Wednesday, February 1, 2012

JQC: Profiting From A Metamorphosis

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:
Ticker
Fund
Market Cap
Effective Leverage
Yield
Premium/Discount
JQC
Nuveen Multi-Strategy Income & Growth 2
1196
19.7%
9.1%
-9.3%
BLW
BlackRock Limited Duration Income
630
27.6%
7.4%
1.1%
EFT
EV Floating Rate Income
576
34.7%
6.5%
-0.7%
EVV
EV Limited Duration Income
1876
29.3%
7.8%
-2.9%
EFR
EV Senior Floating Rate
518
36.8%
6.7%
1.3%
PPR
ING Prime Rate Trust
805
30.2%
6.4%
-4.9%
VTA
Invesco VK Dynamic Credit Opportunities
847
23.6%
7.6%
-6.8%
VVR
Invesco VK Senior Income
821
36.3%
6.3%
-6.2%
JFR
Nuveen Floating Rate Income
548
20.4%
7.2%
-2.4%
ERC
Wells Fargo Adv Multi-Sector Income
646
25.1%
7.8%
-5.9%
Peer Average

807
29.3%
7.1%
-3.0%

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

5 comments:

  1. You say that you scan the markets looking for bargains, opportunities the markets have overlooked.

    A wiser perspective is that the markets are full of some very smart people...some with information that has not been made public. And these people are engaged in buying and selling until stocks are appropriately priced. Mostly, they force small movements in the prices. Yet, I gather you feel you are finding large price discrepancies. I'm guessing a small investor is only seeing the discrepancy between actual prices and the information available to the general public. Insiders looking at this picture, enjoying superior (inside) information and enjoying an insiders perspective, likely see that the share price is appropriate for what they know.

    When a stock looks wrongly priced to a small investor, he should cautiously assume that others have superior information or perspective. He is not in a position to be "correcting" the market mechanism. If he tries to assume this role, he will find himself losing out to his betters.

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    Replies
    1. I see your subsequent comment below, but since this is an interesting philosophical question I thought it was worth responding specifically to your initial post.

      There is academic evidence both for and against "efficient" markets, with peer reviewed published articles giving a variety of degerees of efficiency in markets. As a result, you can pretty much find research to justify whatever position you wish to take on the issue and making a strong statement either way on the efficiency of markets is like proclaiming that XXXX is the one true religion and all others are false. Consequently, I am quite comfy to live and let live on this subject. If someone is a firm believer in efficient markets and views all individual securities selection as a waste of effort, fine by me. By the same token, if someone views markets as fundamentally inefficient and Mr. Bogle is essentially a pied piper, I am not about to argue.

      Personally, I think that markets are somewhat efficient. The more liquid and highly followed a market or specific security is, the more efficient that market is. It is highly unlikely that an individual investor would find a significantly mispriced treasury bond, for example. However, when markets are less liquid or watched or start to break down (e.g. the financial crisis or the flash crash) they become significantly less efficient. In extreme cases, markets can be inefficient to the point of dysfunction (like early 2009 when I was buying 5 year maturity investment grade corporates at double digit yields). So when you think that you have found a mispriced security, a good gut check consists of the following:

      - Is this market likely to be efficient or not?
      - Are there reasons why this asset might be mispriced?
      - What are other investors who are selling or shorting this asset looking at?

      Caution and careful due diligence are essential survival traits for any investor regardless of what they invest in.

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  2. I responded above before reading your full post. I have to admit, you make a compelling case for this trade.

    I'm wondering if the discount to NAV is to account for unrealized losses in the portfolio. As the fund shifts to a more conservative strategy of senior loans, they will sell off assets that perhaps have losses associated with them. These will then be "realized" and investors may find the stated NAV discount evaporates.

    Am I understanding correctly how these funds operate?

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    Replies
    1. The NAV is marked to current market every day by the fund sponsor (Nuveen in this case). There are no unrealized losses in NAV as long as Nuveen is correctly marking the fund's investments. I particularly like Nuveen CEFs in part because the company publishes a spreadsheet once a month that shows every single asset in each fund and the price at which they have marked it. So if you wish to sniff through their marks, you can do so extensively.

      I think that the reason for the fat discount versus the peer group of senior loan and short duration funds is that the fund is not yet viewed as being among that peer group. Once the fund gets reclassified as a loan or short duration fund, I expect the discount will narrow since it has the widest discount by a large margin.

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  3. Looks like other investors have started to get the idea:

    http://www.forbes.com/sites/katestalter/2012/02/06/open-your-portfolio-to-closed-end-funds/3/

    ReplyDelete