Tag Archives: cefl

Opportunity In Calamos Convertible Opportunities And Income Fund

Summary The recent sell-off in the CEF space has brought CHI to a discount value not seen since the financial crisis. 2- and 4-year z-scores in excess of negative 3.5 indicate extreme oversold conditions. CHI offers a current 10.91% yield with a possible chance of capital appreciation. With a fixed number of shares, CEFs can exhibit substantial premia or discounts to their net asset values [NAVs]. When investors become pessimistic, they become inclined to sell their CEF holdings even it if means selling at a price below the intrinsic value of the fund. Not surprisingly, the recent market turmoil has punished CEFs especially hard. As detailed in my recent article entitled ” Sell-Off In CEF Space Brings CEFL’s Discount To Record High “, 20 of the 30 constituents of the fund-of-funds CEFL (NYSEARCA: CEFL ) are at or close to 52-week high discounts. Exploiting of mean reversion in CEFs is a potential strategy to lock in higher yields as well as the chance for capital appreciation. In a July 2014 paper entitled Exploiting Closed-End Fund Discounts: The Market May Be Much More Inefficient Than You Thought , authors Patro, Piccotti and Wu provide significant evidence of mean reversion in closed-end fund premiums. This article identifies an opportunity to buy the Calamos Convertible Opportunities And Income Fund (NASDAQ: CHI ) at a greater discount than any time since the financial crisis. The fund Pertinent details for the fund are shown below. Details were obtained from Morningstar , CEFConnect or Calamos . CHI Inception 6/2002 AUM $731M Avg. volume 293K Yield (on price) 10.92% Yield (no NAV) 9.72% Adjusted yield (on price) 8.51% Adjusted yield (on NAV) 7.57% Leverage 28.34% Premium/discount -10.91% 5-year average P/D -0.30% Expense ratio 1.35% Active expense ratio 0.65% Morningstar rating **** As can be seen from the table above, CHI currently sports a 10.92% yield on price, while distributing 9.72% on its NAV. The reason for this discrepancy is due to its wide discount of -10.91%. Additionally, CHI uses 28.34% leverage. The adjusted yields shown assume 100% leverage for easier comparison to an unleveraged fund. CHI charges a total expense ratio of 1.35%. I previously devised an “active expense” metric that takes into account two factors: leverage and the expense ratio charged for a corresponding passive instrument. Taking into account the 28.34% leverage of CHI and the 0.40% expense you would to pay for the SPDR Barclays Convertible Securities ETF (NYSEARCA: CWB ), the price for the active management of CHI is a reasonable 0.65%. In terms of composition, CHI has its majority of assets in convertibles (57.06%), followed by corporate bonds (38.54%). Short-term debt and equity make up a very minor component of CHI. Widening discount Until recently, both CHI and the benchmark ETF CWB have had robust performances over the past few years. As can be seen from the graph below, CHI and CWB moved very closely from Jan. 2013 to around Mar. 2015 of this year. However, a major divergence suddenly appeared over the last few months, causing CHI to underperform by some 15% over brief period. What was the cause of CHI’s underperformance? Tracking the market price and NAV changes of the fund reveals the answer. As can be seen from the graph below, while the NAV of CHI decreased by around 10% over the past few months, mainly due to a general malaise in the high-yield credit market, the market price of CHI slumped by 20% over the same time period. The premium/discount chart of CHI over the past 1-year period shows this clearly (source: CEFConnect). Historical premium/discount Just having a wide discount alone is not good reason to buy a CEF. For mean reversion to take place, one must consider the historical premium/discount behavior of the fund. As can be seen from the chart below (source: CEFConnect), the current discount of CHI has reached levels that have not been seen since the financial crisis. Moreover, that was also the only time that the discount has exceeded -10%. In the boom years of 2002 to 2007, CHI actually experienced premia of 10%-20%, although this is unlikely to be replicated given that the ETF CWB became available from 2009 onwards. The following chart shows the current, and 1-, 3- and 5-year premium/discount values for CHI (data from CEFConnect). The z-score is a measure of the deviation of the premium/discount value of CEF from its historical value taking into account the volatility of said value. The following chart shows the 1-, 2- and 4-year z-scores for CHI (source: CEFAnalyzer). Mathematically, the 1-year z-score of -2.59 means that the discount would be expected to appear 0.48% of the time, the 2-year z-score of -3.52 corresponds to a 0.02% probability of appearance, and the 4-year z-score of -3.93 represents a measly 0.004% probability of occurrence. However, one should understand that this doesn’t mean that there’s a 99.996% chance that the discount will narrow, only that the observed discount is an extremely rare statistical occurrence. Moreover, it could be that the current discount represents a “new normal” of sorts, rendering the historical premium/discount value meaningless. Nevertheless, the z-score is a good starting point for gauging the sentiment of CEFs. Historical performance Besides having