CEF Insights Quarterly Review: January 2023 Interview - Tom Roseen

Tom:

Diane, thanks for having me. Great to be here.

Tom:

Well, Q4 was an interesting one. Basically started with a bang, October, November, fantastic returns. And then we ended the quarter in December with just a whimper. It's interesting, all the headlines were talking about China's lockdown being rescinded and slowly but surely, and now we know that they have taken that off, but it was just early on in the quarter they were talking about that. We were talking about soft landings in the economy. The Fed had raised interest rates three consecutive months in a row, 75 basis points, and then another 50 in December. I mean, so people were saying maybe we're approaching a soft landing. Goldilocks employment reports and really Q3 earnings were pretty good. I mean, everybody was expecting kind of more of a disaster than it was. But then the concerns, I think realization that inflation was rearing its ugly head, that recession was possible and that even with better than expected nonfarm payrolls even recently, that that really supported the Fed really keeping that foot firmly on the brakes.

And so we had a Tale of Two Cities if we take a look at Q4 and what the returns were like. And this was all really based on one thing. And I say it's one thing, but it is the yield curve. It's what the Fed has been doing. And the yield curve remained inverted at the two-year yield over the 10-year yield. And I know 99% of the people already understand this, but the two-year yield is generally lower than the 10-year yield. You and I, if we put our money, lock it up for a number of period of time, we want to have a higher return at the longer end than we do the shorter end. Well, recently that has not been the case. And in fact, we've been talking about the inversion of the two-year yield against a 10-year yield for quite some time.

But what we did notice here in December, and it actually started in November, is that we started to see that the one-month yield was actually higher than the 10-year yield. And this is not something we've seen for quite some time. So from about November 15th to December 30th, we saw what's called an inverted yield for the one-month yield versus a 10-year yield. And we saw some of the biggest moves during the quarter at that one month level. So the one-month yield for the treasury yield ended up at 4.12%. That's really quite high from whatever at the beginning of the year. I think it was at 0.03 or something ridiculously low like that. But they saw 133 basis point increase. The two year we saw about a 19 basis point increase for the quarter, and this is all for Q4 to 4.41%. And then the 10-year yield only saw about a five basis point increase for the quarter to 3.88%.

And the reason I point this out is this is what actually made a very good quarter for us. Prior to that, we've been seeing fixed income funds really just get hammered. Equity funds just get hammered. And this turned out to be a really good quarter. In fact, this was the best quarterly returns that we have seen since Q4 2020. That's a pretty big statement. And the average closed-end fund returned 4.93%. Now, I know people say the average closed-end fund, well, equity funds actually returned 6.4% overall, and on the fixed income side average return to 3.82%. So really this issue, this consternation of whether we're hitting inflation or recessionary periods only impacted us during the month of December, and that's where we suffered monthly returns for the first month in three. So if I take a look at this again, December returns, we see the average fund lost about 1.50%.

Equity funds lost about 3.12%, and fixed income funds only declined about 0.27%. So this was a good story, but I do want to wrap up the one-year period of time. This was one of the worst one-year periods that we have seen since 2008. So when we take a look at this, and I'm sure everybody's read that as well. The DOW posted I think the worst return since 2008, the S&P, et cetera. The NASDAQ actually had worse years, but 2008 was about twice as much as these losses. So I do want to do a little comparison - contrast. So the average closed-end fund is down about 11.23% for the year of 2022. Now, if we look at 2008, and again, this was the worst return this year that we've seen since 2008. 2008 was much worse. The average closed-end fund was down 30.30%.

But what is maybe more alarming is in 2022, we saw that all funds were down about 11.23%. Equity funds were down about 9.98%, and fixed income funds were down 12.21%. That is something we do not normally see. First of all, we generally don't see fixed income doing that poorly. I mean, we've always been in what I'm going to call a bull market for fixed income funds. That's not the case any longer, right? Interest rates are rising. There's an inverse relationship. So we saw a very correlated performance for the one-year mark. And I know people say, well, 9.98% minus versus 12.2% is not highly correlated, but it certainly is very correlated at that. So those are the things that we saw. But for 2022, there was some light at the end of the tunnel, if you will. I mean we saw natural resources funds up 22.06%.

