NCV: Attractive Entry Point For This High-Yielding Multi-Sector CEF (NYSE:NCV)

Income investors are always on the lookout for higher-yielding investment options. In this article we take a look at one such option – the AllianzGI Convertible & Income Fund (NCV). The fund has a number of attractive features and this is why we have recently added it to our Core […]

Income investors are always on the lookout for higher-yielding investment options. In this article we take a look at one such option – the AllianzGI Convertible & Income Fund (NCV). The fund has a number of attractive features and this is why we have recently added it to our Core and High Income Portfolios.

First, the fund features a robust borrowing profile due to its reliance primarily on preferred stock. Unlike bank-facing leverage instruments, preferred stocks do not force a fund to deleverage in order to maintain a certain asset coverage ratio. Though this raises the fund’s overall cost of borrowing relative to funds that rely primarily on repo or credit facilities by about 0.5-0.75%, in our view this is more than compensated by a stronger profile. The fund has been able to maintain the same level of borrowing through and out of the drawdown, unlike many other higher-leveraged CEFs.

Secondly, the fund has a more growth-oriented allocation than a typical income CEF due to its 1/3 allocation to convertible bonds. This is fairly attractive in the current macro environment due to both low interest rates which favor growth over value assets and benefit sub-sectors that can continue to perform well in a pandemic.

Thirdly, the fund is trading at an attractive discount valuation relative to its own history, its sister CEF and the broader sector. In the sections below we take a look at the fund in more detail.

Meet NCV

NCV closed Friday at a 11.04% current yield and a 13.48% discount. The fund runs a portfolio of high-yield bonds (a third) and convertible securities (two-thirds) at a 42% leverage. Most income investors are aware that convertible yields are very small so the obvious question is how can the fund boast such a high distribution rate with a two-thirds allocation to convertibles? The answer here is that the fund holds both convertible bonds and convertible preferreds (each at a roughly 1/3 allocation). Convertible preferreds are often issued with sizable coupons and many of these securities are convertible in name only. For example, at least three of the fund’s top 10 holdings are, what are known as, busted convertibles such as the Wells Fargo 7.5% Series L Preferred (WFC.PL). These preferreds are trading so far from their conversion price that they are, for all intents and purposes, simply perpetual preferred stock.

The fund’s portfolio has another advantage – convertible bonds tend to skew in a growth direction which is attractive in the current market environment for three reasons. First, the sectors that convertible bonds tend to overweight, such as technology and healthcare, have outperformed in a COVID environment and should continue to perform well out of it. secondly, the low interest rate environment has rewarded growth sectors at the expense of value as low interest rates disproportionately reward higher future growth. And thirdly, convertible bonds are directly linked to equity performance and have more potential upside than regular corporate bonds. This does mean that the fund’s NAV volatility and drawdown potential are somewhat higher than other multi-sector funds which don’t allocate to convertible bonds. However, the fund’s wider discount should mitigate the fund’s relative price drawdowns to some extent.

Another key attractive feature of NCV is its relatively robust leverage profile. More than 90% of the fund’s borrowing profile is sourced via preferred stock. Unlike bank-facing leverage instruments such as repos and credit facilities, preferred stocks cannot force the fund to deleverage. Of course, the fund can choose to do so as a discretionary decision and there can be distribution suspension for common shareholders but the asset coverage requirements of preferred stocks are fairly loose. They can allow the fund to breach its coverage ratio without having to sell down assets in an unattractive market environment. Bank-facing leverage instruments, on the other hand, can force the borrower to immediately deleverage, as we saw with a number of mREITs earlier in the year. This has allowed the fund to maintain its borrowing level into and out of the drawdown.

This combination of a “growthy” portion of the portfolio and a more robust leverage profile is what, in our view, has allowed the fund’s NAV to perform strongly over the past year, rising over 7%. The fund has outperformed the sector in NAV terms by nearly 4.5% over the past year.

A Look At Income

A key question for investors is how much the fund is generating in income and whether it is covering its distribution.

