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Summary Some say that CEFL price will always drop, so it is better not to be tempted by the high yield; others say that CEFL will never recover. In my opinion, those that will be patient enough to reap the high distributions over a long period of time will be highly rewarded. The CEFL premium over the YieldShares High Income ETF more than compensates the added risks. This article is a sequel to my previous one, UBS ETRACS Monthly Pay 2x leverage Mortgage REIT ETN: A Pragmatic Approach ( here ). So I will short the presentation. I bought the UBS ETRACS Monthly Pay 2xLeveraged Closed – End Fund ETN ( CEFL) shares April 7, 2014 at $27.42 for less than 5% of a non-taxable account. The purpose of this article is to evaluate if CEFL is a sound long term investment or not. And more precisely to answer the nagging question: will it recover? Because as we know, it closed at $16.92 on September 4th; a severe 38.3% decrease since my purchase. I remember a comment from some months ago stating that “CEFL will never recover.” More recently, a commentator on SA wrote: “CEFL has a problem that means its price will always drop, so don’t get tempted by CEFL.” To address that problem I will use the same computation model as the one in the UBS Pricing supplement. And I will try to evaluate what type of growth would be needed to ‘recover’ from today depth. I will then analyse the ISE High Income™ Index (the “Index”) to evaluate what type of growth could be achievable over the long term. I will make also some assumptions on the LIBOR rate evolution. And, finally, I will try to evaluate what type of return on investment (NYSE: ROI ) could be expected over a ten year time frame. (Note: Please refer to the UBS Pricing supplement ( here ) for examples of the computation model, definitions, risks description and more details) The growth model. The marginal cost, while different from MORL, is comprised of the same three elements: one variable, the LIBOR rate, and two fixed, the financing spread and the tracking rate I have already stated that, for some reasons that I have not yet fully understood, the MORL price is tied to the Indicative value as computed by UBS (before accrued fees). It is the same thing with CEFL. In fact the correlation is almost perfect at 0.9984; meaning that practically all the variations of the CEFL closing market price are induced by the variations of the Indicative value and not the reverse as we could expect. In those ETNs there is no meaningful discount or premium over the Indicative value. This is a key element for those willing to trade heavily this stock. Consequently, as the Indicative value is directly tied to the Index variations we are left with only two variables: The Index variations and the LIBOR rate variations. I have also explained in my previous article how the Principal amount (Indicative value less accrued fees) depends on the sequence and the variation of positive and negative Index months during a given period. So there is no curse that the CEFL price will always go down; it depends on the evolution of the Index and of the Libor rate. In this section I just want to show that, taking into account reasonable assumptions, CEFL can grow over time. And for that I will use my own case. Could I recoup my initial purchase price? Of course, if we want to consider the possibility of a CEFL growth, we have to place ourselves in the context of a positive Index growth trend over the long term. If not, if we think that the Index will ALWAYS trend down over the long term, for sure CEFL will go down much faster. There is no need to go further; end of the case. So, if we assume an Index positive growth trend over the long term that means that during that period the positive months will outgrow the negative ones by the net growth rate. But, as we saw in my previous article, this positive growth rate must be above ½ of the marginal cost, if not the Principal amount could still decline inexorably. The sequence of monthly Index increases and decreases is also of great importance to determine the Principal Amount (i.e. Indicative Value less accrued fees). But as it is impossible to forecast the sequences, we will make the hypothesis that a positive month will be followed by a negative month but of lesser amplitude. The increase and decrease rates will be set so that the end Index level will achieve the net Index growth rate over the given period. Having run plenty of simulations this looks a good approximation. So, let us assume, for the sake of it, that we have a LIBOR rate of 0.90% (three times more than actually), an average Index growth rate of 4.3% per year, a base Index at 71.60 and a base price of $16.92 (September 4th value), the model shows that I can recoup my purchase price of $27.42 in 8 years with an upside multiplier of 1.57. If the Libor rate were at 0.30% and the Index growth rate at 6%, my payback could be advanced