Here's Why You Shouldn't Pay $1.10 For A Dollar Of Investment Grade Bond Assets

I’ve received questions from prospective subscribers about the types of trade alerts that we issue to the members section of the Cambridge Income Laboratory. One type of trade is CEF arbitrage, or more specifically a pairs trade, where we simultaneously identify an overvalued CEF and an undervalued CEF in the same sector. The strategy then entails selling or selling short the overvalued fund while simultaneously buying the undervalued fund.

The advantage of a CEF pairs trade is that because both the sold and bought funds are from the same sector, we aren’t making a directional bet on the performance on the underlying assets. Instead, we’re simply relying on the powerful concept of reversion of CEF premium/discount values (see Reflections On Chemist’s CEF Report Pick Performance In 2017 for how this has worked well for us in the Chemist’s monthly CEF picks).

There are two main limitations of the CEF arbitrage strategy. The first is that the magnitude of the gains are unlikely to be very large, simply because it is by nature a hedged strategy. That’s the trade-off for the strategy being relatively low risk. The second limitation is that unless you already own the overvalued CEF identified in the pairs trade, you would have to locate shares of the overvalued CEF to sell short. With some of the smaller, less liquid CEFs, this can range from expensive to downright impossible. The most optimal set-up is therefore already owning the overvalued CEF, and then locking in profits by selling the fund and then replacing it with the undervalued CEF in the same sector.

With the introductory blurb out of the way, let’s see how this has played out for one of the more recent CEF pairs trade that we identified in the members section of the Cambridge Income Laboratory.

About 4.5 months ago (see Sell This Investment Grade Income CEF Now), we noticed the premium of Western Asset Income Fund (PAI), an investment grade bond CEF, suddenly spiking up to +10.16%. The 1-year z-score was +3.6, indicating that this fund was significantly more expensive than its recent history. My comments from the initial article are reproduced below:

I was looking through the CEF database today and noticed the Western Asset Income Fund (PAI) trading at an exceptionally high z-score of +3.6.

Its current premium of +10.16% is at a 5-year high.

(Source: CEFConnect)

A 1-year z-score of +3.6 tells us that the premium/discount is trading 3.6 standard deviations above its 1-year historical value. Statistically speaking, this would be a 0.02% probability of occurrence, assuming that the distribution of values is normally distributed (which it isn’t, but the point is that such a high z-score is a rare occurrence).

The 5-year chart above showed that the fund traded at quite substantial discounts over the past 5 years, sometimes exceeding even -10%. This makes the current premium of +10.16% even more unusual than the 1-year z-score of +3.6 would indicate.

At this juncture, I wanted to look at the entire history of the CEF since inception. Perhaps the past 5 years was just an anomaly, and that the CEF has commanded a consistent premium in the past? It turns out that was not so.

Going back to inception, only during a brief period in 2009 did the fund’s premium exceed 10%. An unusually high premium for an investment grade fund might be understood during the immediate recovery period after the financial crisis…but why now? I can’t think of a fundamental reason why someone would pay $1.10 for a dollar of investment grade debt.

(Source: CEFConnect)

I then check out the premium/discount values of the peer group. Maybe investment grade bond CEFs are for some reason on a tear thus accounting for PAI’s unusual premium? Nope, that’s not it.

The premium of PAI is 3rd-highest out of the 15 CEFs in the “investment grade” category of CEFConnect. But I don’t consider PIMCO Corporate & Income Strategy Fund (PCN) and PIMCO Corporate & Income Opportunity Fund (PTY) to be traditional investment grade income CEFs, so not counting those two funds PAI has the highest premium in the peer group.

(Source: Stanford Chemist, CEFConnect)

OK, so PAI is a pretty good sell or short candidate. What did I pair my short PAI position with?

What did I pair my short PAI position with? I chose the BlackRock Credit Allocation Income Trust (BTZ). I wanted to choose a fund with a negative z-score, but rather amazingly all 15 investment grade CEFs had z-scores 0 or greater. BTZ’s z-score of +0.8 wasn’t the lowest, but its discount of -9.04% was the widest in the peer group, as you can see from the chart above.

Next, I wanted to see compare the price and NAV returns of these two investment grade bond CEFs to check if there were signs of deteriorating portfolio values in the undervalued CEF, which might cause me to consider BTZ as the long partner in this pairs trade.

