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keppelbay
Participant ○

DMO this week

 

DMO took a hit this week, with some fairly aggressive selling on Wednesday on larger than normal volume. This coincided with the release of an article at seeking alpha by alphagencapital in which he speculates on the possibility of a distribution cut. I was not convinced by some of the rationale (you can read it for yourselves, if interested).  I took a fresh look at the numbers to make up my own mind:

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NII: Going back to FY 2013, we can see that NII per share has been fairly stable - it ramped up a bit from 2013 to 2015 and then back down, but holding fairly steady in the 1.5 to 1.6 range. In other words no obvious downward trend.

UNII Jumped way up in 2015 by over $2 per share and has been slowly reduced since then, finally going negative in FY18. The negative trend continues in 2019.

Distributions from income: In every year, distributions from income exceeded NII. This presumably reflects UNII being used up. The massive UNII jump in 2015 allowed the monthly distribution rate to be hiked up from 0.16 to 0.18 to 0.21 and finally to 0.235. Evidently, this was a way to burn off the excess UNII gradually over several years. And this allowed them to keep the monthly distribution higher, through FY16 and FY17, gradually reducing it through FY18 until it approached a level more consistent with monthly NII.

NII represented as monthly EPS (2nd column from right): note that NII represented as earnings per share per month has changed much less than the distributions per month. There was a small increase in FY14/15, then back to fairly steady around 0.13/sh/mo. This seems to be about the level of income we should  expect them to continue to distribute (all else staying constant, and ignoring the contribution from capital gains).

Distributions from capital gains have been significant over the entire period.

Alphagen suggests in his article that they have been taking gains to support distributions as part of their wind-down strategy. This does not bear scrutiny. Gains have been a constant part of the income stream, long before the need to wind down comes into play. I'm not persuaded that with >2 years to go there is any reason to make this claim. Any unrealized gains are part of the NAV that will have to be returned at that time. Closer to the date it might make sense to harvest gains, but not more than 2 years ahead.  Rather it seems more likely that gains are being harvested and distributed for reasons intrinsic to the portfolio.

Conclusion: should we be afraid of a looming distribution cut?

The huge UNII bump from 2015 has been distributed. The monthly distributions have been gradually reduced while this was ongoing, so we are not far from equilibrium:

NII EPS = 0.132 and current distribution = 0.15, and they have gains of 0.3/share.

UNII has become increasingly negative over the 1st 3Qs of this year (-0.28 to -0.38 to -0.46). This will likely turn out to be covered by capital gains (now ROC in the Section 19s). So, barring a collapse in NII, there should be limited pressure for further cuts.  At worst we might see down to 0.13/month - if there are no more gains to be had. But if the gains keep coming predictably, and they keep spreading those gains over the year, there might not be much need to cut.

 

5 Replies
John_H
Follower ○○○

Re: DMO this week

Very well written analysis.  Another reason for the steep drop may be that the proposal to convert DOM from a term fund to a perpetual fund is still up in the air. Management has extended the voting period in order to get enough votes for the proposal to pass. I may be interested in investing if it becomes a perpetual fund. 

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AlphaGenCapital
Explorer ○

Re: DMO this week

Hi Keppelbay-

Great analysis.  It looks like we have largely the same quantitative data but came to different conclusions about that data.  DMO has exhibited the same trends in NII and UNII that many other term and target term trusts use.  Under-distribute early on in the life of the fund to build up UNII in anticipation of a wind down process later on.  In the case of DMO, their pure play into non-agency MBS has allowed them to generate significant capital gains – thanks to the purchase of these near the bottom of the housing crisis.  DMO has been burning off the UNII – both through excess distributions and through specials.  But that, as you note is exhausted. 

They have already been cutting the distribution, twice in the last year.  And as you note they are still under earning the payout.  The gains are part of the wind down process.  All non-agency positions are held to maturity.  Western is going to sell any of those.  But I wouldn’t rely on gains in perpetuity.  Just look at 2015 and 2016.

If the fund is going to wind down, they will slowly liquidate the portfolio and reinvest the proceeds into short-term assets. That will reduce the NII further.  Since there is no target, they do not have to meet a certain price and don’t necessarily have to cut the distribution.  If they perpetuate the fund, with NII down steadily, and the payout of gains as part of the distribution, I would imagine that another cut would be forthcoming.   I actually think the NAV will tell a lot about if a cut is coming.  Although the NAV vol is artificially low given the lack of any liquidity in the underlying.

As I noted in the article, I would like the fund to continue to operate.  It is one of the few pure play non-agency MBS funds which remains my favorite part of the fixed income marketplace.  My issue with the fund is the premium valuation, which makes sense given the yield-chasing behavior of most CEF investors. 

A cut wouldn’t be the end of the world.  But I do think investors will sell the fund and reduce the premium valuation.  Everything is expensive here and DMO is not nearly as crazy expensive as it was a couple of years ago when it was over a 20% premium. 

Happy Thanksgiving!

Just posted this blog.  

https://seekingalpha.com/instablog/16243802-alpha-gen-capital/5380082-happy-thanksgiving-exploiting-...

 

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judger
Explorer ○○

Re: DMO this week


@John_H wrote:

Very well written analysis.  Another reason for the steep drop may be that the proposal to convert DOM from a term fund to a perpetual fund is still up in the air. Management has extended the voting period in order to get enough votes for the proposal to pass. I may be interested in investing if it becomes a perpetual fund. 


Do you have more specifics, John?

I voted to extend its life. The vote took me by surprise, but I am a CEF newbie. Are term funds common?

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John_H
Follower ○○○

Re: DMO this week

Judge, if you get the quote page up for DOM on the Morningstar website, the top News, Alerts and Opinions has the news release from Western Asset. I'm not sure exactly How many term CEFs there are. I know Black rock has several.

 

John

 

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AlphaGenCapital
Explorer ○

Re: DMO this week

John-

There are 46 term trusts.   Of those 19 are target terms meaning they liquidate at a certain price and date.  

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