In this post I am going to explore how I think about the new wave of ASX listed fixed income closed end funds (CEFs). To be clear, I am not referring to various fixed income ETFs that are open ended. Regarding the CEFs in this sector, I am not very optimistic from this point in time. Well that is unless you are the fund managers offering them. They are clipping some juicy fees and as a result appear addicted to issuing more shares.
Another point I wish to clarify about this post, is I am assuming the investor sees liquidity as reasonably important. That is, the way I define this, as the ability to sell at very close to the stated NTA. I suppose if you are confident you want to hold these investments indefinitely, a lot of my points I am about to make may not be as relevant. Yet I don’t think many investors fit into this category.
The 3 main reasons I don’t like the outlook for these investments are:
- Potential for a large discount to NTA
- High management fees in the context of expected returns
- Lack of upside potential in the context of the first two points
ASX Fixed Income ETFs vs LIT’s / LICs
I am mainly focusing here on the funds that have more modest return targets. I note that a handful of these investment vehicles have targeted annual returns (net of fees) approximately in the 4-5% range. Some names readers may have heard of are NB Global Corporate Income Trust (ASX:NBI), Perpetual Credit Income Trust (ASX:PCI), Partners Group Global Income Fund (ASX:PGG), Gryphon Capital Income Trust (ASX:GCI) & MCP Master Income Trust (ASX:MXT). This paragraph may have already covered the second point I made above. The management fees aren’t all the same for this bunch, but a broad comment is that the average fee is near 1%. To put it simply, fees represent close to 20% of the expected return. If an equity fund was targeting 10% per annum and told me they were charging a base fee of more than 2%, I doubt it would appeal to me.
If I did want some ASX listed fixed income exposure I would look elsewhere. Some of the open ended fixed income ETFs come far cheaper and sound more appealing to me than the CEF structure. One would have to check the quality and liquidity of the underlying ETF holdings though first. A whole other topic that I won’t address in this blog post anyway.
Why the current premiums to NTA may turn to discounts?
2019 saw many equity CEFs trade at very large discounts to NTA, especially around election time and into financial year end. They have copped a lot of criticism in recent times, most of it justified I think. These new fixed income CEFs have received pats on the back from some of the financial media because they have traded at premiums to NTA.
I think it is far too early in their lives to conclude this is necessarily sustainable. It is not unusual in the CEF life cycle to go through a honeymoon phase early and avoid the inevitable discount issue. They are marketed heavily to launch the IPOs but eventually such hype can wear off. I covered this topic here in a blog post about the stages a typical CEF goes through.
Best ASX LITs / LICs to AVOID perhaps for 2020?
There is no doubt these funds have been given a decent plug to the investing public. If you follow the livewire markets site, these are the funds where the articles are often marked “sponsored”. Renowned marketing machine Switzer has also given them a good run at the conferences I get emailed about every month to attend. At least I can say some of these fixed income CEFs look more appealing than when I get the Switzer emails to invest in Fine Art for yields of up to 10.25%.
Why am I harping on about the marketing aspects? Sometimes I have argued it is a good thing for CEFs. Where I like to see it as after I have bought a LIC at a large discount and that previously it was doing very little in the way of marketing. Demand can therefore improve. In these fixed income CEFs I fear that when the prospects of them issuing more shares dries up, we won’t hear much about them. This contributes to the hype wearing off and a discount to NTA setting in. Just as I blogged about where I linked to the typical stages of the CEF life cycle.
Surge in supply of Fixed Income LITs
For the time being no such problem seems to be around the corner. As I write the premiums to NTA exist. Therefore the fund managers can smell the locked in fee revenue they can get if they can get yet another share issue away. Hence the recent investor presentations at the Switzer conference I referred to.