The opportunity for the pairs trade comes from the fact that PAI’s price return is significantly outpacing its NAV return, whereas that is not the case with BTZ. We can see from the chart below that PAI appears to be blowing BTZ out of the paper with a +19.29% YTD return compared to only +8.94% for BTZ.

Chart

However, their YTD NAV returns are nearly identical.

Chart

No warning signs there. That leads me to the conclusion that:

In summary, if you own PAI, now would be a great time to sell!

Let’s see how the thesis played out 4.5 months later. BTZ had a total return loss of -3.88% over this time frame. That’s bad, of course, but still relatively much better than PAI’s loss of -14.1% over the same period. In other words, BTZ outperformed PAI by 10.22 percentage points in only 4.5 months, or about 27% annualized.

Did PAI’s portfolio do much worse than BTZ’s? No, and in fact the reverse was true. PAI’s net asset value [NAV] fell by -2.10% over this time period, but BTZ’s was even worse at -3.24%.

If BTZ’s portfolio did worse than PAI’s, why was its total return (much) better? My regular readers will have already guessed at the answer: premium/discount mean reversion! Over the last 4.5 months, PAI’s premium of +10.16% has sank to a discount of -4.82%, while BTZ’s discount of -9.04% has widened slightly, to -11.9%. Therefore, the majority of the outperformance of the long BTZ/short PAI pairs trade was due to the contraction of PAI’s discount.

Chart
PAI Discount or Premium to NAV data by YCharts

Summary

This article hopefully conveys our thought process in recommending a pairs trade to our members. Anyone who owned PAI and swapped to BTZ to would have profited to the tune of ~10% in only 4.5 months (~27% annualized), which is equivalent to about 2.5 years worth of distributions from PAI!

Note that I did not need to do a deep dive analysis of either PAI or BTZ to initiate this pairs trade. This was based almost entirely on premium/discount mean reversion, or as my fellow SA author Arbitrage Trader likes to say, “simple statistics”.

Taking stock of the situation today, the long BTZ/short PAI trade has to be considered to be largely completed, as PAI is now trading with a discount of -4.82% and a 1-year z-score of -1.5, indicating that is now cheaper than its historical average. Although BTZ’s z-score of -2.5 is even lower, as is its discount (-11.9%), the gap in valuation is no longer there.

Are there any current opportunities? The following table shows the 12 CEFs in the database that currently have z-scores greater or equal to +2.5. If you own ones of these funds, if might be a good idea to seek out another fund in the same category that is trading with a more attractive valuation, particularly if the fund that you own is also trading at a premium. Don’t let mean reversion catch you out!

Name Ticker Yield Discount z-score
MS Income Securities (ICB) 2.71% -1.47% 3.9
BlackRock Science and Technolo (BST) 5.32% 3.05% 3.2
Tortoise MLP Fund (NTG) 8.61% 9.26% 3.2
ClearBridge Energy MLP (CEM) 8.85% 5.53% 3.1
Gabelli Utility Trust (GUT) 8.50% 44.95% 3.1
Templeton Emerging Mkts Income (TEI) 3.79% -8.17% 3.1
Sprott Focus Trust (FUND) 4.97% -8.86% 3.0
Nuveen S&P Dynamic Overwrite (SPXX) 5.58% 9.54% 2.9
RiverNorth Opportunities Fund (RIV) 12.09% 6.83% 2.7
Deutsche High Income Oppos (DHG) 5.42% -0.60% 2.6
First Trust New Opps MLP & En (FPL) 10.52% 6.67% 2.5

Western/Claymore Infl-Lnk Opps

(WIW) 3.79% -9.71% 2.5

(Source: CEFConnect, Stanford Chemist)

We’re currently offering a limited time only free trial for the Cambridge Income Laboratory. Prices are going up on March 1, 2018, so please join us and lock in a lower rate for life by clicking on the following link: Cambridge Income Laboratory.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: I am long the portfolio securities.

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Washington, D.C., Has Given the Boring Company a Permit for a Possible Hyperloop Station

Washington, D.C., has issued a permit allowing Elon Musk’s Boring Company to do preparatory and excavation work in what is now a parking lot north of the National Mall. The company says the site could become a Hyperloop station.

