GBAB CEF: A Year Later, The Outlook Remains Challenging

Essential Thesis & Background

The aim of this text is to guage the Guggenheim Taxable Municipal Bond & Funding Grade Debt Belief (NYSE:GBAB) as an funding possibility. This fund presents publicity in taxable municipal bonds, with a main funding goal to “present present earnings with a secondary goal of long-term capital appreciation”. In apply, this can be a diversified fund, however with a heavy allocation in direction of taxable muni bonds, together with a wholesome portion of financial institution loans and different excessive yield credit score merchandise.

I noticed some worth in GBAB final 12 months when the bond and credit score markets began to sell-off. Suffice to say – this was not a superb name. The broader fairness and earnings markets fell all through 2022 leading to a detrimental return for each:

The sort of drop would usually point out a purchase alternative for me, however on this case I’ve considerations. I believe the fund’s excessive yield might usher in some patrons however I usually suppose a extra risk-off strategy is smart. That is the explanation for my downgrade to “impartial” for this fund, and I’ll clarify the logic behind it intimately under.

Why Take into account Bonds At All?

To start out, I wish to talk about why anybody would even be contemplating fixed-income in any respect proper now. After a disastrous 2022, the sector has seen a rebound in early 2023, though a few of these good points have slipped away as inflation has remained persistent. This has led the Fed to reiterate its rate-hiking plans and compelled a re-set on investor expectations almost about the benchmark price.

Even on this local weather there are causes to contemplate bonds (and GBAB by extension). For one, the truth that it’s so unloved factors to a purchase alternative. Whereas that will sound counter-intuitive, that’s the level. Bonds, in any sector, are a little bit of a contrarian play proper now. It is because buyers have fled this funding concept constantly to the purpose the place shopping for in now may provide potential alpha when buyers do determine to rotate again in.

The thought being that purchasing as everyone seems to be promoting permits buyers to front-run the eventual rotation again in to the sector. This indicators to me {that a} contrarian play may have fairly a little bit of worth right here and that’s one thing to significantly take into account.

GBAB’s Variety A Plus

If one is certainly then contemplating bonds, GBAB might catch their eye. Whereas I usually lump GBAB in with its taxable muni friends – the Nuveen Taxable Municipal Revenue Fund (NBB) and the BlackRock Taxable Municipal Bond Belief (BBN) – it truly is not a direct peer. That’s as a result of these two funds focus nearly completely on taxable muni debt and GBAB doesn’t.

The truth is, there’s extra to GBAB than meets the attention as a result of even its title says “funding grade debt” might give buyers the mistaken impression. Is the fund largely IG-rated. Sure. However it additionally holds excessive yield bonds as effectively. I am not saying that is unhealthy as a result of it does give the fund some range. However it is a crucial level of reference as a result of that will shock somebody who solely appears to be like on the fund’s title and doesn’t dig deeper:

I deliver this up as a result of if somebody is in search of a one cease store with respect to fixed-income, this might be the play. GBAB provides buyers publicity to quite a lot of sectors and permits them to seize the elevated yields from quite a few elements of the fixed-income market:

Can yields push greater from right here? Completely – and so they very effectively may if the Fed retains pushing charges greater. However on a historic foundation these are affordable entry factors. No one can assure good points from shopping for at these ranges, however the earnings is excessive sufficient in relative phrases to current an affordable risk-reward proposition in my view.

Why The Concern? Valuation A Sore Spot

As I famous early on on this overview I’ve a impartial/maintain ranking on GBAB. I’ve simply mentioned just a few explanation why somebody would wish to purchase GBAB – so let’s now talk about the rationale behind the warning. A main driver of that is the fund’s valuation, which is all the time an vital attribute for myself personally. Trying again to February 2022, GBAB had a reduction to NAV round 4%. At time of writing, regardless of a 7.5% loss since that point, GBAB has now seen this metric climb to a premium of 6.5%:

The takeaway I draw right here is simple. GBAB is not “low cost”, and truly is beginning to look fairly dear. Proper now I would like worth, and GBAB is brief on it at present costs.

Regular Revenue – A Warning Signal?