a large and negative z-score, it is also important to consider the historical performance of a fund. The following chart shows the total return performances of CHI, CWB and the SPDR Barclays High Yield Bond ETF (NYSEARCA: JNK ) since early 2009, the inception date of CWB. CHI Total Return Price data by YCharts We can see from the chart above that CHI has remained competitive with CWB and JNK from early 2009 to the start of 2015. As the premium/discount of CHI remained within a narrow range of +5% to 5% during this time, the price total return profile of CHI during this period roughly approximates its NAV total return profile during this time. The outperformance of CHI over CWB and JNK during rising markets is expected due to CHI’s use of leverage. Moreover, CHI has posted respectable NAV returns since inception in 2002. The following chart shows the annualized price and NAV returns of CHI over various historical time periods (source: Calamos). We can see that CHI’s historical performance has been very strong, with a 10.0% annualized return since 2002, and a 10-year annualized return of 7.3%. Keep in mind, however, that CHI uses leverage, which is currently at 28.34%. Distribution CHI pays a monthly distribution of $0.095, representing an annualized dividend yield of 10.92%. The following chart shows the dividend history of CHI since inception (source: CEFConnect). (click to enlarge) The dividend has been remarkably stable since 2008. However, one warning sign is that the fund has been paying out some of its distributions from return of capital over the past 12 months. My calculations show that 19.8% of the past year’s dividends consisted of return of capital. If this continues, the return of capital distributions will either erode CHI’s NAV, or force a distribution cut. Summary The sell-off in the CEF space has pushed CHI’s discount to levels not seen since the financial crisis. The extreme 2- and 4-year z-scores in excess of -3.5 indicate severe pessimism regarding the fund. Purchasing CHI now allows an investor to lock in a higher yield as well as the opportunity for capital appreciation if mean reversion takes place. Moreover, CHI has a strong historical track record since 2002, and its expense ratio is also reasonable. Risks of CHI include interest rate risk and credit risk of the underlying holdings, as well as a further widening of the discount value. The former risks can be somewhat reduced by pairing a long position in CHI with a short position in CWB and/or JNK, but the latter risk remains. (See my previous articles here and here for previous examples of where mean reversion allowed annualized profits of ~20% to be made on CEF pairs trades). Disclosure: I am/we are long CHI, CEFL. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

CEFL Now Yielding 23% – What’s Wrong With The Closed-End Funds?

The decline in closed-end funds has now reduced the total return on CEFL to a negative 5.2%. That decline has brought he yield on CEFL to 23% on an annualized monthly compounded basis. The decline in the closed-end funds overestimates both the possible impact that an increase in interest rates should have on the closed-end funds and the likelihood of the rate increase. The 12.9% discount to book value of the closed-end funds in the index upon which CEFL is based also makes CEFL attractive at present levels. Of the 30 index components of UBS ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ), 29 now pay monthly. Only the Morgan Stanley Emerging Markets Domestic Debt Fund (NYSE: EDD ) now pays quarterly dividends in January, April, October, and July. Thus, only EDD will be not included in the August 2015 CEFL monthly dividend calculation, while the 29 others will. My calculation using all the 29 components which are expected to have ex-dividend dates in July 2015 projects a August 2015 dividend of $0.2973. None of the closed-end funds in the index have changed their dividends. Thus, the decline in the CEFL monthly dividend is primarily due to the reduction in the indicative or net asset value of CEFL. The indicative value of each CEFL share has decreased about 4.5% from June 30, 2015, to July 24, 2015. Only 29 of the 30 CEFL closed-end fund components also had ex-dates in April 2015, so the May 2015 dividend was also based on 29 of the 30 components. From April 30, 2015 to July 24, 2015 the indicative or net asset value of CEFL has declined from $22.801 to $18.9324 a decline of 17.0% As I explained in MORL Dividend Drops Again In October, Now Yielding 21.5% On A Monthly Compounded Basis, if the dividends on all of the underlying components in a 2X leveraged ETN, such as CEFL, were to remain the same for a specific month, but the indicative value (aka net asset value or book value) was lower, the dividend paid, which is essentially a pass-through with no discretion by management, would also decrease by about half as much. This is the result of the rebalancing of the portfolio each month required to bring the amount of leverage back to 2X. Of course, an increase in indicative value would result in a corresponding increase in the dividend. The problem with CEFL is that the market prices of the closed-end funds in the index have declined precipitously, especially in recent weeks. The total return on CEFL from the closing price of $27.03 on January 7, 2014, the first day of trading, to the