to 5 years with an upside multiplier of 1.86. So yes, depending of the variables evolution, the CEFL market price could regain its April 7, 2014 prices, but it will take a long time for the reason we have already stated that the decline is always faster than the rise. We will see in the next section what kind of Index growth rate we can anticipate over the long term. The ISE High Income Index Evolution 2.1 Historical background The ISE High Income Index (The Index; YLDA) was launched on December 31, 2003 with a 100 basis. We can see its evolution here From the beginning of 2004 to mid-2007 it increased 22%. Then it went down 60% to a low of 47 in November 2008 and of 50 in March 2009. By the end of 2009, it climbed back to 88 for a 76% increase. During all 2010 and 2011 it stayed range bound in between 80 and 90. It stayed there up until the announcement of the Taper in mid-2014. It started to decline since then to finish at 71.6 September 4th; a 24% decline since the mid-July 2014. Strangely, it is exactly the same pattern than with MORT. When the economic growth is strong the high interest rates are not a detrimental factor. But when the economic growth is tepid the interest rates are of major importance as if the financial spread were the only source of profitability. 2.2 The Index built I do not want to repeat all the methodology of the Index. I refer the reader to the Solactive Guide. I just want to emphasize one thing. The funds are ranked by descending yield (from the highest to the lowest) and by ascending premium/discount to NAV (from the lowest discount to the highest premium). In the Solactive Guide there is no indication on the yield calculation method. Because the Index is not computed on the NAV but on the market price we assume it is some sort of dividend annualization on the closing market price at the calculation date. For the discount, we assume that it is the one at the calculation date. So, in effect, the Index is selecting the funds with the highest yield and with the highest discount. This is of major importance. On one hand we can say that the funds have a high yield because they have a low price due to a very high discount; not a good combination. On the other hand, we can say that those funds have a great growth potential in reducing their very high discount; a more attractive combination. In fact, the price/discount relationship is based on the NAV evolution and the factual financial situation (i.e. NII, Capital appreciation, dividends, fees) AND the overall sector and market perception. The important point here is that the Index is not computed on the funds NAV but on their market price. So there is no direct relation in between the NAV of the funds and the Index. There is only an indirect relation through the premium/discount of each fund. 2.3 The recent Index decline As we saw in the historical background, the Index suffered a sharp decline of more than 24% since mid-July 2014. This is not surprising. It had been a great worst case scenario. Think about it; the Taper, then the end of ZIRP, then the energy crisis, then the China crisis, etc., etc. Look at the Index components: High yield debt, emerging market debt, global real estate, energy debt, convertible options, high leverage, etc., etc. Take the High yield components; there are some great funds here with great management as Double Line Income Solutions (NYSE: DSL ), Eaton Vance Limited Duration Income fund (NYSEMKT: EVV ) and several other similar funds. But the market is assimilating them to ‘junk’ without differentiating in between pure ‘garbage’ and legitimate, genuine, debt. In the actual conjuncture since mid-july 2014, the market is overreacting. The discount rate of most of the fund soared with Zscores greater than -2.0. For several funds the increase in the discount rate has been two times more than the NAV decrease. I would say that the discount of most of the funds is, at this moment, 50% overvalued. 2.4 Index component changes The Index has an annual review in December of each year. Component changes are made after the close on the last trading day in December and become effective on the next trading days. But the changes are announced on ISE website at least five days prior to the effective date. And that could cause a problem detrimental to the Index in depreciating the price of the component removed (to be sold) and increasing the price of the component added (to be purchased). More important than that is the shift, if any, in the core composition of the Index. Will it get more debt funds or more equity funds, more or less discount and yield, more or less American or Global funds, etc. In other words, will the Index exacerbate the finishing year weakness or, to the contrary will provide room for growth in the coming year? Projections 3.1 The index growth I fully recognize that, due to the fact the Index component funds pay a very large portion of their available income and appreciation as distribution there is not much left for the NAV growth. Consequently, even if we get a snap-back of the discount in the next 12 to 16 months, it is hard to envision that all the funds prices will trade at a premium in the future. Necessarily, we need a base NAV growth of the funds if we want to achieve sustainable components market prices growth and consequently Index growth. This kind of NAV growth is only possible in growing economy conditions with an accommodative interest rates structure. Only those conditions can give the funds the extra margin they would need to grow their NAV while serving a hefty distribution on their market price. 