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Summary Closed-end funds offer significant opportunities for swing traders thanks to the irrational inflows/outflows of some investors. Recent movements in high yield CEFs, when compared to JNK and HYG, demonstrate how irrational the CEF world can be. While high risk, trading CEFs more aggressively can offer significant rewards if done properly–and significant losses if done poorly. Traditional money managers tend to dissuade clients from investing in closed-end funds, citing fees, the dangers of leverage, and the shrinking CEF universe as causes for concern. At the same time, income-hungry investors are rightly dissatisfied with the low-yielding income options in both the ETF and mutual fund universe, while the lack of leverage and stricter mandates of many of those funds limits their managers’ abilities to deliver high performance to clients. On top of that, CEFs have the unique value of trading sometimes at a steep discounts or premiums to NAV and diverging from historical average prices, providing opportunities to rotate in and out of CEFs to boost returns on top of providing a strong income stream. This is hard to do, and requires both diligence and knowledge. But it is also an excellent feature of the CEF universe that investors can use to their advantage. One other advantage of the CEF universe: many of the investors in these funds are slow to act and irrational. For the most part, this results in volatility and severe underperformance, as we have seen this year: (click to enlarge) But it also provides excellent mispricing opportunities that more savvy and diligent investors can take advantage of. This is especially the case with one fund: The Pimco High Income Fund (NYSE: PHK ), although its peers are showing signs of increasing divergence from their underlying investments, providing additional opportunities to swing trade these funds. Proof of Irrational PHK Investors There are many moments in the CEF universe that prove the irrationality of many market participants. The quasi-historical FOMC meeting and rate hike of last week is a phenomenal example of that irrationality-and the opportunity it provides. If we rewind three months, we see that there was relative stability in the world of high yield closed-end funds until quite recently: (click to enlarge) The Dreyfus High Yield Strategies Fund (NYSE: DHF ) and the Pioneer High Income Trust (NYSE: PHT ) remained relatively flat until earlier this month, when panic caused those funds and PHK to suffer steep declines. The fact that PHK continued to appreciate to a peak premium of 30% above NAV throughout October and November demonstrates the irrationality of many of the investors in this fund. This does not mean that I dislike it; on the contrary, it is one of the best managed and best performing (on a NAV basis) high income CEFs with one of the longest track records. But the way this strong performance attracts too much capital makes it a sometimes crowded trade worth betting against at peaks and buying at troughs. Proof of Irrational High Yield CEF Investors Recent history demonstrates that the other two funds do not have significantly more rational investors (probably because there is some overlap between them and PHK). Let’s look at three days of trading, starting with December 15th. This is shortly after the high yield panic caused by major headlines about redemptions and liquidity issues hit the entire high yield sector. (click to enlarge) Alongside the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) and the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA: JNK ), our three high yield CEFs experienced strong price growth, with PHK outperforming significantly. The next day, the “high yield is oversold” narrative continued across the financial press, with commentators insisting this was a wonderful “buy-the-dip” opportunity, and the rising tide raised all boats again: (click to enlarge) Again DHF and PHK outperform significantly, bringing investors who bought the dip nearly double-digit capital gains in a couple short days. After the FOMC meeting and the historic decision to raise the Fed funds rate target by 25 basis points, the market’s sigh of relief was short-lived and equities sold off after a brief rally shortly after the announcement on Wednesday afternoon: (click to enlarge) Yet the high yield CEFs weren’t sold off at all. In fact, DHF and PHT saw a slight uptick and PHK was flat, indicating that some concern was trickling into these CEFs, but not enough to cause the sell-off seen in JNK and HYG. The short-term implications of this are clear: if JNK and HYG sell off again for another day or two, CEFs investors will likely panic and cause outsized declines. The selling opportunity will be obvious. But if the high yield market broadly fails to sell off, the irrational inflows into these high yield CEFs could turn into exuberance. Is it Time to Short PHK? With PHK up and JNK/HYG down, it seems a no-brainer to short PHK in anticipation of the inevitable cratering that PHK usually endures after a run-up. There are two reasons why this would be unwise right now. Firstly, the run-up in PHK happened over the course of a couple of days, which is rare for the name; historically, it runs up steadily over several weeks or months as inflows cause the premium to grow and grow. With that not being the case here, the price run-up is not founded on strong volumes and could not be victim to the typical outflow pattern of the past. Secondly, the technical indicate PHK could stay horizontal or even go up in the short term. Looking at the relative strength index (RSI) for the name, we see a sharp uptick in the last few days, but it remains at the lower end of the range it has seen since its dividend cut: (click to enlarge) And it is more in its mid-range historically: (click to enlarge) With a relatively modest RSI relative to the weakness in the high yield market, there is a possibility of a short-term decline but it is less obvious than in early November, when I sold out of the name, and in December, when I wish I’d shorted it. A Timeline to Act If now is not necessarily the time to short PHK, keeping track of the fund’s premium to NAV and the rate of change for HYG and JNK may provide a viable buy/sell signal to indicate when to act. Because it can take several days after a sharp move for a CEF to reset according to the market that it acts within, the divergence between high yield CEFs and the high yield bond market provides an opportunity for swing trading on a time frame of at least one week, and most likely several weeks. A quick look at when this month’s carnage began will demonstrate the timeframe with which to act and the signal to act on. (click to enlarge) The weakness in high yield began in earnest on December 7th, but was hinted at in the prior week on December 3rd. At the same time, the three high yield CEFs under consideration were up on average, indicating the beginning of a divergence: (click to enlarge) The sell signal was weak on the 3rd when the CEFs were on average up 1.44% and the high yield ETFs were down only slightly, but the sell signal got stronger on a second day of declines for ETFs and a second day for CEFs. The weakness in the junk ETFs only percolated into the CEFs on December 8th, and only really reached a level of significant declines the two days after, meaning a swing trader had four trading days (from the 3rd to the 8th) to sell off the high yield CEFs on the warning signal that they were becoming relatively overvalued to the ETFs that invest in the same underlying asset class. If we look at the last five days of trading, and note Monday’s weakness in high yield markets versus the strength in high yield CEFs at the same time, we can conclude that a similar week-long swing-trade opportunity is coming again: (click to enlarge) Conclusion A look at recent history shows how irrational the CEF universe is and how prone it is to volatility. This does not mean these funds should be avoided, but that they need an approach most income-seeking investors will not appreciate: more aggressive swing trading on weaknesses and strengths to fully take advantage of the opportunities the funds provide. If this sounds dangerous, that’s because it is; swing trading and rebalancing between CEFs will not only incur transaction costs and short-term capital gains taxes, but if done poorly will either lock investors into funds at too high of a price or will incur losses from poorly timed and executed trades. For instance, people who bought PHK in July and August when the fund showed comparative weakness faced massive losses after the surprise dividend cut in September. This is why the swing-trade approach to CEFs should only be done when investors have confidence and conviction in their understanding of the funds. If they can gain this perspective, the potential for very high returns by being a CEF contrarian is outstanding. Scalper1 News
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