July 24, 2015 price of $18.71, taking into account the $6.915 dividends paid over that period, is now -5.2%. That does not take into consideration any income that might have been earned by reinvesting the dividends nor any losses that could have been incurred if the dividends had been reinvested in additional shares of CEFL. As recently as July 16, 2015 the total return since inception for CEFL had been positive. The decline in the prices of the 30 closed-end funds upon which CEFL is based seems to be part of the flight from all things that could be hurt by higher interest rates, which could accompany improving economic activity. In an article, X-Raying CEFL (Part 3): Interest Rate Sensitivity , published June 23, 2015, Seeking Alpha contributor Stanford Chemist presents well supported arguments as to why CEFL “is not very interest rate sensitive, and investors therefore do not have to unduly worry over the effect of increasing interest rates on CEFL.” However, at this moment, especially during the last few weeks, the markets do not seem very interested in any well supported arguments regarding the effects on closed-end funds of possibly higher interest rates. This seems to be the case even though the security that would absolutely be impacted by higher interest rates, the 10-year US treasury bond has not moved much during that period. My original interest in CEFL resulted from an attempt to benefit from my view that interest rates would remain low for a long period when many were predicting the exact opposite. I wanted to collect the high income that would result from effectively borrowing at very low short-term rates to finance higher yielding securities. The obvious choice for an investor who believes that interest rates would remain low for a long period, but cannot or does not want to take the margin call risk associated with: swaps paying floating and receiving fixed, interest rate futures or borrowing money to finance securities on margin, would be inverse floaters. Unfortunately, due to the media vilification and the persecution by regulatory agencies of financial institutions that invested in agency inverse floaters in the 1990s, I as a retail have been unable to buy any inverse floaters. See: Are mREITS The New Inverse Floaters? After not being able to find any inverse floaters, I looked for the next best thing. An inverse floater is usually an instrument that takes a pool of fixed income securities and divides it into two tranches. For example you could start with $10 million of fixed-income securities paying a 4% coupon, You would use those securities to issue $9 million floating rate securities that might pay LIBOR +1%. Then, the other $1 million would be an inverse floater that paid 31.0% – 9 x Libor. Thus if LIBOR was .25%, as it has been for the last few years. The floating rate note would pay 1.25% and the inverse floater would pay 28.75%. This would mean that the $400,000 annually paid by the $10,000,000 fixed income securities with the 4% coupon would be divided with $112,500 going the floating rate security holders and the remaining $287,500 going to the inverse floater holders. Typically, the rates would be adjusted monthly with LIBOR. Thus, the inverse floater holders are bearing the interest rate risk. The principal payments made by the $10,000,000 in fixed-income securities are passed through to the holders. Thus, the holders of the inverse floater will absolutely receive their principle back at some point. However, they bear the risk that if LIBOR interest rates rise high enough their coupon will be zero for some period. There never can be a margin call. An institution or large investor who could borrow at LIBOR + 1.0% could emulate the return on the inverse floater by buying the same $10,000,000 in fixed income securities and financing $9,000,000 it at LIBOR + 1.0%. Today, institutions can finance such securities at about LIBOR making the income from such a carry trade even more lucrative. However, a major difference between owning an inverse floater and buying the same underlying security on margin is that if the value of the underlying securities falls below a certain point, you can have a margin call. Mutual funds are not allowed to borrow more than 33% of their assets. A mutual fund that simply owned fixed-income securities and borrowed 33% would not be much of an improvement over just owning the fixed-income securities outright, after the mutual fund fees and expenses are considered. Ideally, I would have liked to find a mutual fund that owned a significant amount of inverse floaters. I still would. One investment vehicle that is not limited as to its’ borrowing and leverage in an mREIT. The Securities and Exchange Commission is not too happy with what they consider a loophole and have at times made some noise about regulating the amount of borrowing and leverage in mREITs. However, that would involve taking on the powerful real estate lobby. So action by the Securities and Exchange Commission in regard to mREIT leverage is not likely any time soon. On the surface, an mREIT that buys agency mortgage backed securities using leverage via repurchase agreements looks a lot like an inverse floater. Actually, using the example of an agency mortgage backed security with a 4.0% coupon using 9-1 leverage, since an mREIT can borrow at close to LIBOR rather than LIBOR + 