Of course if there is further share issuance, the subjective argument that shareholders will benefit will be made. That is, it lowers the fixed expenses of the fund, and enhances liquidity. With the five funds I mentioned earlier, if I averaged the fund size it would be about $700 million. At this level I think the fixed expense ratios and liquidity should be fine. In fact, in my view not raising any more capital would enhance liquidity. By that I mean it keeps supply tighter and boosts the odds of the premium staying around. I see liquidity defined as being able to sell these near the NTA. If you constantly keep raising capital eventually you suck out all the potential demand. If a heap of more volume trades, but at a 15% discount to NTA, well I wouldn’t appreciate that “enhanced liquidity” if I was a shareholder.
I am not sure if all of them have raised further capital since their initial IPOs but MCP Master Income Trust (ASX:MXT) have given it a decent old nudge. NB Global Corporate Income Trust (ASX:NBI) haven’t been shy coming to the table to ask shareholders for more money either. Gryphon Capital Income Trust (ASX:GCI) just completed further issuance in November. Perpetual Credit Income Trust (ASX:PCI) is quite new. Yet consider their effort in marketing going on there post IPO. It smells of a fund that wants to lock in more AUM revenue next year through a capital raising. Holders of underperforming Perpetual shares would probably prefer that. Perhaps they will follow in the footsteps of Nueberger Burman, Metrics Credit Partners and Gryphon Capital of dramatically boosting the fund size not long after IPO!
ASX LICs / LITs conflict of interest?
Given these underlying funds are investing in very large markets I am not really sure where it all stops. There doesn’t appear to be a capacity constraint. So I doubt you get a situation like I have seen with equity fund managers a year or two ago declining to raise more money even though they could have got away with it given their shares were at large premiums. For example WAM Microcap Ltd (ASX:WMI) or Forager Australian Shares Fund (ASX:FOR) could have got more money in the door a couple of years ago when listing on the ASX, but they didn’t do so. Therefore I struggle to see in these fixed income CEF cases how a sustainable premium to NTA comes about. I ask myself why they wouldn’t just keep slowly conducting further raisings if the premium exists. Until of course, the premium vanishes.
If you are wondering if I am just imagining all this new supply coming onto the market then the below image puts the sudden surge into perspective.
Even if the fund itself decides to pause in regard to constantly increasing the supply of units, be rest assured there are jealous competitors watching. PIMCO appears to be one example set for early next year but get ready for others. There are probably many meetings being held now from rivals in this space about how we can get in on the action. So if you think some of these funds are special and therefore a premium is sustainable, just keep an eye out for copycats from other fund managers. This will boost supply and suck out further demand from the market. It must be tempting for the fund managers. My guess is that outside of this pocket of marketing ASX listed funds to retail investors, selling fixed income funds now may not be so easy.
I have no issues with the fund managers in terms of their investing capabilities.
This blog post may seem like I am negative about the fund managers which is not necessarily the case. I agree that the asset classes have a useful role to fill in a diversified portfolio for many. The investment skills of the fund manager may well be good. The asset classes themselves may perform perfectly fine, and the fund manager may add some alpha on top of that.
In a good scenario that could mean they may even achieve a bit better than the 4-5% targeted after fee returns that exist in many of these funds. Let’s say they even get north of 5% returns on an NTA plus income basis from here over the medium term. Isn’t that good and they are doing what they set out to? Well I am more concerned with the likelihood of discounts to NTA developing in an asset class with less upside than equities. I also think management fees are too high, but for the moment the market disagrees with me!
Upside v Downside Risk?
Well in the positive scenario I outlined I would say that the performance figures the funds use will look fine. (as distinct from total shareholder return numbers).
However I still come back to the potential increase in supply. In a positive scenario it will encourage more issuance. Eventually I think even if the headline returns are sound, as the CEFs age then investor fatigue will set in, and I expect them to drift to discounts to NTA of more like 10%.
I also think if asset markets remain buoyant, investors could get tired of these and simply sell and chase higher returns in picking stocks. This phenomenon sometimes occurs with the “grandfather LICs”. Discounts can widen during the end stages of a bull market as investors sell these thinking they can earn 20% per annum for the rest of their lives picking their own stocks instead.
