Monday, August 27, 2012

Trade Recap: JQC Has Followed The Script

I Love It When A Plan Comes Together

Back at the beginning of February, I highlighted what appeared to be an attractive medium risk trading opportunity stemming from the repositioning of a closed end fund with ticker JQC (see  Aided by a scramble for yield all over the globe, my expectations for the trade have largely panned out over the past 6 months.  This post will detail what has happened with JQC and try to answer the eternal question that stems from successful trades: now what?

As I mentioned way back in February, JQC was about to switch from being an oddball mixture of 70% preferred stock and 30% common equity to becoming mostly a bank loan fund.  A new management team was installed and the asset switch was done.  JQC also switched from a quarterly dividend to a monthly one while maintaining the same overall yield.  Instead of being an orphan strategy which did not appeal to many investors, the fund is now a bank loan/high yield fund which offers a generous payout while taking credit risk and largely avoiding interest rate risk.  JQC is in good company, as there are a number of other bank loan funds which by and large trade at little or no discount to NAV (some are at a premium) and generally find a warm reception from investors because the entire world seems to be chasing the kind of yields that these funds offer.  At the time I first mentioned the fund, JQC was trading at a discount to NAV of between 9 and 10% compared to a peer average of about 3%.  As you can see from the table below JQC is still trading at a modest discount to its peers, but the gap has become much smaller:

Ticker Premium/Discount
JQC -2.78%
BLW 3.87%
EFT 5.98%
EVV 1.02%
EFR 5.84%
PPR 0.00%
VTA -2.62%
VVR 0.40%
JFR 1.67%
ERC -4.14%
Peer Average 1.34%

So JQC's performance has benefited from a discount to NAV which fell about 7% while the peer group went from a 3% discount to a 1% premium, or a 4% tailwind overall.  Aided by a favorable environment for high yield bonds and bank loans, NAVs for JQC and its peers generally ticked upward modestly over the past 6 months as well.  Finally, all of these funds offer a generous yield and JQC shareholders collected $.5335 in payouts since February 1, 2012 for an additional yield of 6.1% (unannualized).  All of this adds up to a total return in a bit over 6 months of 13.7%.  I will leave annualization of that return as an exercise for the reader, but it appears to be in the region of a 25% annualized return.  Not bad for a fixed income instrument and a lot better than the S&P 500's performance with far less volatility.

That was then, this is now.  The question facing anyone who owns this fund is, what to do now?  Clearly JQC is far less of a piece of low-hanging fruit than it was in the past, given that the discount to NAV has closed significantly and the discount to peers is smaller than it was.  Since JQC still has the second largest discount in its peer group, there is probably still room for further tightening of the discount to NAV especially as the fund builds an increasingly long track record as a bank loan fund.  But since we are only talking about 2 or 3 percentage points of potential extra return, any tightening of the NAV discount relative to peers will just be a "cherry on top" and not the kind of bonanza the past 6 months have offered.  So in the future it is highly likely that returns from holding JQC will be lower than the blistering ~25% annualized returns we have seen.  Investors who choose to continue holding this fund should temper their expectations.

Future returns will be composed of three pieces: the cash yield, changes in discount to NAV, and changes in the value of the underlying assets.  JQC currently sports a cash yield of 8.5%, well above most alternatives.   The yield may diminish if rates continue very low and the markets are favorable to high yield issuers refinancing, but it probably will not change much.  With a discount to NAV of a bit under 3%, the discount could tighten as much as 3 to 5% based on peer discounts, but the discount could also potentially widen.  The underlying assets of the fund are leveraged loans and high yield bonds.  Typically upside is limited on these securities because issuers can call the loans and bonds at a premium equal to about 6 months' worth of interest, while downside can be 100% in the event of default.  Defaults are at low levels currently and do not appear set to rise much, but upside is also probably limited to a further 2 to 5%.  Adding all of these sources of potential return and risk together, returns on JQC over the next 6 months are likely to be 8.5% annualized (the cash yield) plus or minus 3 to 5%, assuming that the credit markets do not fall apart again.  Your guess is as good as (or likely better than) mine as to whether the credit markets will fall apart, but it does not appear to be imminently on the horizon.

If you want exposure to junk credit or are reaching from yield, a position in JQC would seem to be a reasonable alternative.  JQC yields more and has a higher discount to NAV compared to its peers and as one of the larger of such funds it should be significantly more liquid.  Other alternatives might be one of the bank loan mutual funds out there (which unlike JQC and its CEF peers are usually not leveraged), a recently rolled out ETF that focuses on bank loans (BKLN), or junk bonds/a junk bond fund.  On the other hand, if your attraction to JQC was due to its potential for outsized gains in a relatively short time period, it may be a good choice to collect your winnings and move on.  It is highly unlikely that the next 6 months will be as lucrative as the last 6 months for JQC investors.

Since I am sitting on a larger than normal cash position already, I have decided to hold my stake in JQC for now.  I happen to like the asset class (bank loans/junk), JQC still has a greater than peer discount to NAV, and I don't see a lot of more attractive alternatives.  Notably, the discounts to NAV on virtually any kind of CEF that holds fixed income assets have plummeted over the course of 2012, presumably the result of the global hunt for yield.  As such, I don't see obviously very attractive new CEFs to rotate into from JQC.

As always, the above is not intended as investment advice.  Do your own due diligence, consult your advisors, take your own risks and be careful.  You can (and probably will at some point) lose money on anything that isn't a bank account.

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