1% that was assumed in the inverse floater example, its yield would even more. With LIBOR at .25%, the inverse floater would pay 28.75% while the agency mREIT would pay 37.75% less any non-interest mREIT expenses. From an investor’s viewpoint the biggest drawback in terms of agency mREITs as opposed to inverse floaters is that with agency inverse floaters you will receive the full face value at some point. Agency mREITs must mark their borrowings to market and thus will receive a margin call if the value of the underlying agency mortgage backed securities declines beyond a certain point. In an attempt to avoid the possibility of a margin call or even forced liquidation, the mREITs use various hedging strategies. I would prefer an mREIT that employed no hedging but reduced risk with less leverage. An mREIT with only 4 to 1 leverage and no hedges would have paid double-digit dividends in each of the last seven years and not have lost any share price. It would have declined in value during the taper tantrum but would have fully recovered in price and then some by today. Despite my apprehension over the fact that mREITs did not guarantee ultimate return of 100% of face value, as agency inverse floaters would, I started buying mREITs based on my view that interest rates would remain low for much longer than many market participants believed. Logically, if interest rates were to remain low, there should not be that much risk that agency mREITs would decline in value. When the UBS ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (NYSEARCA: MORL ) was created in October 2012, it looked like an even better way to bet on my view that interest rates would remain low. MORL is structured as a note and thus circumvents the regulation that limits mutual fund leverage to only 33%. With very low borrowing costs, MORL would be paying almost twice as much in dividends than the weighted average of the mREITs that comprised the index upon which MORL is based. As long as the value in the mREITs did not decline significantly, the 2X leverage of would not be a problem. When CEFL was created it also looked like a good way to benefit from a continuation of low interest rates. CEFL, also structured as a 2X leveraged note, had the benefit of not being tied to the mortgage markets the way that MORL was and thus generating almost as high a yield while providing diversification. Later I added the ETRACS 2xLeveraged Long Wells Fargo Business Development Company ETN (NYSEARCA: BDCL ) for the same reasons. The problem is that the prices of the 30 closed-end funds upon which CEFL is based have declined. I had implicitly considered the closed-end funds to be proxies for fixed-income securities. In some respects a portfolio of 30 closed-end funds chosen by a formula that more heavily weights those with the highest yields and greatest discounts to book value seemed possibly better than ordinary bonds. However, that has not been the case. A simple portfolio of buying treasury bonds on margin, if the borrowing cost was the same low rate that CEFL implicitly uses, would have had a very good positive return from on January 7, 2014, the first day of CEFL trading to July 24, 2015. There have been numerous problems plaguing the individual closed-end funds upon which CEFL is based. Some have investments in the energy sector which have declined with oil prices. However, it seems to be fear of rising rates that has had the greatest impact. Beyond the argument that CEFL should not be very sensitive to interest rates, which the market seems to be rejecting, my view is that the market is also overestimating the probability that the Federal Reserve will be aggressive in raising rates. The most succinct way that I can express my view on the outlook for interest rates is that the Federal Reserve has many reasons not to raise rates. The economy is now showing modest growth with tepid inflation. The reason why we now have the current modest growth rates and tepid inflation as compared to negative growth and deflation is primarily due to the policy of the Federal Reserve since 2008. Over the past few years, fiscal policy has had very little impact on the economy. If anything, the reduction in federal deficits and thus fiscal thrust has been a headwind to economic growth. The Federal Reserve low rate policy is the reason why economic conditions are what they are now. It makes no sense to risk a return recession by raising rates. One of the reasons why I am still constructive on CEFL is the 12.9% weighted average discount to book value of the components that comprise the index upon which CEFL is based as of July 25, 2015. This is a relatively large increase in the discount that I measured last month of 11.1%. Three months ago CEFL had a 8.6% weighted discount to book value. Thus, in just three months the discount has increased from 8.6% to 12.9%. If the discount to book value of the components that comprise the index upon which CEFL is based was still 8.6%, the total return on CEFL since inception would still be positive. The weighted average discount is determined by taking the price-to-book value for each of the closed-end funds that comprise the index and multiplying it by the weight of each component. The sum of the products is 87.1%. None of the 30 closed-end funds in the index are currently trading at a premiums to net asset value. Last month