The permit, reported Friday by the Washington Post, was issued way back on November 29th of 2017. The permit is part of an exploratory push by the city’s Department of Transportation, which according to a spokesperson is examining the feasibility of digging a Hyperloop network under the city. The Hyperloop is an as-yet theoretical proposal to use depressurized tubes and magnet-levitated pods to move passengers at very high speeds.

A Boring Company spokesperson told the Post that “a New York Avenue location, if constructed, could become a station” in an underground transportation network. The Boring Company last year showcased the possibility of moving cars underground on mag-lev sleds, though that concept wasn’t quite a version of the Hyperloop proper.

The increasing prominence of Musk’s own Boring Company in pushing for Hyperloop construction is a notable reversal of the entrepreneur’s initial plans for the concept. When he unveiled a paper describing the idea in 2013, Musk said he wouldn’t be directly involved with building it. That led several independent startups, including Hyperloop One and Hyperloop Transportation Technologies, to take up the cause.

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But last summer, Musk started touting tentative Hyperloop partnerships between the Boring Company and governments in the Northeast U.S. A few weeks before the D.C. permit was issued, Maryland issued a permit for the Boring Company to build a 10.3-mile tunnel on a route between Baltimore and D.C.

Other Hyperloop projects have made headway in Europe and the American midwest, presenting the possibility of multiple regional Hyperloop systems operated by different companies.

The Hyperloop concept as a whole, though, has come under renewed scrutiny lately. It’s unclear how such a huge project would be paid for — selling Boring Company flamethrowers is unlikely to cover the bill. More fundamentally, urban planners have argued that the Hyperloop, which would use small pods to carry a few riders at a time, can’t scale sufficiently to really address urban transportation needs. Musk, in an unusual fit of pique, recently replied to one such criticism by calling its author an ‘idiot.’

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Can Machines Save Us From the the Machines?

Is it just me or is the cyber landscape getting more scary? Even as companies and consumers get better at playing defense, a host of new cyber threats is at our doorsteps—and it’s unclear if anyone can keep them out.

My doom-and-gloom stems from the dire predictions of Aviv Ovadya, the technologist who predicted the fake news epidemic, and now fears an “information apocalypse” as the trolls turbo-charge their efforts with AI. He points to the impending arrival of “laser phishing” in which bots will perfectly impersonate people we know by scraping publicly available images and social media data. The result could be the complete demolition of an already-crumbling distinction between fact and fiction.

Meanwhile, the phenomenon of crypto-jacking—in which hackers hijack your computer to mine digital currency—has quickly morphed from a novelty to a big league threat. Last week, for instance, hackers used browser plug-ins to install malignant mining tools on a wide range of court and government websites, which in turn caused site visitors to become part of the mining effort.

The use of browser plug-ins to launch such attacks is part of a familiar strategy by hackers—treating third parties (in this case the plug-ins) as the weakest link in the security chain, and exploiting them. Recall, for instance, how hackers didn’t attack Target’s computer systems directly, but instead wormed their way in through a third party payment provider. The browser-based attacks feel more troubling, though, because they take place right on our home computers.

All of this raises the question of how we’re supposed to defend ourselves against this next generation of threats. One option is to cross our fingers that new technologies—perhaps Microsoft’s blockchain-based ID systems—will help defeat phishing and secure our browsers. But it’s also hard, in an age when our machines have run amok, to believe more machines are the answer.

For a different approach, I suggest putting down your screen for a day and picking up How to Fix the Future. It’s a new book by Andrew Keen, a deep thinker on Silicon Valley culture, that proposes reconstructing our whole approach to the Internet by putting humans back at the center of our technology. Featuring a lot of smart observations by Betaworks founder John Borthwick, the book could help us fight off Ovadya’s information apocalypse.

Have a great weekend.

Jeff John Roberts

@jeffjohnroberts

[email protected]

Welcome to the Cyber Saturday edition of Data Sheet, Fortune’s daily tech newsletter. You may reach Robert Hackett via Twitter, Cryptocat, Jabber (see OTR fingerprint on my about.me), PGP encrypted email (see public key on my Keybase.io), Wickr, Signal, or however you (securely) prefer. Feedback welcome.

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