayed away.  The changes in the portfolio and management do not appear to have convinced many allocators.  In addition, in some screening tools (such as Morningstar’s) BTZ is not characterized as what one would expect: as either a multisector bond fund, or an intermediate term bond fund; instead it is considered a conservative allocation fund (a more typical example might be the Wellesley fund).  I don’t know why that is – it may be a statistical artifact driven by correlations, or a function of the preferred holdings (which looks like equity to many analysis packages), or simply because of the name.  The effect of that is that when retail investors go hunting for yield ideas, and run simple screens, BTZ may not show up in all typical searches for leveraged taxable income CEFs.  So despite its functional earned yield, and hefty discount to NAV, it’s overlooked.  To put it in perspective, typical pfd. CEF’s trade with only slightly more yield, and much more duration, and tend to be at roughly NAV.  And comparable (in terms of distribution yield) junk CEF’s are also more typically flat to NAV.  

Sometimes large discounts to NAV are warranted; one typical case is egregious management fees.  The portfolio management fee runs 65 bps on the total assets, and when converted to a fee on the net assets (by multiplying by the typical 30% leverage the fund runs) it works out to 85 bps in mgmt. fees, and 107 bps in total.  Compared to a cohort of 50-60 comparable taxable funds that I follow, with an average fee of 82 bps, it doesn’t seem that the fee is wildly excessive, and causing the discount.  In prior years, expenses were held to 100 bps, which seems possible now that all the legal machinations are over.  An excellent investment grade corporate open ended fund like PIGIX, run by Mark Kiesel, costs 50 bps which is a reasonable analog.  However PIGIX offers a current yield about 200+ bps less, and costs NAV, unlike BTZ, which is discounted.

Is the discount warranted because of excessive risk?  Again, going back to the same peer group of funds, the market price volatility of the typical bond CEF is about 13.5%.  BTZ is significantly less volatile, at 9.3% reflecting the more stable investment grade names it holds.  The NAV volatility is 3.8%; those ratios are fairly typical in my observation.  The effective leverage adjusted duration is 5.5, which is somewhat less than either PIGIX or the low cost LQD alternative (both are in the 7’s).  I would argue that this is -- if anything -- lower risk than many other offerings.  In terms of yield/volatility – a quasi-Sharpe ratio – it seems very attractive at .74, and is among the top ranked on that dimension in my screens, in its cohort.

BTZ, in its new incarnation, is a large CEF at 1.5 Bn in AUM, and that could draw in new holders as the fund can now soak up larger allocations from professional liquidity constrained CEF investors like the PCEF ETF, RiverNorth, FirstTrust etc.  Compared to AWF, a similar sized fund, it has only 100 bps less yield, but trades 1300 bps cheaper on a discount to NAV basis.  It seems reasonable to trade a touch of run rate yield, for the chance at capital gains from tightening discounts, as well as the increased margin of safety that buying cheap offers. 

Lastly, there are huge embedded carry forward losses available for the fund to shield gains for a number of years.  Even though it’s unlikely that the management co. will be able to generate massive capital gains from trading, those are another small plus, especially for holders who might consider placing this in a conventional taxable account.  It also creates a mild incentive sometime in the next five years for a fixed income OEF in the Blackrock fund family, perhaps with large unrealized gains, to swallow up the CEF for the tax benefit.  Paying NAV in that situation could work out well for both sides.  That being said, that particular play is an extreme long shot for value realization.

In summary, the attractions of BTZ are:

·         Sustainable, earned yield of 6.68 % in world of low yields

·         A discount to NAV of 9.5%, providing a margin of safety, and a chance for capital gains

·         A discount wider than most peers, which appears unwarranted

·         Lower volatility compared to peers, both in terms of price and NAV

·         Investment Grade portfolio, although on the borderline low end of that in aggregate

·         Solid prospective Sharpe ratio

·         Functional management  

·         Acceptable fee drag

·         Liquidity and size

The risks include

·         Some small downside to the distribution

·         If systemic / liquidity risks flare up, closed end funds tend to trade at deep discounts

·         If default rates spike up, the exposure to credit could lead to impairments

·         Management may do capricious things, such as unwarranted fee hikes

In full disclosure, the author has long exposure in certain accounts.

Banks & Sovereigns - Why are they so intertwined?

Occasionally, I am asked why I care so much about a bank’s parent sovereign when evaluating them. Here’s a short comment on why I believe the two are strongly interrelated and why bank risks cannot be considered in isolation of their country. This is from the perspective of a market practitioner rather than a regulator or academic.

There are five essential connections between modern banking systems and their host country that makes the two systems vulnerable to shocks between each other. These connections include:

•                     Fractional Reserve Lending

•                     Central Banking

•                     Fiat Money

•                     Depository Insurance

•                     Regulatory Control

Fractional reserve banking means that banks can take in deposits and subsequently loan out most of the funds, while keeping only a small percentage as cash in their vaults. Think of this as the bank borrowing money in the short term (such as taking in deposits) and lending it for the long term (like making a mortgage loan).  As long as short-term interest rates are lower than long-term interest rates, banks make money on the difference between the two since they “pay” the short-term rate to depositors and “receive” the long-term rate from borrowers.  Keep in mind that this cycle repeats itself: The borrowers spend the money that they borrowed, which ends up in the hands of another person who deposits it with a bank.  That bank then loans out most of these deposits, and the cycle continues.  As this cycle keeps getting repeated through the economy, these deposits are effectively multiplied many times over, allowing the amount of money created (“printed”) by the central bank to grow larger. When the financial system is functioning smoothly, the system is stable because depositors do not need their money all at once. The amount of reserves that need to be held for the demand deposits (i.e. cash in the vault) is a key connection between the sovereign and the bank system.

