Hitting a Single With A Fund Under Transition
In a prior post (http://lifeinvestmentseverything.blogspot.com/2012/01/how-to-buy-dollar-for-90-cents.html), I explained how I scan the world of closed end funds (CEFs) for bargains. Usually the realization of excess value requires patience, and the time you must wait can extend well over a year. However, from time to time an opportunity presents itself in the CEF world which offers a far more timely excess return. The Nuveen Multi-Strategy Income & Growth 2 fund (ticker JQC) offers just such an opportunity for excess potential returns which are likely to emerge within a relatively short period of time.
JQC was originally formed to offer investors a hybrid strategy of high yield fixed income combined with equity exposure through investments in equities, convertibles and preferred stocks. Despite its high (managed) payout and relatively low expense base, JQC has not been popular with investors and has traded at a relatively high discount to NAV (frequently above 10%). The managers of the fund have clearly felt some pressure from investors to improve this state of affairs and late last year Nuveen (manager of the fund) announced that they would seek shareholder approval to change the investment restrictions under which the fund operates and pursue a new strategy. Shareholders approved the changes and Nuveen is now in the process of transitioning the fund from a 70% debt, 30% equity strategy to a 70+% senior bank loan, up to 30% other high yield fixed income portfolio. The fund will also change its name to the Nuveen Credit Strategies Income Fund, remove a requirement to maintain a specified minimum exposure to the financial industry and switch from a quarterly managed distribution to a monthly income-based payout. With the bounce in the equity markets in January, trades are apparently being made in the portfolio:
“The Nuveen Multi-Strategy Income and Growth Fund 2 today announced that implementation of the fund’s previously announced portfolio repositioning will begin January 23, 2012… JQC currently features a mix of debt and equity investment strategies. After the completion of its portfolio repositioning, the fund will focus on a single, broad-based credit strategy with an emphasis on senior loans.” – January 23, 2012 press release
Importantly, once the transition is complete JQC will be classified as a senior loan or limited duration fund rather than a “miscellaneous” or “multi-sector” fund. Why do we care how the fund is classified? Simply, most investors will select a fund from a list of peers in a given strategy based on yield, trailing performance, discount to NAV, expense ratios and other considerations. When we look at a peer group of senior loan and limited duration CEFs with market caps of at least $500MM, it appears that JQC is deeply discounted to its new peers:
Nuveen Multi-Strategy Income & Growth 2
BlackRock Limited Duration Income
EV Floating Rate Income
EV Limited Duration Income
EV Senior Floating Rate
ING Prime Rate Trust
Invesco VK Dynamic Credit Opportunities
Invesco VK Senior Income
Nuveen Floating Rate Income
Wells Fargo Adv Multi-Sector Income
Source: www.cefconnect.com, data as of January 31, 2012
If we average the peer group, it appears that the average discount to NAV is about 3% compared with JQC’s 9% and change discount. In addition, JQC is less leveraged, has a lower expense ratio and is more liquid (based on market cap and daily trading volume) than the peer group. If we were to apply the peer group 3% discount to JQC, the fund’s price would rise from $8.77 (1/31/12 closing price) to $9.38, or about a 7% increase. This suggests that JQC presents an attractive trading opportunity to earn a mid to high single digit excess return over the medium term (months). As JQC will transition to a monthly payout based on actual income, it is likely that the fund will ultimately yield about 7% (the peer group average). So an investor’s prospective return assuming it takes as long as a year for the fund to transition to the peer group average discount would be 7% (discount narrowing) + 7% (fund yield) + the change in the group discount level + the change in the value of the underlying assets in the fund (mostly high yield loans and bonds). If an investor does not want exposure to the underlying assets or the risk that the group’s discount could widen, as easy way to capture the excess return would be to short a basket of funds in the peer group. Such a long/short strategy would reduce the trade to simply capturing the narrowing discount.
Of course, we should always be mindful of the risks of any trade we consider. Nuveen has a track record as a reasonably capable manager of senior loan funds (such as JFR listed in the peer group above), so execution risk on the portfolio transition is likely to be low. More material risks are as follows: 1) it could take longer (or forever) than anticipated for JQC’s discount to the peer group to narrow; 2) the peer group discount could widen if senior loan and limited duration funds fall out of favor with investors; and 3) the value of the loans and bonds in the repositioned portfolio could drop precipitously if the high yield market implodes. All that taken into account, JQC appears to offer a compellingly cheap way to get exposure to relatively well-secured high yield fixed income assets and capture an excess return as the fund’s discount to the peer group narrows.
As always, do your due diligence. We live in an uncertain world and you must be careful. It is quite possible to lose money buying a leveraged junk bond/loan fund.
Disclosure: I am long JQC