CEFL: Overstated Yield Due To Leverage Costs And Underlying Coverage – UBS ETRACS Monthly Pay 2xLeveraged Closed – End Fund ETN (NYSEARCA:CEFL)

The leveraged ETRACS exchange-traded notes issued by UBS have been historically popular with income investors for two main reasons: substantially high headline yields and historically low cost of leverage. However, the current environment of low asset yields and still-high leverage costs present a challenge to this model. In this article we take a look at the ETRACS Monthly Pay 2xLeveraged Closed-End Fund ETN (CEFL) as well as its sister leveraged notes.

Our key takeaway is that the way these ETNs make distributions makes it difficult for investors to gauge how much additional income the ETN is earning for the additional risk provided by the second turn of leverage. This is due to the fact that leverage costs are both relatively high and taken out of ETN NAVs rather than the ETN distributions. If we adjust for these costs, we find that many ETRACS ETNs have earnings yields that are not only substantially lower than their headline yields but also not significantly higher than the yields of their unleveraged alternatives.

We think investors need to be clear-eyed about the investment case for CEFL and other ETRACS notes. If investors are long CEFL for total returns and capital gains then a leveraged bet on a basket of CEFs may very well do the trick. However, investors who are in CEFL for income should consider carefully the actual risk-reward on offer. For example, we calculate that the earnings yield of CEFL is closer to 10% – a far cry from the trailing twelve month distribution rate of around 17%.

This suite of UBS ETNs is a set of funds that we closely follow on our service. This is because these funds demand relatively high-frequency analysis due to a number of fast-moving parts. Ultimately, our view is that investors should avoid poorly compensated risk and this belief is at the heart of this article.

A Low Yield Landscape

Closed-end fund yields have fallen from their December sell-off and are now close to their 5-year lows. In fact the CEF market has been under pressure for some time due to low secular long-term interest rates and steadily rising short-term rates which have limited reinvestment opportunities and increased the cost of leverage.

Source: ADS Analytics LLC, TIINGO

No wonder then that some investors have looked to more heavily leveraged funds such as the ETRACS suite of products for higher yields. These vehicles have been consistently sporting TTM yields well higher of the median CEF.

Source: ADS Analytics LLC, TIINGO

ETRACS Quick-Take

In this section we briefly review some of the salient features of these products which create some unusual or unexpected dynamics that may be new to investors.

• ETRACS Exchange Traded Notes are senior, unsecured, unsubordinated debt securities. So although these products look like exchange-traded products, they are somewhat akin to UBS corporate “bonds”. This means that investors are on the hook for UBS credit risk in the sense that if UBS defaults on its senior debt, investors will have a claim on the bank. The UBS credit risk itself we don’t find particularly worrisome; what we find slightly annoying is that investors are not compensated for taking this risk at all, particularly since the maturities of the ETNs are quite long-dated.
• ETN fees are composed of tracking fees (general management fees you normally see: on the order of 0.50% to sub-1%) and financing fees (on the order of 3-Month Libor flat to 0.85%). Not all the financing fees are “fees” as such as UBS incurs costs to fund the leveraged portion of the ETN. However, the spread over Libor is clearly set high enough to ensure that UBS does not expect to take a loss while doing this.
• For leveraged ETNs, it is generally more expensive to leverage the underlying assets yourself. The cheapest margin loans we are aware of for small amounts is from Interactive Brokers at Fed Funds + 150 which is typically higher than the total ETN fees which are around 3-Month Libor + 1% – 1.7% (Fed Funds around 3-Month Libor currently). However, there are some notes like PFFL which are actually cheaper to leverage yourself.
• ETN fees get taken out of NAV (technically the indicative value but we will use the term NAV in the article). This is something that happens with other exchange-traded products, however the much larger total fees of the leveraged ETNs (on the order of 10x of other passive vehicles like ETFs) creates some unusual dynamics.
• The corollary of the above fact is that the headline trailing-twelve month yield or current yield of the notes is overstated. The main reason is that the notes are structured in such a way as to mimic what someone would receive had they held all the securities underlying the note. This means that UBS has to take the fees out of somewhere else and the only other choice is the NAV. To give an example, a $20 annual distribution with $5 fees over an NAV of $100 will be presented as a 20% yield on various sites whereas the fund is really only earning $15 after fees. There is a second bit of irony and that is the fact that UBS taking the fees out of the NAV actually further inflates the apparent yield on the notes because of the lower NAV denominator over which the distributions are divided. To get some intuition on this, let’s consider an extreme case – you give me $10 and I give you back $9 at the end of the year paid entirely out of the original $10. The yield on this “investment” is an enormous 900% ($9 of distributions over the remaining $1 of NAV).
• One corollary of the reduction in NAV due to fees, all else equal, is that distributions will steadily decrease as well. This is because unlike actual funds, the ETNs don’t actually hold any assets. In other words, imagine a high-yield bond fund which distributes the coupons it receives on its bond portfolio. If rates or credit spreads rise, the NAV of the fund will most likely fall; however, assuming no defaults, the fund’s coupon stream will not change. The ETN’s do not work this way; instead they reference an index and distribute a rate which is proportional to the ETN’s market value.
• Another corollary of fees taken out of NAV is that, all else equal, the NAV will reduce with time. This often riles investors who like to think of their principal as inviolable and steady. In our view, cash is fungible so as long as investors are aware of the mechanics it’s not a real concern apart from tax impacts. In other words, by virtue of taking fees out of the NAV, the notes increase ordinary income taxes and decrease potential future capital gains taxes.
• Another consequence of the steady reduction in the NAV means that making a decision based on the current price relative to its historical range is not a good idea because the note NAV will tend to trend lower, all else equal.
• Confusingly, UBS has issued Series A and Series B notes which, apart from the next comment, do the exact same thing. It looks like the intention is for UBS to stop all Series A note issuance and only issue Series B notes. This has to do with the lack of Series B guarantee of what appears to be the local Swiss UBS entity. FINMA, the Swiss regulator, often takes a conservative view of things so we wonder if this is what is behind the rotation but that is a pure guess.
• Related to the issuance comment above, UBS has suspended sales (sales is not the same as issuance as sales can come from an existing inventory of previously issued notes) in a number of ETNs which has caused a divergence between different series, most notably between the MORL/MRRL ETNs. This area is worth watching because it can pay to switch between notes in different series.
• Notes can be early redeemed in a benign way due to, say, a lack of demand, or due to a hard price trigger with the investor receiving what is left after termination. The latter can lead to some significant capital losses, particularly if no new notes are issued to allow investors to retain their market exposure.
• Leveraged notes may suffer from volatility drag which has to do with the compounding of returns. Generally speaking, the more mean-reverting and more volatile the asset, the worse the volatility drag. This is generally not an issue for the ETRACS notes as the impact tends to be fairly small. For example, equally balanced 12 monthly returns of +3% and -3%, in any order will cause the NAV to fall by 0.5% by the end of the year.