3.2 The US and Global economy growth I know the past years economic growth has not been stellar. It is cliché to say that the American economy is changing. Unless there come disruptive major innovations, the rate of growth will remain relatively low for the next 10 years. And that is in forgiving major, dramatic risks that I will address in Section 5. But, one think I am sure, is that the American economy is not entering a prolonged period of recession or, to say it bluntly, a constant economic decline. On a long term basis it will continue to grow, perhaps slowly, but to grow nevertheless. Just the demographic pressure plus some inflation and a bit of organic growth will be enough to generate an average 3.5 – 4% annual growth rate over the next ten year. With such a modest growth, normally the interest rates structure should stay accommodative over the long term notwithstanding some sharp adjustments to get out of the actual ZIRP policy. By accommodative, I mean that the Effective Federal Funds Rate should stay around 2 – 2.5% on average for the period and that the rate structure should adjust accordingly (the yield curve should steepen). 3.3 The Index growth rate This long term economic trend should be favorable for the CEFs to increase their assets appreciation and their NII while maintaining their distribution thus increasing slightly but regularly their NAV while decreasing their discount and increasing their price. In this context, and I will talk about the uncertainties in the Section 5, I think the Index will grow at least 3% – 3.5% per year, on average, during the next ten years from my purchase date of April 2014. This growth should put the Index around 120 by April 2024. For the short term, I think that the Index will continue to decrease until the end of the year and the beginning of the next (2016). It has to go through the year end fiscal sales, the December 2015 components review and the normalization of the FED monetary policy. That is a lot of headwinds. But, after that, it should start to recover. The CEFs discount will abate, the assets valuation will start to rise and within 1 or 2 years the Index should revert to the 90 level from the actual 71.60 one; a 25% increase. It should then continue en route to the level 100 in the next 2 to 3 years and continue to 120 until the end of April 2014. 3.4 The LIBOR rate As saw earlier the LIBOR rate is an important variable of the computation model. Over the long term, the rate should increase a lot from the actual low of 0.3330% for the USD LIBOR 3 months. Based on my forecast of a 2.5% average effective Federal Funds rate during the ten years period to April 2014, I cannot put the LIBOR rate at less than 3.0%. I know it is a lot of increase from the actual rate, but just look at the historical data since 2000 to be convinced that 3.0% is a minimum. 3.4 The Index and CEFL dividends High distribution is always stated as the primary goal of CEFs. Capital appreciation comes as a second objective. According to Morningstar the average CEF had a distribution rate of 6.72% in 2014. Actually, according to Left Banker ( here ), “the average distribution yield are in the 8%-9% range for taxable funds.” In fact the nominal distribution stayed about the same while the price dropped 20% thus increasing mathematically the yield percentage. (Note: for the CEF funds we can use the terms ‘dividends’ or ‘distributions’ indifferently, but for CEFL we should use the term ‘distributions’ as they are assimilated to interest income for tax purpose; in taxable accounts) On the short term, it is expected that funds nominal dividends will decrease inducing a sharp price reduction so maintaining in effect the same 8%-9% yield percentage. On the long term, however, as I forecast a 3% – 3.5% Index growth rate, I think that the yield percentage will decrease to 7% all sectors combined. But due to the Index growth rate, the number of components shares detained in the CEFL shadow fund will increase by half the growth rate in order to maintain the 2:1 leverage ratio. That means I will take 15.5% ( 2 x 7% + (0.5 * 3%) as the average yield percentage over the 10 years period ending April 2024. This average long term yield cannot be compared with the Current annualized yield computed by UBS,(actually 