As nominal treasury rates and global interest rates continue their downward trend, opportunities for attractive, risk-adjusted returns in today’s market are seemingly few and far between. However, the closed-end fund market still offers a number of opportunities. At RVP, we scour these overlooked areas of the market to find underpriced, quality assets for our investors. Western Asset Variable Rate Strategic Fund Inc. (ticker: GFY) is one such opportunity.
GFY is an example of an “orphaned position”: a stock that has been largely ignored by the market. GFY is a closed-end fund with a diverse portfolio of 400 holdings, primarily non-agency mortgages and corporate bonds that have a near-investment-grade average credit quality and a duration of less than one year. The fund currently has $83 million in net assets and is very modestly leveraged (22%), due in part to the fund’s relatively low-risk investments.
Both nominally and relative to other mortgage-focused funds, GFY continues to trade at an attractive discount: the fund’s current discount of -8.13% is approximately 750 basis points cheaper than TCW Strategic Income Fund, Inc. (TSI) and 1650 basis points cheaper than Western Asset Mortgage Defined Opportunity Fund Inc. (DMO), a sister fund of GFY. DMO investors are willing to pay a premium of 8% to NAV, which we expect to erode over the following two and a quarter years as it is a term trust with a liquidation date of March 2022. A similar fund, Nuveen Mortgage Opportunity Fund (JLS) recently conducted a tender and is trading at a -2% discount. In our view, GFY offers more value than its peers at these levels.
GFY has a current yield of 5.68%, which is very attractive when compared to the yields of the Bloomberg Barclays U.S. Aggregate (2.35%) and Municipal (1.87%) indexes. GFY’s yield even outpaces that of the Bloomberg Barclays U.S. High Yield YTW (5.49%) index. This yield, combined with a short duration and a significant allocation of securitized assets, gives the fund a much more attractive return profile in comparison to common fixed-income benchmarks.
Historically, GFY has performed well compared to its multi-market peers, particularly in periods of volatility where the fund experiences much less downside: GFY’s underlying assets are up 6.04% annualized over the last three years. The fund also gives investors access to the considerable resources and investment capabilities of Western Asset, one of the largest fixed-income managers in the world with $450 billion in assets under management. GFY represents less than two basis points of the firm.
Despite these attractive underlying assets, the competency of the management team, and the formidable portfolio characteristics, the market continues to overlook GFY. In our view, this lack of awareness is primarily due to the fund’s relatively small size in comparison to Western Assets’ more well-known funds.
At current prices, GFY is an attractive holding, and we would expect the market to realize its value over time, causing it to trade in-line with its peers.