There are basically two ways to gauge fund income levels and distribution coverage: a naive backward-looking approach and a forward-looking approach. The advantage of the backward-looking approach is that it’s fairly straightforward – all we need to do is take the fund’s net investment income of $41.1m from the latest shareholder report and divide it by its total distributions of $57.8m to get to an 81% distribution coverage.

There are a few issues with this approach. First, it tells us something about the fund’s past income and coverage but doesn’t necessarily tell us much about its current income and coverage. This is particularly true in the case of NCV whose latest report only covers the period up to the end of February. This is important because the market dislocation in March drove sharp changes in some key CEF income drivers. In particular, CEF income is driven by short-term rates (via both floating-rate assets such as loans and liabilities i.e. leverage costs) as well as borrowing levels (a large number of CEFs were forced to deleverage, which lowered their income levels going forward). Both of these key drivers caused sharp changes in fund borrowing levels, so ignoring these changes doesn’t give us a good sense of the fund’s current income level.

Secondly, a backward-looking perspective does not recognize that the fund’s distributions were cut by 20%. Curiously, investors often approach distribution cuts in radically different ways. Some investors actively avoid those funds that have historically cut distributions, often paying very high premiums to hold those funds that have not cut distributions. Other investors, however, are more pragmatic and are more than happy to tilt to those funds that have made recent adjustments since it makes the current distribution level more sustainable and means that the fund’s distributions more correctly reflect the fund’s true earnings capacity.

CEFs often have their hands forced in cutting distributions such as when they deleverage, see their leverage costs rise or see income on their assets fall. Interestingly, this did not happen to NCV. The fund did not deleverage, its leverage costs fell and it only holds fixed-coupon securities and so did not see a drop in income due to the fall in short-term rates. One can argue that the fund could have cut its distribution to improve its preferred coverage ratio to keep the rating on its preferred unchanged but Moody’s cut the rating anyway and, in any case, given the fund’s rock-bottom ARPS interest rate increase in the multiplier is just a rounding error on the fund’s total cost of leverage.

Thirdly, and this is a smaller point, NCV uses preferreds for a bulk of its borrowings. Preferreds distributions do not go into the fund’s interest expenses (since they are considered a type of fund distribution, much like distributions on common stock). However, from the point of view of common shareholders they are nothing but interest expense and so should be subtracted from the fund’s investment income.

Taking each key driver in turn. The fund’s borrowing composition has not changed from the previous year. The bulk of the borrowing is done via preferred stock (both floating-rate ARPS and fixed-rate $25-par preferreds) and a small amount via a floating-rate loan. Two of these three types of borrowings are floating-rate and have adjusted substantially lower from the previous year.

The interest rate on the ARPS is linked to the 7-day AA commercial paper rate with a multiplier that depends on its rating. Earlier in the year the ARPS was downgraded by Moody’s from Aa3 to A1 causing the multiplier to rise from 150% to 200%. However, even with this elevated multiplier, the interest rate of the ARPS is 0.176% – an extremely low figure. In contrast, interest rates on repos and credit facilities, which are also floating-rate leverage instruments, tend to range from 0.75% to 1.5% in the current environment. There is only a handful of other funds, most notable PIMCO funds, which boast similar instruments but ARPS makes up a much bigger proportion of the NCV capital structure for PIMCO funds.

The interest rate on the small loan is at a rate of 3-month LIBOR + 0.55%. There are a couple of unusual features of this loan. First, fund bank loans are usually linked to 1-month LIBOR. This is because historically 1-month LIBOR has tended to trade a bit below the 3-month rate, making the overall loan optically cheaper. However, the optics of the lower base rate did not necessarily translate into a cheaper overall loan since bank cost of funding and the present value valuation of a 1-month loan is still linked to 3-month LIBOR. This meant that the credit spread on the loan was often adjusted upward to reflect the lower 1-month base rate. Now that both LIBORs are trading at extremely low levels, the base rate advantage of 1-month LIBOR has compressed to very low levels – just 0.07% at current levels which should favor loans agreed on the basis of the 3-month rate.