there were two CEFL components trading at premiums. The AGIC Convertible & Income Fund II (NYSE: NCZ ) with a weight of 1.43% had a price-to-book ratio of 1.041. The AGIC Convertible & Income Fund (NYSE: NCV ) with a weight of 2.28% had a price-to-book ratio of 1.016. Now both are trading at discounts. This can be seen in the table below that shows the weight, price, net asset value, price to net asset value, ex-dividend date, dividend amount, frequency of the dividend, contribution of the component to the dividend and the amount if any of the dividend included any return of capital for each of the closed-end funds in the index. The 12.9% discount makes CEFL more attractive. The discount also makes CEFL a better investment than buying the individual securities that are included in the portfolios of the closed-end funds yourself in a margin account at 50% leverage to replicate CEFL. Even if you could borrow at less than 0.90% that the CEFL tracking fee plus the current LIBOR rate approximately equals, the discount on the CEFL components makes buying the funds rather than the individual securities a superior investment. This large discount to net asset value alone is a good reason to be constructive on CEFL. It should be noted that saying CEFL components are now trading at a deeper discount to the net asset value of the closed-end funds that comprise the index does not mean that CEFL does not always trade at a level close to its own net asset value. Since CEFL is exchangeable at the holders’ option at indicative or net asset value, its market price will not deviate significantly from the net asset value. The net asset value or indicative value of CEFL is determined by the market prices of the closed-end funds that comprise the index upon which CEFL is based. While the 2014 year-end rebalancing has reduced the monthly CEFL dividend, it is still very large. For the three months ending August 2015, the total projected dividends are $0.9769. The annualized dividends would be $3.9076. This is a 20.9% simple annualized yield with CEFL priced at $18.71. On a monthly compounded basis, the effective annualized yield is 23.0%. Aside from the fact that with a yield above 20%, even without reinvesting or compounding you get back your initial investment in only 5 years and still have your original investment shares intact, if someone thought that over the next five years markets and interest rates would remain relatively stable, and thus CEFL would continue to yield 23% on a compounded basis, the return on a strategy of reinvesting all dividends would be enormous. An investment of $100,000 would be worth $281,587 in five years. More interestingly, for those investing for future income, the income from the initial $100,000 would increase from the $23,000 initial annual rate to $64,765 annually. CEFL components as of July 24, 2015 Name Ticker Weight Price NAV price/NAV ex-div dividend frequency contribution return of capital Clough Global Opportunities Fund GLO 4.56 12.26 14.2 0.8634 7/15/2015 0.1 m 0.01408 First Trust Intermediate Duration Prf.& Income Fd FPF 4.53 21.77 24.03 0.9060 7/1/2015 0.1625 m 0.01280 Eaton Vance Tax-Managed Global Diversified Equity Income Fund EXG 4.51 9.75 10.37 0.9402 7/22/2015 0.0813 m 0.01424 0.068 Doubleline Income Solutions DSL 4.47 19.14 21.95 0.8720 7/15/2015 0.15 m 0.01326 Alpine Total Dynamic Dividend AOD 4.42 8.54 10.13 0.8430 7/22/2015 0.0575 m 0.01127 Eaton Vance Limited Duration Income Fund EVV 4.39 13.5 15.63 0.8637 7/9/2015 0.1017 m 0.01252 MFS Charter Income Trust MCR 4.35 8.28 9.69 0.8545 7/14/2015 0.0658 m 0.01310 Alpine Global Premier Properties Fund AWP 4.29 6.31 7.48 0.8436 7/22/2015 0.05 m 0.01287 0.0283 PIMCO Dynamic Credit Income Fund PCI 4.24 19.67 22.78 0.8635 7/9/2015 0.1563 m 0.01275 Blackrock Corporate High Yield Fund HYT 4.2 10.39 12.29 0.8454 7/13/2015 0.07 m 0.01071 0.0012 ING Global Equity Dividend & Premium Opportunity Fund IGD 4.19 7.93 9.05 0.8762 7/1/2015 0.076 m 0.01521 Eaton Vance Tax-Managed Diversified Equity Income Fund ETY 4.16 11.41 12.55 0.9092 7/22/2015 0.0843 m 0.01164 BlackRock International Growth and Income Trust BGY 4.15 7.19 7.75 0.9277 7/13/2015 0.049 m 0.01071 0.0337 Prudential Global Short Duration High Yield Fundd GHY 4.13 14.51 17.04 0.8515 7/15/2015 0.125 m 0.01347 Western Asset Emerging Markets Debt Fund ESD 4.07 14.46 17.51 0.8258 7/22/2015 0.105 m 0.01119 0.0268 Morgan Stanley Emerging Markets Domestic Debt Fund EDD 3.68 8.28 9.98 0.8297 6/26/2015 0.22 q GAMCO Global Gold Natural Resources & Income Trust GGN 3.6 5.28 6 0.8800 7/15/2015 0.07 m 0.01807 0.07 Prudential Short Duration High Yield Fd ISD 3.25 15.01 17.43 0.8612 7/15/2015 0.1225 m 0.01004 Aberdeen Aisa-Pacific Income Fund FAX 3.23 4.72 5.71 0.8266 7/17/2015 0.035 m 0.00907 0.0143 Calamos Global Dynamic Income Fund CHW 3.17 8.4 9.54 0.8805 7/8/2015 0.07 m 0.01000 0.0161 MFS Multimarket Income Trust MMT 2.92 6 6.97 0.8608 7/14/2015 0.0473 m 0.00871 Backstone /GSO Strategic Credit Fund BGB 2.72 15.31 17.96 0.8524 7/22/2015 0.105 m 0.00706 0.0012 Allianzgi Convertible & Income Fund NCV 2.12 7.31 7.74 0.9444 7/9/2015 0.09 m 0.00988 Western Asset High Income Fund II HIX 2.07 7.06 8.08 0.8738 7/22/2015 0.069 m 0.00766 0.0006 Blackrock Multi-Sector Income BIT 2.04 16.45 19.31 0.8519 7/13/2015 0.1167 m 0.00548 Wells Fargo Advantage Multi Sector Income Fund ERC 1.73 12.4 14.75 0.8407 7/13/2015 0.0967 m 0.00511 0.0283 Wells Fargo Advantage Income Opportunities Fund EAD 1.33 8.04 9.34 0.8608 7/13/2015 0.068 m 0.00426 Allianzgi Convertible & Income Fund II NCZ 1.33 6.69 6.9 0.9696 7/9/2015 0.085 m 0.00640 Nuveen Preferred Income Opportunities Fund JPC 1.2 9.21 10.44 0.8822 7/13/2015 0.067 m 0.00331 Invesco Dynamic Credit Opportunities Fund VTA 0.96 11.49 13.29 0.8646 7/9/2015 0.075 m 0.00237 Disclosure: I am/we are long CEFL, MORL, BDCL. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

