GUG: Potential Pressure On The Distribution, But The CEF Looks Decent Right Now (NYSE:GUG)

The Guggenheim Active Allocation Fund (NYSE:GUG) is a closed-end fund, or CEF, that income-hungry investors can purchase as a method of pursuing their goals. The fund certainly appears to do a good job at this particular task, as its 9.63% current yield is attractive even in today’s high-interest rate environment. In fact, this yield compares quite well to that of many of the company’s peers. Morningstar classifies the Guggenheim Active Allocation Fund as a “Hybrid-Global Allocation” fund, so we will use that classification to establish a peer group for the fund. Here is how its current yield compares to some of its peers:

Fund Name	Morningstar Classification	Current Yield
Guggenheim Active Allocation Fund	Hybrid – Global Allocation	9.63%
Calamos Global Dynamic Income Fund (CHW)	Hybrid – Global Allocation	9.22%
Clough Global Dividend and Income Fund (GLV)	Hybrid – Global Allocation	11.28%
Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund (ETO)	Hybrid – Global Allocation	6.61%
LMP Capital and Income Fund Inc (SCD)	Hybrid – Global Allocation	9.02%
PIMCO Global StocksPLUS and Income Fund (PGP)	Hybrid – Global Allocation	10.87%

Click to enlarge

As we can see, the Guggenheim Active Allocation Fund compares reasonably well to its peers in terms of distribution yield, although it is not the highest on the list. That may be disappointing, but it is important to keep in mind that sometimes very high-yielding assets have a high yield for a reason. In short, it can be a sign that the fund is distributing more than it can realistically afford and may be forced to cut the payout in the near future. The fact that this fund’s yield represents a median could therefore be encouraging, although we naturally still want to investigate its finances to determine whether or not this is the case.

As regular readers can likely remember, we previously discussed the Guggenheim Active Allocation Fund in late December 2023. The bond market since that time has been somewhat weak, as many market participants began to realize that they were wrong about the likely pace of the Federal Reserve’s interest rate cuts in 2024 and started selling off bonds in early January. This has continued through to the present day, which has caused bond prices to fall and yields to rise. The stock market, meanwhile, has been very strong since the previous article was published, although it could be showing some signs of fraying right now.

As this fund invests in both stocks and bonds, the fund’s performance could have been somewhat mixed since the prior article’s publication date. This is indeed the case, as shares of this fund are up 3.87% since December 26, 2023. That is right between the 9.62% gain in common stocks and the 1.22% loss in bonds since that date:

This could be something that income investors will accept, especially because the fund’s yield is substantially higher than either the S&P 500 Index (SP500) or the iShares Core U.S. Aggregate Bond ETF (AGG). In fact, it is higher than the market yield for any stock or bond index in any developed country around the world. That may be important as the Guggenheim Active Allocation Fund is technically a global fund that invests its assets all over the world. This could also have an impact on the fund’s performance, although lately, most international stock and bond markets have been exhibiting a high degree of correlation with one another. Indeed, I have seen a handful of reports that suggest that the European Central Bank wants to cut its benchmark rate but is hesitant to do so until the Federal Reserve moves due to the effect that such action would have on currency exchange rates.

As I have noted in various previous articles, investors in closed-end funds such as the Guggenheim Active Allocation Fund tend to do much better than the share price performance would suggest. This is because these funds typically pay out most or all of their investment profits to the shareholders in the form of distributions. The basic goal is to keep the size of the portfolio relatively stable and simply give all of the profits to the investors. As the distributions include both coupon income and realized capital gains, the yield tends to be substantially higher than just about anything else in the market. The distribution also represents a real return for the fund’s shareholders, so they do much better than just the return suggested by the share price movements.

As such, we want to include the fund’s distribution in any analysis of its performance. When we do so, we see that shareholders of the Guggenheim Active Allocation Fund have benefited from a 6.45% total return since my previous article on this fund was published. This is still not as good as the 9.62% total return provided by the S&P 500 Index, but it is far above the 0.64% loss that investors in the Bloomberg Aggregate Bond Index suffered:

A 6.45% total return over three months works out to 25.80% annualized, so I am pretty sure that any investor in the fund would be more than happy with the return that the fund has delivered since late December. Indeed, the distribution yield alone delivers an acceptable pre-tax return for most people and anyone holding the fund in their retirement account should be more than happy. However, we do want to have a closer look at this fund in order to determine how well it can hold onto these gains.

As three months have passed since the date of our previous discussion, we can expect that quite a few things have changed. Most importantly, the fund has released an updated financial report so we will want to pay very close attention to that in order to determine how well the fund can sustain its distribution going forward.

About The Fund

According to the fund’s website, the Guggenheim Active Allocation Fund has the primary objective of providing its investors with a very high level of total return. This objective makes a great deal of sense given the strategy that the fund uses. As the website explains:

The Fund’s investment objective is to maximize total return through a combination of current income and capital appreciation.