Secondly, and this is most likely linked to the above point, but the spread over LIBOR of 0.55% is very low as far as bank loans go, particularly given the fund’s high-beta and relatively low quality portfolio. For instance, the Nuveen preferreds funds which boast majority investment-grade portfolios are paying 0.70% over 1-month LIBOR. By contrast, NCV only has 12% of the portfolio in investment-grade securities even though it pays a lower rate on the loan.

The chart below gives a decomposition of the fund’s yield. The combination of a moderate fee of 0.70% on total assets (by contrast the other multi-sector managers such as DoubleLine and PIMCO tend to charge higher fees), decent income and a sizable discount combine to generate an attractive price income yield on net assets.

Source: Systematic Income

So, returning to the fund’s distribution coverage. When we put all these new factors together we get to a figure of just over 90% – well above the previous estimate of 81%.

Relative Valuation

Whenever investors look at individual CEFs, it is important to consider other similar investment options. This is because most CEFs aren’t all that unique – they often share similar investment mandates, allocate to similar assets and, more broadly, co-exist in a competitive fund ecology with investment managers trying to outperform each other. In this section, we look at the fund relative to its sector and relative to its sister fund AllianzGI Convertible & Income Fund II (NCZ).

Let’s have a look at NCZ first. The two funds appear to have followed somewhat different mandates prior to about 2017, judging by the following chart which plots the 3-month rolling NAV return correlation. Over the last 3 years, however, the NAV correlation of the two funds has basically converged to 100%, suggesting that the two funds now run very similar portfolios.

Source: Systematic Income

The longer-term NAV return picture echoes this. The performance of the two funds has tended to diverge from each other prior to about 2017 when it became hard to distinguish the two funds from each other.

Source: Systematic Income

A quick look at the top 10 holdings of both funds follows this pattern – the top holdings are not only identical but the order is the same and the holding percentages do not differ more than a few hundreds of one percent.

Over the last 3 years or so NCV has tended to trade at a slightly tighter discount than NCZ. This is due to the fact that NCV has tended to have a higher NAV distribution rate which would allow it to have a higher price distribution rate if the two funds traded at the same discount.

Source: Systematic Income

More recently, however, the discounts of the two funds have converged and are trading at essentially the same level.

Source: Systematic Income

If the two funds are so similar and NCV has a higher NAV distribution rate, doesn’t this mean that NCV is overdistributing relative to NCZ? The answer is no. Just because the two funds look very similar on the asset side does not mean they are similar on the liability side. As the liability table below shows, NCV enjoys a weighted-average leverage cost that is 0.54% lower than that of NCZ due to its larger allocation of ARPS.

Source: Systematic Income

This leads to NCV having a NAV NII yield that is 0.31% higher than that of NCZ and, despite its higher NAV distribution rate, its coverage of 90% is slightly higher than that of NCZ by 2.5%. That the two funds are trading at nearly identical discounts creates a good entry point for NCV over NCZ.

Let’s have a look at NCV relative to its own sector. The fund is trading at a 13.5% discount and a 15th 5-year discount percentile (i.e. its discount has only been wider than current level 15% of the time over the last 5 years). By comparison, the average discount of its sector is just 2.2% and the average discount percentile is less attractive at 45%.

Source: Systematic Income

If we plot the fund’s discount relative to its sector we see that over the last 4 years the fund used to trade at a tighter discount but has now moved to a level well wider of the sector average. This is despite boasting a current yield well above the sector average.

Source: Systematic Income

Conclusion

NCV is a mixed-sector high-yield bond, preferred and convertible CEF that looks attractive on a number of fronts. It boasts a high distribution rate of just over 11% with decent coverage of about 90%. The fund features a very robust leverage profile that has allowed it to maintain its borrowing and hence income level through and out of the drawdown, in contrast to many other higher-leveraged funds. Finally, its growth-tilted portfolio should continue to be rewarded in an environment where the Fed has committed to keep rates low for an extended period.

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Disclosure: I am/we are long NCV. 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.

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