X-Raying CEFL (Part 3): Interest Rate Sensitivity

Summary Previous articles in this series investigated the leverage, expense ratio and geographical statistics of CEFL, a 2X leveraged CEF fund-of-funds. This article seeks to analyze the interest rate sensitivity of CEFL by comparing the performance of different classes of CEFs during the interest rate spike of 2015. How sensitive is CEFL to rising interest rates? Introduction This is Part 3 of a series of articles designed to “X-ray” into the holdings of the ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (NYSEARCA: CEFL ) to allow investors to better understand the characteristics of the fund. CEFL tracks twice the monthly return of the ISE High Income Index [YLDA], an index that is comprised of high-yielding close-ended funds [CEFs]. The methodology used to construct YLDA has been summarized here . The YieldShares High Income ETF (NYSEARCA: YYY ) tracks the same index as CEFL. In the first article , the equity/debt, leverage and expense ratio of CEFL was analyzed. In the second article , the geographical allocation of CEFL was discussed. In the comment streams of the first two articles, I received a number of comments asking about the interest rate sensitivity of CEFL. This is an especially pertinent question given the mini-“Taper tantrum” that has occurred in early 2015. As the chart below shows, the U.S. 10-year treasury rate has increased from around 1.70% to a peak of 2.50% over short span of less than 6 months. 10 Year Treasury Rate data by YCharts Over the same time period, CEFL has dropped by -3.87% in price, although its total return has been +3.13% after dividends are accounted for. This suggests that CEFL has been holding up quite well despite the recent spike in interest rates. CEFL data by YCharts In this third article, I seek to analyze the debt holdings of CEFL to see how individual classes of CEFs fared during the recent interest rate spike. Methodology CEFL contains 30 CEFs, of which 7 are equity funds, 21 are debt funds and 2 are mixed funds. For this analysis, I only included the 21 debt funds as bonds are more sensitive to fluctuations in interest rates compared to stocks. For each debt CEF, I assigned it a primary classification for its largest type of debt holding (usually 40-100% of the total fund assets). I also assigned the CEF a secondary classification if its second-largest type of debt holding was at least 20% of the total fund assets. The classification types are: [i] corporate bonds [corp], [ii] government bonds [gov], [iii] securitized bonds [sec], which include various agency/commercial mortgage or asset-backed bonds, [iv] senior loans [loan], [v] convertible bonds [CB], and [vi] preferred shares [PF]. Note that this classification does not distinguish between U.S. and foreign bonds. The primary and secondary classifications of the 21 debt funds are shown in the table below. Fund Ticker Assets Primary Secondary DOUBLELINE INCOME SOLUTIO (NYSE: DSL ) 4.38% Corp Sec FIRST TRUST INTERMEDIATE (NYSE: FPF ) 4.28% Pref EATON VANCE LIMITED DURAT (NYSEMKT: EVV ) 4.26% Loan Sec MFS CHARTER INCOME TRUST (NYSE: MCR ) 4.24% Corp Gov BLACKROCK CORPORATE HIGH (NYSE: HYT ) 4.20% Corp WESTERN ASSET EMG MKT DBT (NYSE: ESD ) 4.18% Gov Corp PRUDENTIAL GL SH DUR HI Y (NYSE: GHY ) 4.11% Corp Gov PIMCO DYNAMIC CREDIT INCO (NYSE: PCI ) 4.11% Sec Corp MORGAN STANLEY EMERGING M (NYSE: EDD ) 3.88% Gov ABERDEEN ASIA-PAC INCOME (NYSEMKT: FAX ) 3.43% Gov Corp PRUDENTIAL SHORT DURATION (NYSE: ISD ) 3.15% Corp MFS MULTIMARKET INC TRUST (NYSE: MMT ) 2.84% Corp BLACKSTONE/GSO STRATEGIC (NYSE: BGB ) 2.65% Loan Corp ALLIANZGI CONVERTIBLE & I (NYSE: NCV ) 2.42% CB Corp WESTERN ASSET HIGH INC FD (NYSE: HIX ) 2.19% Corp BLACKROCK MULTI-SECTR INC (NYSE: BIT ) 1.89% Sec Corp WELLS FARGO ADV MULTISECT (NYSEMKT: ERC ) 1.56% Corp Gov ALLIANZGI CONV & INCOME I (NYSE: NCZ ) 1.35% CB Corp WELLS FARGO ADVANTAGE INC (NYSEMKT: EAD ) 1.33% Corp NUVEEN PFD INC OPP FD (NYSE: JPC ) 1.12% Pref INVESCO DYNAMIC CREDIT OP (NYSE: VTA ) 0.96% Loan Corp The performance of each class of debt CEF during the current interest rate spike (Feb. 1, 2015 to date) is compared with a benchmark ETF as identified using the correlation tool from InvestSpy . Corporate bonds 9 of the debt CEFs have corporate bonds as their primary holding, while 8 CEFs have corporate bonds as their secondary holding. All 9 debt CEFs that have corporate bonds as their primary holding are most correlated with the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ). The following chart illustrates the 1-year correlation coefficients for these 9 funds arranged from highest to lowest correlation. The following chart shows the total return performance of the 9 debt CEFs with corporate bonds as their primary holding during the most recent interest rate spike compared to HYG from