We saw energy Master Limited Partnerships up 20.24%. And then on the bottom side we saw convertible securities, which by the way had a fantastic 2020 and 2021, but they were down 23.92% for the year. Emerging markets were down 23.67%. And I know people are probably listening going, wow, all these numbers coming at me. But the reason I'm highlighting this is it is showing us some opportunities and changes on the fixed income side.

Everybody thought we were going to have this inflationary period. It didn't turn to pan out. I mean we're in inflation. But at the long end of the curve, people are discounting it that the Fed's going to take care of it. It's loan participation funds that mitigated losses better than other funds in the fixed income universe, but it still lost 4.45%. The US mortgage closed-end funds down 5.97%, but the big losers were munis, High-yield muni lost 21.14% for the year. The next worst category was emerging market debt losing about 18.99%. So, this really was a story about differences and about changes, certainly alarmed about the year, but wonderful quarter end. I think it sets us up for a better 2023.

Tom:

Well, let's talk a little bit more about the macro groups. I often talk about equities and fixed income, but we break those down into three different groups. And so on the equity side, what we saw was mixed asset funds did a better job mitigating losses than they did for the other groups. So they lost about 2.01%, but world equity funds lost about 2.78%, and domestic equity funds were down 3.58%. So really we saw, I'm going to say people putting the brakes on domestically, we really had a strong run-up, but they really were kind of questioning how badly they wanted to punish the world, the global side of the fence. And this shows up in the fixed income side, which we were taking a look at the December returns on the fixed income side, world bond funds actually were up 0.58%, and taxable domestic bond funds were only down 0.26%.

Munis still took a little bit on the chin, but again, for December wasn't too bad. Most of their losses were done in the prior months, but muni bond funds were down 0.53%. So that was kind of the story for that. But looking at the individual groups now, kind of the best performers and the worst performers on the equity side, again, it was down 3.12% for December, but developed market funds were down minus 1.12%. Preferred income, so income and preferred stock funds were down 1.39% and sector equity funds were down 2.41%. However, the pariahs of the group of this equity universe for December. Energy Master Limited Partnership lost about 5.87%. Diversified equity funds on the closed-end side obviously on a NAV basis lost 5.16%, and natural resources lost about 5.15%. Now, if we move now towards the fixed income side, which again only lost about 0.28%, as I said earlier, we saw emerging market debt rise to the top. This bit that China might be able to start opening up its borders and doing a little bit more trade and free up that strong COVID-19 restriction that they had.

Well, emerging market debts were up 2.2% for the month. High yield funds, so people were putting risk on, were up 1.3% and global income funds were up 0.16%. So here's kind of that story I was belaboring in the one-year return portion is that we are seeing some change. Now on the downside, we saw safety not do so well. So the triple B rated corporate debt funds leveraged lost about 1.25%. New York munis lost about 0.8% and then high-yield munis lost about 0.72%. So overall we would've had a much better quarter had we not had December happen. But even with the declines in December, Q4 was really pretty strong.

Tom:

I do think we saw tax loss harvesting in December, but I think there was so many things going on at once. And again, it wasn't just another 50 basis point hike that we saw by the Fed, but also that really collaboratively the Fed came out and with their dot plots and said, hey, listen, we're looking at a terminal rate for the Fed funds rate to be more like five and a quarter in that area, when in September they were talking about being like four and a quarter. So I think that between that, those losses, the really strong gains that we saw in Q4 and also us leading up to Q4 earning season, I think some investors may have just taken some of those hard won profits off the table. But in fact, we do know that people did do some tax loss harvesting in order to capture those losses, offset them. And this may set us up for January gains as people get back by that wash rule of selling those in 30 days or less, so.