How We Think About Leveraged ETRACS Notes

The reason why we think it is important to look at these products now is because short-term rates have increased over the last few years as the Fed has maneuvered away from its previously highly accommodative zero interest-rate policy. The Fed has recently made what they call a “mid-term adjustment” and short-term rates appear to have peaked. However, they still remain well wide of their post-recession lows and are likely to remain so for the medium term.

Source: ADS Analytics LLC, TIINGO

The ETRACS ETNs provide a good illustration of how we approach the fund market. Our fundamental view is that it is not reasonable to make an investment case for a particular fund without looking at the alternatives. This is because a given fund exists in a competitive ecology of similar funds that compete with each other on the basis of valuation, alpha, governance and other metrics.

How does this apply to the ETRACS ETNs? For a given ETN, there are two obvious alternatives: the unleveraged asset and the other leveraged ETNs.

Why look at the unleveraged asset? Well, imagine a leveraged note like CEFL gave you an additional yield pickup of just 1% while doubling your volatility and drawdowns. This doesn’t seem like a great deal.

And why look at other leveraged ETNs? Well, the other leveraged ETNs can provide a similar yield with a different risk profile. So, an allocation to CEFL has to make sense against those potential similar alternatives.

CEFL vs YYY

To start off with, let’s compare CEFL to its unleveraged alternative. What is the unleveraged alternative? Well, there isn’t one. At least no exact one. The Yieldshares High Income ETF (YYY) is based off the same ISE High Income Index however it actually holds the underlying CEFs while CEFL does not. This means YYY will have some tracking error due to the timing of rebalancing and trading slippage whereas CEFL, being a synthetic product, will not. Is this a problem? Well, not really as it’s close enough for our purpose here.

The simplest thing we can do is to simply look at risk and return.

Source: ADS Analytics LLC, TIINGO

Source: ADS Analytics LLC, TIINGO

YYY has generated a positive return since 2014 (year of CEFL inception). CEFL has outperformed YYY over this period due to this positive return and the 2x leverage, which is a good start. CEFL has generated an additional absolute 2.1% of return over YYY or 42% in relative terms. While CEFL has come out well ahead of its unleveraged alternative, an excess return of 2.1% seems somewhat disappointing during a period of strong stock and bond returns.

For this additional 41% boost in total return, CEFL saw 217% of the volatility of YYY and twice the drawdowns of YYY. You can clearly see a step-down in the Sharpe ratio in the table. The fact that CEFL delivered a fairly small pickup relative to YYY has to do mostly with the fact that the cost of leverage took a big chunk out of the additional yield.

This suggests we should take a closer look at the CEFL yield. As we briefly discuss above, the tempting thing to do would be to just compare current or TTM yields of CEFL vs YYY. However, this misses out on the fact that CEFL fees are 1) very high (mostly due to the cost of leverage) and 2) taken out of NAV. So we need to adjust the CEFL yield for these fees to gauge what additional actual cashflow CEFL provides over and above YYY.