Feb. 1, 2015 to date. HYG Total Return Price data by YCharts We can see from the chart above that DSL has had the best total return performance of +4.98%, while GHY had the worst performance of -4.33% since Feb. 1, 2015. The average of the 9 CEFs was +0.28%, while the benchmark index HYG returned +1.14%. This indicates that the 9 debt CEFs with corporate bonds as their primary holding slightly underperformed the benchmark HYG over this time period. Government bonds 3 of the debt CEFs have government bonds as their primary holding, while 3 CEFs have government bonds as their secondary holding. Of the 3 debt CEFs that have government bonds as their primary holding, ESD and EDD are most correlated with the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ), with 1-year coefficients of 0.51 and 0.60, respectively, while FAX is most correlated with HYG, with a coefficient of 0.29. Note that all three CEFs are actually either emerging market (ESD, EDD) or Asia-Pacific bond funds. The following chart shows the total return performance of the 3 debt CEFs with government bonds as their primary holding during the most recent interest rate spike compared to EMB and HYG from Feb. 1, 2015 to date. ESD Total Return Price data by YCharts We can see from the chart above that ESD has had the best total return performance of +0.67%, while EDD had the worst performance of -12.80% since Feb. 1, 2015. The average of the 3 CEFs was -6.22%, while the benchmark indices EMB and HYG returned +0.23% and +1.14%, respectively. This indicates that the 3 debt CEFs with government bonds as their primary holding significantly underperformed the benchmarks EMB and HYG over this time period. Senior loans 3 of the debt CEFs have senior loans as their primary holding. All 3 debt CEFs that have senior loans as their primary holding are most correlated with HYG. EVV, BGB and VTA have 1-year correlation coefficients to HYG of 0.40, 0.40 and 0.28, respectively. The following chart shows the total return performance of the 3 debt CEFs with senior loans as their primary holding during the most recent interest rate spike compared to HYG from Feb. 1, 2015 to date. The PowerShares Senior Loan Portfolio (NYSEARCA: BKLN ) is included for comparison. EVV Total Return Price data by YCharts We can see from the chart above that VTA has had the best total return performance of +5.35%, while EVV had the worst performance of +1.65% since Feb. 1, 2015. The average of the 3 CEFs was +3.53%, while the benchmarks HYG and BKLN returned +1.14% and +0.66%. This indicates that the 3 debt CEFs with senior loans as their primary holding significantly outperformed the benchmarks HYG and BKLN over this time period. Preferred shares 2 of the debt CEFs have preferred shares as their primary holding. JPC is most correlated with HYG (0.36), whereas FPF is, somewhat strangely, most correlated with the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEARCA: PCY ) (0.33). Therefore I have replaced PCY with the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) in the following chart. JPC Total Return Price data by YCharts We can see from the chart above that JPC has had the best total return performance of +2.47%, followed by FPP at +0.26% since Feb. 1, 2015. The average of the 2 CEFs was +1.37%, while the benchmarks HYG and BKLN returned +1.14% and +0.11%. This indicates that the 2 debt CEFs with preferred shares as their primary holding slightly outperformed the benchmarks HYG and PFF over this time period. Convertible bonds 2 of the debt CEFs have convertible bonds as their primary holding. NCV and NCZ are both most correlated with the SPDR Barclays Convertible Securities ETF (NYSEARCA: CWB ), with 1-year correlation coefficients of 0.40 and 0.34, respectively. The following chart shows the total return performance of the 2 debt CEFs with convertible bonds as their primary holding during the most recent interest rate spike compared to CWB from Feb. 1, 2015 to date. NCV Total Return Price data by YCharts We can see from the chart above that NCV has had the best total return performance of -1.00%, followed by NCZ at -5.89% since Feb. 1, 2015. The average of the 2 CEFs was -3.45%, while the benchmark CWB returned +5.22%. This indicates that the 2 debt CEFs with convertible bonds as their primary holding significantly underperformed the benchmark CWB over this time period. Securitized bonds 2 of the debt CEFs have securitized bonds as their primary holding, while 2 CEFs have securitized bonds as their secondary holding. The 2 debt CEFs that have securitized bonds as their primary holding as both most correlated with HYG, with PCI and BIT having 1-year correlation coefficients of 0.54 and 0.44, respectively. The following chart shows the total return performance of the 2 debt CEFs with securitized bonds as their primary holding during the most recent interest rate spike compared to HYG from Feb. 1, 2015 to date. The iShares MBS ETF (NYSEARCA: MBB ) and the iShares CMBS ETF (NYSEARCA: CMBS ), which hold agency and commercial mortgage-backed bonds, respectively, are shown for comparison. PCI Total Return Price data by YCharts We can see from the chart above that PCI has had the best total return performance of +2.06%, followed by BIT at -0.33% since Feb. 1, 2015. The average of the 2 CEFs was +0.87%, while the benchmarks HYG, MBB and CMBS returned +1.14%, -0.50% and -1.32%, respectively. This indicates that the 2 debt CEFs with securitized bonds as their primary holding slightly outperformed the benchmark HYG over this time period. Discussion What does this all mean for investors? One major finding that resulted from this analysis is that most of the CEF debt classes in CEFL (including corporate bonds, senior loans, preferred shares and convertible bonds)* are most correlated with the high-yield ETF HYG. This bodes well for investors in CEFL who are worried about rising interest rates since high-yield debt is less interest-rate sensitive compared to investment-grade debt. (*Note that BKLN and PFF did not show up in the top-10 ETFs most correlated with the senior loans or preferred shares CEFs, respectively, indicating that InvestSpy might have for some reason excluded these ETFs from its correlation tool.) Indeed, inputting CEFL into the Investspy’s correlation tool indicates that has been the most correlated with HYG, EMB, JNK, PCY and CWB over the past 1-year, as shown in the chart below (but note that the past 1 year includes the final six months of 2014 which are before the rebalancing of CEFL to its present constituents). Encouragingly, all five of these ETFs and CEFL have outperformed the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ) (-4.75%), the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) (-3.46%) and the iShares 20 Year Treasury Bond ETF (NYSEARCA: TLT ) (-12.7%) during the interest rate spike of 2015. This is not surprising because investment-grade debt and treasuries are much more sensitive to interest rates, as mentioned above. The total return performances of these ETFs are shown in the chart below. CEFL Total Return Price data by YCharts In terms of the individual debt classes of CEFL, CEFs with corporate bonds (as their primary holding) averaged +0.28%, government bonds averaged -6.22%, senior loans averaged +3.53%, preferred shares CEFs +1.37%, convertible bonds -3.45%, and securitized bonds +0.87% since Feb. 1st, 2015. The strongest performance of senior loan CEFs (+3.55%) may be rationalized by the fact that these are normally floating-rate instruments that may benefit as interest rates rise, although it should also be noted that the benchmark ETF BKLN was essentially flat over this time period. A quick check on CEFConnect shows that the premium/discount of the three senior loan CEFs (EVV, BGB, VTA) was steady over this time period, suggesting either that the CEF managers were able to outperform the benchmark or that the other components in the CEFs were responsible for the outperformance. Conversely, the weakest performance of the government bond CEFs (-6.22%) may also be understood on the basis that this debt is relatively interest rate-sensitive, although again the benchmark index EMB was actually also flat over this time period. This time, however, the discounts for the three CEFs in question (FAX, ESD, EDD) actually widened by about 2 to 4 percentage points over this time period, indicating that the discount expansion could account for a significant fraction of the underperformance of these CEFs. Moreover, this observation indicates investor pessimism regarding these CEFs, which are actually all emerging market or Asia-Pacific bond funds. The total return performance of the six classes of debt CEFs within CEFL since Feb. 1st, 2015 are summarized in the chart below. Conclusion Based on this analysis of CEF performances during the interest rate spike of 2015, I conclude that CEFL is not very interest rate-sensitive, and investors therefore do not have to unduly worry over the effect of increasing interest rates on CEFL. The main findings supporting this conclusion are: Most of the holdings of CEFL are most-correlated with high-yield debt, which is not very interest rate-sensitive. The five ETFs that are most correlated with CEFL all outperformed investment-grade bonds LQD and treasuries IEF and TLT since Feb. 1, 2015. CEFL itself outperformed LQD, IEF and TLT over the same time period. CEFL contains three senior loan CEFs, which are typically floating rate instruments, and these may provide protection against increasing interest rates. The main limitations of this analysis are: The premium/discount of the individual funds were not studied. Seeking Alpha contributor Lance Brofman has calculated the overall discount of CEFL to be 9.5% on Jun. 1, 2015, an increase compared to 8.6% a month prior, but the overall discount on Feb. 1, 2015 was not determined. The 10-year treasury rate increased from 1.70% to a peak of 2.50% over the past 5 months. Therefore, this analysis may not be valid for interest rate increases that are much greater in magnitude or velocity (although this seems to be an unlikely scenario at the present time). This analysis is only valid until Dec. 31, 2015, when CEFL becomes repopulated with different CEFs due to rebalancing. Finally, as a 2X leveraged fund, the cost of maintaining the leverage of the CEFL (based on 3-month LIBOR) would go up as interest rates rise. While not having an immediate effect on NAV, this effectively increases the total expense ratio of the fund, leading to a drag on NAV over time. I hope this information will be helpful for investors in or considering investing in this fund. Disclosure: I am/we are long CEFL. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.