Tom:

We saw, I'm not going to say meltdown, but a really large widening during the month. And the median discount for, and the reason, by the way, I use median rather than the average, averages that there are some funds out there, I'm not going to name them off the top, but have 100% or over 100% premium. There are funds there that have a 30% or 40% discount. So what we like to do is get rid of that skewness of that data and take a look at the median, kind of right in the middle. So we saw the median discount all funds for December. Now, and this is obviously on December 30th, because that was the last trading day of the month, widen about 260 basis points, widen or worsened to 9.92%. Now equity funds saw about, and again, remember everybody says, well, it's not the average, so you can't really compare these. But equity funds saw about 256 basis point widening to 10.75%, and fixed income funds overall saw about 252 basis points widening or worsening of their discount to 9.61%.

Tom:

Well, they are much wider. I mean, I'm going to say almost a doubling since a year ago. So I'm going to give you January 31st, 2022. And when you count the months that's actually 12, as everybody knows instead of doing it from December. But basically we saw that at January 31st, 2022, the median discount for all funds was at about 4.59%, while as I told you the most recent one on 12/30/2022 was 9.92%. And how that broke out for equities a year ago, 4.71% discount. Now we're at 10.75%. And for fixed income, 4.55% and now we're at 9.61%. So it really was quite a widening that we've seen. And it really goes hand in hand with what happened in this last quarter. Because it was actually doing a little bit of improving over let's say October, November and December. It really just took a shot down. As again, the realization that we might be heading for recession, we might have more inflationary concerns around there. And of course, ahead of the Q4 earning season, people just want to keep their heads down.

Tom:

Well, the high-yield closed-end funds macro groups. And so again, when I use the words macro group, it means that we're taking high yields from all the categories and putting them together. Basically saw the largest widening of discounts. It was 453 basis points to 9.35%. Now, that might tell you that high yields actually had a really nice discount prior to the December month end. But again, to see almost a double in that category was I don't think amazing. People were trying to take a little bit of risk off. High yields certainly had that, but the most, I'm going to say the smallest widening of discounts we saw from World Equity Macro Group and those in the equity funds group, and they only saw a widening of their discounts by about 53 basis points to 12.64%. So still pretty high as far as the discount goes, but certainly they weren't punished as severely as some of the other groups.

Tom:

I think we may see some benefits from that, especially if investors, I'm kind of answering your last question first. If we have investors that are looking at opportunities to buy in something they wanted to be in anyway, but they just did it for tax loss harvesting for tax purposes, once they hit that 30 day kind of limit to be able to avoid the wash rule that has to do with tax loss harvesting, I do think there are opportunities. Now that said, I think we have to remember all eyes are going to be, and I've mentioned it three or four times at least already, Q4 earnings, this is going to be a very important period for us. An employment report just came out recently, and in the unemployment report, we actually had a better than expected number of new jobs being put out there by the US economy.

But one of the things, if you dug deeper into the report, we did see that there was some sort of degradation in the part-time or if you will, seasonal employment going down a little bit more than people had thought there was going to do. And this is because people are concerned that we are hitting this period of time where we could have inflation or a period that's going to cause a recession or even people have not been kind of floating out the term of stagflation anymore. But certainly that's a concern that we have inflation continuing up and kind of a stagnant economy coming around. But if you take a look at those, the idea that we've, again, I've told you that the premium discounts were just monstrous, right? A doubling in some cases, but in most cases rising about 250 basis points. There are some classifications that are probably worth taking a look at.

But again, not for the faint of heart. For instance, we know that the dollar has weakened against most of the major currencies for the quarter. Now that's not true for the year. The US dollar really did well, but if we are starting to see the fading of the strength because of this inflationary pressure, interest rates going up and the like, but at the long end kind of coming down, emerging market funds were down 23.67%, developed market funds were down 19.92% for 2022, and global funds were down 18.89%. So is there an opportunity to get into some of those international and global regions at a very deep discount and also after being punished quite severely? Well again, we all could jump in and we could be in another year of downturn. I mean, if we take a look at some of the other periods of times where we lost in 2008 or in other periods where we saw a big period of downturns, usually the next year does pretty well.