Coming back to my earlier point of assuming the investor values being able to have the liquidity to sell shares near NTA, then that is a problem. If you have a patient time frame of 5 or so years, but pay a premium to NTA now to invest, the total shareholder return may not be so great. The discount to NTA problem is magnified when you are investing in funds with modest return targets (i.e. less upside). If they do very well and hit targets of about 5% per annum over the next 5 years, but then you sell at a 10% discount, suddenly the returns are not a great deal better than cash. I am assuming if you pay the current premiums to NTA.
Of course it could be worse if such discounts develop within a year and you want to sell. Perhaps that seems unlikely? Well the CEF market is very fickle. How else do you explain for instance L1 Long Short Fund Ltd (ASX:LSF) IPO investors? Only months after committing funds, suddenly wanting to sell at way below NTA because the fund went through a rough patch? Part of the problem is when you combine huge capital raisings and use heavy marketing. Advertising which sees the shares get sold into “weak hands” who don’t understand their investments well enough. Is that a fair description for the current wave of fixed income CEFs hitting the market?
So in the scenario where at the fund level performance with these fixed income CEFs disappoints, it would look worse. I would at least expect in that scenario the issue of new funds coming to the market pauses or even ceases. However I see problems in regard to the investors potentially not having a great understanding of what they have invested in. That can lead to less conviction and a temptation to hit the sell button pretty quickly, regardless of what discount it trades at. If you visit forums like Hotcopper occasionally you will notice investor’s easily justify selling at a large discount. They simply blame the fund manager rather than themselves for paying the premium. They get angry, feel like selling is fixing up a problem that was the fund manager’s fault, and quickly move on.
If this sort of anger sets in at some point in the future, that might be the point at which I would be keen to examine these type of investments. From an angle of potentially profiting from takeovers or wind ups as I discussed in this previous blog post
Perhaps fixed income funds are special and won’t suffer from the same discount issues as equity LICs?
Perhaps but I wouldn’t want to bet on it. I sometimes invest in CEFs on the New York Stock Exchange, and there is a lot of choice available for fixed income funds. In the US I would argue that the fund’s generally have better governance on the issue of discounts, and there are more activists circling them also. Despite that I have seen numerous examples of fixed income funds trading at double digit discounts to NTA there. I don’t view the ASX ones as doing anything particularly special to warrant any sort of premium, especially given the fees they are charging.
If you want to see the general odds of various CEFs have of retaining the premium to NTA I think it is worth checking a couple of sites. You can google “Morningstar LIC report”, and “closed end fund connect”. The former does a monthly LIC report and you can open in up and view how many of the universe are at premiums vs discounts. The CEF connect site covers the US CEF market and you can use the “fund screener” tool to sort the universe by discount. Interestingly, with this screener you can choose to just view the fixed income category if you like.
Not to worry if you have persisted with reading this blog post up to this point
Before I get trolled by either the fund managers or investors here I want to point out I don’t have any positions in these funds long or short.
At the time of writing now, an investor has probably made sound returns so they are more correct than me at this point in time. If they wanted to get out of these type if investments they could do so successfully. Or stay invested if you think this blog post is like others you may have seen here. Just a clueless guy with too much time on his hands, harping on about listed managed investments he doesn’t like!
PIMCO ASX LIT IPO next?
Things are looking good for the fund managers in the shorter term anyway. My views here may well be mistaken. Just look at plenty of other views on this blog that have proved wrong! At least in the short term I would imagine the fund managers can raise some good money in early 2020. So no need to be depressed if you are a fund manager. Get to work searching for those google images of the elderly sipping coffee happily glancing at their investments on the laptop. Insert a big headline figure of the expected yield to go on the front page of the prospectuses. Then headlines such as “Are you sick of pathetic term deposit rates?” etc etc.