When GBAB it’s arduous to discover a direct peer. As I discussed, BBN and NBB are the closest when it comes to being “taxable muni” centered. So GBAB aligns pretty intently with them since roughly 2/3 of its portfolio focuses on that sector. Nonetheless, its range units it aside and may clarify the efficiency divergence between these funds over the previous 12 months. As an example, whereas GBAB has fared poorly, that pales compared to the collective drops by NBB and BBN:

It could be simple to write down this off solely on the totally different portfolios. However that solely explains a part of it. One more reason for the differential is the earnings story. Whereas GBAB has stored its earnings regular for the reason that starting of 2022 till now, NBB has seen two earnings cuts and BBN one, as proven under, respectively:

On the floor this appears to be like like a superb backdrop for GBAB. So – that begs the query – why the priority on my half?

The reason is is I do not see how for much longer GBAB can sustain this consistency. I’m impressed by the earnings’s resilience over the previous 12 months and consider its out-performance is justified due to it. But when I had been to purchase the fund now I’m involved about an upcoming earnings minimize (versus persevering with to be impressed by an absence of 1 final 12 months). That is vital as a result of I consider BBN and NBB have each seen their share costs re-set a bit on the backdrop of those cuts. If GBAB sees an analogous minimize, it too will possible sell-off. That presents a chance for affected person buyers, but additionally a threat for present holders of the fund.

The straightforward logic right here is that GBAB is being pressured by the identical macro-forces as all different leveraged CEFs. An inverted yield curve is making short-term borrowing dearer whereas concurrently limiting alternatives on the longer-end of the curve. That does not bode effectively for utilizing leverage to amplify returns. The truth is, it may have the other impact as 2022 confirmed us.

This isn’t concern mongering both. By GBAB’s personal monetary studies we see the fund is struggling to earn sufficient in earnings to cowl the present distribution price. The latest distribution is being paid by nearly 36% return of capital. That isn’t a superb signal for long-term well being of the earnings stream:

I surmise an earnings minimize to be on the horizon sooner or later in 2023. That can most definitely result in a market sell-off, particularly as a result of GBAB is buying and selling at a premium to its underlying value. That is central to downgrading this from a “purchase”. I believe persistence shall be rewarded right here and shopping for in earlier than the eventual distribution minimize will show to be a mistake.

The Fed’s Pause Is Close to

I’ll wrap up the overview by reminding readers that 2023 is nearly sure to be extra favorable for bonds than final 12 months. Given how poor 2022 was, that’s not a daring prediction! However the problem stays inflation and Fed price hike tightening, so it will not be clean crusing essentially.

Regardless of these considerations I’m not alarmed on the risk-reward potential for fixed-income, whether or not within the taxable muni realm or in any other case. If the Fed retains elevating its benchmark price that shall be a headwind, however I see possibly .50 foundation factors left as a result of a pause. Inflation may change this outlook if it stays stickier than anticipated, however historical past reveals us the Fed is nearing its 30-year excessive. Will the Fed push previous these historic precedents? Maybe. However I genuinely do not see 2023 because the 12 months to experiment with charges greater than 6%:

The conclusion I draw right here is the market and the economic system usually are not prepared and in a position to deal with charges in extra of 6% whether or not the Fed desires it to or not. Even 5.5% goes to be a problem. This tells me the Fed has 1-2 strikes left (relying on if it continues with .25 foundation level hikes or .50 foundation factors). When it does hit its ceiling, that pause will show a boon for fixed-income broadly. That provides an vital tailwind for GBAB within the second half of 2023, together with all the opposite leveraged credit score funds I observe and write about.

Backside-line

GBAB may gain advantage from a broad investor return to fixed-income. That is very true given its taxable muni focus. Whereas taxable munis do not have the identical tax benefits as their exempt counterparts, there’s worth within the sector in comparison with taxable company bonds. Spreads have widened for every, however at a higher scale for taxable munis, signaling inherent worth:

As well as, GBAB’s yield stays excessive and its diversification is a notable profit. All of those components play in its favor.

However I’ve considerations as effectively. The fund’s premium to NAV signifies an absence of worth on the open market. Additional, whereas the regular distribution might be interpreted as an indication of energy I believe it means a minimize is on the best way within the short-term. If true, volatility will ensue that ought to open up higher entry factors. For these causes, warning reigns supreme for me. I believe a “maintain” ranking is the best name and counsel readers strategy any new positions very selectively at the moment.