However, we have seen a couple of time periods, take a look at 2000 to 2003 where we had multiple years of down that didn't turn around until that third or fourth year. So I would be cautious here, but again, these are some opportunities we could do. Also, high yield munis down 21.15% for the one-year period, unheard of. I don't know anybody that would've ever thought that high-yield munis, of course it's high-yield, but 21%. Emerging market debts down 18.99% and then New York munis are down 18.52%. But again, I do want to caution people while they're looking at these numbers, trying to find a very wide discount is recessions can play a very big deal on municipal bonds, right, on the debt that's out there. Will they be able to service their debt load? Will the cities and counties be able to make those payments as we get into a recession? That's going to impact the collection of money there as well. So those are some opportunities for us, but again, I don't believe they're for the faint of heart.

Tom:

So for the quarter, interval funds underperformed their conventional closed-end fund counterparts. And I think that might be expected. This is something where we had a very strong return. So if you were in the close-end fund space, but in the conventional space side, you may be able to make some other buys and sells that you may have not had the opportunity to do on the interval side of the fence. And where this example shows is, for instance, when we take a look at it, so the traditional closed-end fund real estate fund actually returned 3.27% while the interval fund posted at a loss of 1.93%. Sector equity funds on the interval side only gained 2.3% during the quarter while traditional closed-end funds were up 8.02%. And one of the last examples, and I have numerous to, I could ramble through, but it'll be lost on the listeners, but global income funds, actually saw about a 2.82% rise for interval funds, but 5.2% gain on the traditional or conventional closed-end fund side.

Now, the reason I cite that is what a difference we saw. So if we look at the loss end of it, the one year, remember all these big losses, biggest loss we've seen since 2008, really what we saw was interval funds mitigate losses better. So on the real estate side, which I just rambled off for the quarter, basically we saw interval funds on the real estate side returned 3.5% return while the average fund on the closed-end fund or average real estate fund on the closed-end fund side lost 28.46%. Wow, what a difference. Same thing with sector equity funds. On the interval fund side, 1.05% on the traditional closed-end fund side down 17.94%. The reason I highlight these is because we've been looking at these as interval funds. As you know, you really need to be able to make it through the rough patches, right?

This is one of the rough patches. When it's going down, it mitigates losses better. But on the upside, there may be opportunities that are missed by not being on the conventional closed-end fund side. I think more study needs to be done in this area, because this was really kind of phenomenal numbers. Every single interval fund or the average interval fund classification underperformed the traditional on a quarterly basis, but outperformed in a really tough year on a one-year basis. So we might be able to use these type of trading tools to help us, if you will, immunize our portfolios. Again, more to be done on that.

Tom:

Again, I think that this is where we need that study I was just talking about. So for instance, if I know that I'm buying these and I'm really not buying them, obviously there is no discount advantage. So what I'm looking for is, I'm going to call it private equity or private fixed income exposure. Something I don't expect a lot of liquidity for, and I'm willing to hold those for a long period of time. I think that you could look at real estate, you could look at general bond, you could look at global income, which did a much better job mitigating losses over that one-year period of time than their conventional closed-end funds.

That said though, again, I mean a lot of folks listening to this are probably pretty active traders and they're going to be looking at the quarterly results of why interval funds did so poorly. Not all that bad, but in the upmarket why they didn't outpace their conventional closed-end funds. So that's the area that I guess I would take a look at is, looking at these for income, you're certainly not going to get the benefit. There is no discount that you can benefit from, but certainly if it's a long buy and hold, it may be used for, again, mitigating losses in downside performance and maybe a hedge against that opportunity of loss.

Tom:

The new funds, the IPOs were by far much higher in the interval side. We had 22 interval funds that were created in 2022 versus on the conventional closed-end fund side, we only saw five new funds come to offer. So that was kind of unique. And this is really compared to, so five to 22, right? That's quite a big spread. In 2021 in comparison, we saw 13 conventional closed-end funds come to market and 24 interval funds. So really obviously the preference was almost one to two in 2021, but it's almost three and a half times larger for 2022 on the interval fund side. So there has been a really large change in preference, I guess, at least for now, for the fund management companies to actually offer closed-end fund interval funds rather than just conventional funds.

Tom:

Diane, thank you for having me. Great to be here.