Central banks are the only entities which can print currency, and while enjoying such rights they also manage the money supply and short term interest rates for the sovereign. In addition to those roles, central banks have a key nexus with the banking system in their role as lenders of last resort during times of financial crisis. When depositors are fearful and demand to be repaid, banks may not have enough cash on hand to meet claims. If banks are properly performing their economic role of transforming short maturity lending (i.e. deposits) into longer dated lending, then the risk of a bank run is an ever present possibility for any bank, no matter how well a bank’s loan portfolio may be performing. Central banking addresses the risk that depositors may not be able to claim their money by providing emergency funding for member banks.

Over the course of monetary history, money has played its role as a medium of exchange and store of value in many forms – metals, shells, arrowheads, even cigarettes. Fiat money is a form of currency that is non-convertible, defined as legal tender, and lacks intrinsic value. Modern fiat money has the property that its value is unmoored from anything tangible: prior to the 1971 Bretton Woods withdrawal, foreigners could redeem a US Dollar via the “gold window” and collect physical gold at a rate of $35/oz.

Governments retain the ability to decide what fiat money can be used for (all debts, public and private) and can declare various contract terms to be illegal (such as gold clauses). Government’s ability to change the rules around the unit of exchange, by fiat, is another manner that tethers banks to their parent sovereign.

Depository Insurance is an additional way that banking systems are conjoined with their governments. There are many ways to set up a depositary insurance system: they can be prefunded, or losses can be mutualized on an as needed basis, and there is debate on what is a rational way to assess costs, and then upon what scope of activities. However, even when limits are fairly low for coverage, during a time of systemic strain, a commercially operated insurance system may be unable to meet all claims, without having a backstop. For example, the FDIC, as a US government chartered corporation, is able to call upon resources that ordinary insurance companies would not be able to summon. In exchange for providing this extraordinary coverage, the FDIC is able to exercise close supervision of certain banking activities. This explains why deposit insurance is another way that banks and sovereigns end up linked, and how a financial virus can flow between the two.

In addition to the controls that the FDIC, and its international analogs, place upon banks, there are other regulatory controls that the sovereign can impose on banks to meet political objectives. Examples might include Community Reinvestment Acts, Anti Money Laundering Laws, Capital Reserve Rules etc. These all end up reducing the pure profit motivations of the banks and blur the difference between a commercial bank, and a “policy” bank such as the GSE’s. The ability of the sovereign to impose/change these requirements, perhaps arbitrarily and capriciously, and often for its own convenience is another aspect of the interconnection between banks and the sovereign. For example, when FannieMae and FreddieMac needed to shore up their capital during the beginning stages of the financial crisis, regulators assigned a highly attractive risk weighting to their junior securities for any US bank that held them for regulatory capital.  Many banks gorged themselves on these since the preferreds delivered higher current income than other comparable zero risk weighted assets; of course in the fullness of time those banks took massive capital losses. Remember that these regulatory levers extend beyond the narrow definition of “banks” and cover the entire financial system: insurance companies and pension funds can just as easily be directed to hold more government bonds by a shaky sovereign having trouble financing a deficit.

After reviewing all of the above, I hope this briefly explains why I consider a bank’s risk profile to be highly intertwined with its parent sovereign’s risk.  Sovereigns are the ultimate backstop for the banking system while banking systems are important ongoing financiers of government borrowings. There is a long history of their mutual problems ending up contaminating each other, so taking an approach that the two are truly independent is unwarranted.

mREITs and Computing "Expense Ratios"

I tend to think of the mREIT sector like closed end funds: they are basically levered up bond portfolios, with in rare cases some tiny sideline businesses that may add a smidge of fees.  But basically to me they are like mortgage CEFs.

However, I find their fee structures somewhat opaque.  (Perhaps kudos to TWO for being fairly plain about their mgt fee)  So I tried to back into what their expense ratios would look like, if they were measured the same way as CEFs.  I compared my calc's to some other numbers I've seen, and they seem in line.  Unfortunately, I could not run the whole sector, as there are many new sponsors, and I don't have 12m costs for them yet.

My main takeaways from this are

• there is quite a range of fees and I doubt investors notice nor care, blinded in the pursuit of fat yields
• levered mortgage management is very expensive in general (compare to Wellington's cheap GNMA funds available for something like 10-20 bps)
• these are pretty close to what you would expect to pay in CEF land, when you exclude interest costs.
• credit sensitive mortgages are costly in terms of analysts, data, trading etc.

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Ticker	Equity	T12M Op Ex	Interest	Total	Mgt Cost	All In Cost
HTS	2,080	19	145	164	0.91%	7.87%
ANH	1,010	15	89	104	1.44%	10.28%
AGNC	6,212	91	285	375	1.46%	6.04%
CIM	3,683	58	152	210	1.58%	5.71%
NLY	15,793	253	480	734	1.60%	4.65%
IVR	1,917	35	155	190	1.83%	9.92%
CYS	1,077	24	19	43	2.22%	3.96%
TWO	1,270	31	23	54	2.46%	4.25%
RWT	893	51	99	150	5.69%	16.79%
PMT	546	48	17	65	8.76%	11.87%

After looking at all this, I realize what a good deal certain levered mortgage OEF's are.

What I find disappointing, given how much efficiencies of scale/scope are in money management, is how the larger trusts do not seem to get more efficient as they scale up.  Running an incrementally larger amount of money doesn't cost as much as the earlier pool, so I would expect that that as trusts grew larger than 2bn they would see their costs grow more slowly than AUM.