21.60% (here) or the ‘spot’ yield computed by Professor Lance Bronfman based on September distribution of 23.2% ( here) . Projections and ROI computation 4.1 For the ten years from April 2014 Based on my Index growth rate and my LIBOR estimation during this period my computation model gives me an Index at 124 and a CEFL Principal value at $34.50 for an average compounded growth rate of 2.3%. The around 1.0% differential in between the Index growth and the CEFL growth is the leverage cost. 4.2 For the 104 months from September 2015 to April 2024 If we take the September 4th price of $16.92, which should be close to a bottom, the Index growth rate will be much steeper. But that will not change my end forecast of $34.50 in April 2024 nor my nominal base distributions ($ per share). The growth rate will then be around 8.5% and that will change considerably the ROI as we will see. 4.3 The ROI for the ten years April 2014 – April 2024. So based on a 2.3% CEFL compounded growth rate, a 15.5% distribution yield and a 3% USD 3 months LIBOR, the ROI will come out at around 17.25% per year. 4.4 The ROI for the 104 months from September 2015 to April 2024 Based on a 8.5% growth rate, while keeping the same nominal distribution than the 10 years case (but a 17.0% effective yield), the ROI will come out to 21.0% per year for a 104 months period. So, it may be an excellent investment opportunity to wait for the real bottom in 2016. 4.5 Comparison with the YieldShares High Income ETF (NYSEARCA: YYY ) YieldShares High Income ETF tracks the same Index than CEFL but without the benefit of the 2X leverage. If I take the exact same variables for YYY than for CEFL, Index growth rate 3.5%, CEFs average dividends 7.0%, same period April 7, 2014 to April 7, 2024, the YYY ROI calculated on the same basis and the same way will come to 9.0% per year. The differential of 8.25% in between 17.25% and 9.0% is in fact the risk premium for the added risks and uncertainties of CEFL over YYY. Uncertainties and risks 5.1 Uncertainties My linear Index growth rate of 3.0 – 3.5% over ten years is, in my opinion, the most probable least square average growth rate amidst an infinity of possible combinations within two standard-deviations due to changing economic conditions. And that, without talking about the possible ‘black swans’ I let everyone imagine. The effective Index level could vary +/- 20% around the linear trend meaning that we could have variations of – 33.3% from top to bottom and of + 50.0% from bottom to top over a 1 or 2 years cycle. That means the effective CEFL price could decrease by 66.6% from top to bottom or increase by 100.0% from bottom to top during such a cycle (assuming a 2:1 multiplier for convenience). So better to be prepared for a lot of volatility. As for the LIBOR rate it could stay under 1.0% for a prolonged period of time or could jump to 5.0% if the Fed monetary policy tightens to control inflation. Over a 10 years period an average 3.0% is in concordance with a Fed ‘normal’ monetary policy. Concerning the distribution, I am not so worried because the effective nominal distribution is forecasted to increase only from $4.35 to $5.34 per share over the 10 years period. Historically this is not very much. The discounted cash-flow method is a big help in confronting those uncertainties because the farther we are advanced in the period the more the present value minimize the errors. 5.2 The risks UBS details at length the various risks involved with CEFL. And I refer the reader to the Product Supplement for more details. There are two more specific risks to CEFL the agency riskthe early redemption risk The UBS is certainly a great bank. But as all the big banks it is not immune to have problems. I let everyone makes his/her own judgement. UBS can call an early redemption 1/ if, at any time, the Indicative value equals $5.00 or less and 2/ if, at any time, the indicative value decreases 60% from the closing indicative value on the previous Monthly Valuation Date. Those two conditions would have been met during the last 2008-2009 recession. Again I let everyone makes his/her own judgement on the probability that a similar recession could occur before 2024. Final points I am a private long term investor. I invest in securities as I would in business. The 17.25% CEFL ROI cannot come without extra risks. And I accept them But, in consideration of those risks, I am not prepared to increase my CEFL holdings nor to reinvest my distributions, as tempting as it could be. The CEFL risk premium over YYY, close to 50%, is worth more than the extra risk. So I prefer to keep CEFL over YYY. I have nothing to sell or to promote. I am just interested in contributing in a better understanding of this very complex product, CEFL. I welcome your comments. Disclosure: I am/we are long CEFL, MORL, BDCL, DVHL. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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