CEFL Yield Breakdown

CEFL and other ETRACS notes are designed in such a way as to synthetically pass through the distributions received on the referenced assets. This is why the headline TTM yields of these ETNs will be roughly double those of the underlying funds. Of course, the nature of those yields is very different. The yield of the unleveraged funds is typically straight earnings (with the exception of YYY which is roughly 20% capital gains + ROC) while the yield of the ETN does not reflect what is actually going on behind the scenes. This is how the prospectus chooses to phrase how the ETN distributions are calculated:

the sum of the cash distributions that a hypothetical holder of Index Constituent Securities would have been entitled to receive in respect of the Index Constituent Securities during the relevant period

Source: UBS

The cost of generating these distributions is not taken into account in the distributions themselves. So to get a better sense of what the ETNs are actually earning, we need to calculate a new metric that we call net yield, which is the distributions of the unleveraged fund x 2 less ETN fees.

Another interesting question is not just how much are the ETNs earning, but how much are they earning in excess of the unleveraged funds. This question is relevant because the leveraged ETNs double the price volatility and drawdowns for the investor, apart from creating some credit risk, acceleration event risk as well as volatility decay. So the additional income stream should look appealing for investors to be willing to take these extra risks. To gauge this, we also calculate marginal yield which is net yield in excess of the yield of the unleveraged asset.

Bring it all together, we plot the three kinds of yields in the following chart. To summarize, the three types of yields are:

• TTM yield: trailing-twelve month distribution rate
• Net yield: i.e. post-fee yield, equal to 2x yield of the unleveraged fund – ETN fees
• Marginal yield: i.e. additional yield over and above the unleveraged alternative, equal to Net yield – unleveraged fund TTM yield

Source: ADS Analytics LLC, TIINGO

One thing that jumps out are LRET and PFFL with very low marginal yields. Both of these ETNs have underlying asset yields which struggle to rise much above the cost of leverage which means that the second turn of leverage creates little to no additional yield.

Another important issue worth mentioning is the unique feature of CEFL vs. the other ETNs in that CEFL references a basket of CEFs. In particular, it references a basket of high-yielding CEFs and as any investor in the CEF market knows the distribution coverage of high-yielding CEFs is not exactly always at par. This means that in order to understand the real earning power of CEFL we need to go a step further and adjust its net yield for its coverage. We calculate the coverage yield or NII yield of the CEF basket at 6.6% (vs. 8.6% TTM yield). Using this figure we arrive at an earnings yield for CEFL of 10.1%. This means that CEFL provides an additional marginal earnings yield of 3.5% over YYY.

Risk vs. Reward

Yields and returns don’t exist in isolation – they are compensation for risk. Let’s compare how marginal yields stack up against marginal volatility. In other words, how much do investors get paid in additional yield by buying the leveraged ETN over its unleveraged counterparty and how much additional risk are they taking by doing this?

Readers occasionally push back against volatility and drawdowns as a measure of risk and we have some sympathy with this view. The reason we use volatility here is not because it is a foolproof metric of “real risk” but because it is the worst metric except for all the others, to misuse Churchill’s quote about democracy. Since we can only know “real risk” in retrospect and we cannot forecast the precise outcome of all investments, volatility is the best we can do.

We also like to use volatility for the following reasons:

• Volatility is correlated with potential permanent capital loss – you can clearly see this in the volatility of various assets, particularly in the fixed-income market.
• Lower volatility conserves capital to be deployed at opportune times
• Lower volatility helps to keep damaging behavioral investing impulses at bay

In the case of CEFL, for example, this comparison shows how much additional yield CEFL provides for the additional volatility it delivers over and above YYY. In the case of CEFL, the answer is about an additional 6% of yield for about 9% of volatility. It’s easier to get a grasp of these numbers by looking at other leveraged ETNs. So, CEFL does better than LRET which delivers negative marginal yield for nearly 14% of extra volatility.

Source: ADS Analytics LLC, TIINGO

Another way we can gauge whether CEFL is particularly attractive now is to see how its current marginal yield compares historically. The answer is the marginal yield is quite low relative to history which is due primarily to increased leverage costs. Now that short-term rates appear to have peaked, leverage costs will most likely start to come down which will gradually increase the the marginal yield, all else equal.

Source: ADS Analytics LLC, TIINGO

Conclusion

To update a proverb – in a land of low yields, the high-yield fund is king. Persistently low yields have made products like the leveraged ETRACS ETNs tempting to investors. These vehicles, however, are structured and behave differently from other standard exchange-traded products. For this reason they demand a different type of yield analysis which strips the fund fees from the headline distributions. CEFL requires an additional adjustment for the fact that its distributions exceed the earnings of the underlying funds. The key takeaway is that CEFL delivers an earnings yield well below its stated TTM or current yield which investors need to take into account in their risk/reward analysis.

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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.