The Fund pursues both a tactical asset allocation strategy, dynamically allocating across asset classes, and a relative value-based investment strategy, utilizing quantitative and qualitative analysis to identify securities with attractive relative value and risk/reward characteristics. The Fund’s sub-adviser seeks to combine a credit-managed fixed-income portfolio with access to a diversified pool of alternative investments and equity strategies. The Fund’s investment philosophy is predicated upon the belief that thorough research and independent thought are rewarded with performance that has the potential to outperform standard indexes on an absolute and/or risk-adjusted basis.

The Fund will seek to achieve its investment objective by investing in a wide range of both fixed-income and other debt instruments (“Income Securities”) selected from a variety of sectors and credit qualities, including, but not limited to, government and agency securities, corporate bonds, loans and loan participations, structured finance investments (including residential and commercial mortgages, asset-backed securities, collateralized debt obligations and risk-linked securities), mezzanine and preferred securities and convertible securities. The Fund may invest in non-U.S. dollar denominated Income Securities issued by sovereign entities and corporations, including Income Securities of issuers in emerging market countries. The Fund may invest in Income Securities of any credit quality.

The Fund may also invest in common stocks, limited liability company interests, trust certificates, and other equity investments (“Common Equity Securities”) that the Fund’s sub-adviser believes offer attractive yield and/or capital appreciation potential. The Fund may employ a strategy of writing (selling) covered call options and may, from time to time, buy put options or sell covered put options on individual Common Equity Securities.

As this description clearly states, the Guggenheim Active Allocation Fund invests in both common equity and debt securities. However, right now common equities only account for 5.87% of the fund’s portfolio:

As I have pointed out in various previous articles, any fund that invests in both fixed-income and common equities should have a total return objective. This is because of the presence of the equity securities in the portfolio. Common equities by their very nature are total return vehicles because investors purchase them in order to receive an income via the dividend that many companies pay out as well as to benefit from the capital gains that accompany the growth and prosperity of the issuing company. The dividend yield provided by most common equities is very low, so capital appreciation accounts for nearly all of the returns provided by these securities in most cases. That is the very definition of total return. Bonds, in contrast, provide no net capital gains over their lifetimes but rather deliver all of their lifetime net investment returns via coupon payments that serve as income. While bonds and other debt securities are income vehicles, income is one component of total return, so the fund’s objective works in this case.

As we saw in the introduction, common equities have outperformed bonds by quite a lot over the past three months. Curiously though, the Guggenheim Active Allocation Fund appears to have decreased its allocation to equities. This chart comes from the fund’s website:

This chart states that 5.43% of the fund’s assets are invested in “Equity Strategy.” That is a very different number than the 4.38% allocation to “Equity Strategy” that the fund’s asset allocation chart (provided earlier) states and it is different from the 5.87% figure that we get by adding together the “Equity Strategy” and “Other Equity” figures in the asset allocation chart. The two charts are both provided by the fund sponsor, and both have the same date on them so the only thing that I can figure out is that the fund is invested in certain equities or derivatives that it is unsure of how exactly to classify them.

Regardless, the last time that we looked at the fund, the chart on the website that was specifically labeled “Portfolio Concentration” stated that the fund had 5.89% of its assets invested in “Equity Strategy.” Today, that figure has declined to 5.43%. As equities have outperformed bonds significantly over the period, the only explanation is that the fund’s management was actively selling equities in order to purchase debt securities. That is certainly surprising, as it would seemingly make more sense to the fund to try and ride out the equity rally for as long as possible. We can easily conclude that the fund was, in fact, selling equities over the period because the equity outperformance should have resulted in the equity allocation increasing relative to bonds had it simply stood pat. The fund only has a 21.00% annual turnover though, so it does not engage in such sales particularly often. As such, this is somewhat confusing, but it is the only logical explanation for what we are seeing here.

As we saw in the introduction, bonds have actually been down over the past three months but shares of the fund are up. While equities have risen since the time of our previous discussion, their allocation in the portfolio is not nearly enough to explain the fund’s recent performance. In fact, the recent performance does not actually make much sense. The fund’s net asset value is down 0.12% since the December 26, 2023, publication date of my previous article on the fund:

Thus, the fund’s share price performance has been significantly out of line with what the underlying portfolio has actually delivered. This is not something that is unusual for a closed-end fund, but it does have some implications on the valuation. We will discuss this in more detail later, but it does appear that the market has been overly enthusiastic about this fund lately. The current valuation is nowhere near as attractive as it was a few months ago and that could be problematic as it could result in this fund giving up its recent gains at some point, regardless of what happens with the underlying portfolio.

The fund’s management also appears to have reduced its confidence about the prospects of near-term interest rate cuts, which is also the reason why the domestic bond market has declined year-to-date. At the time of our last discussion, the largest segment of the fund’s asset allocation was high-yield corporate bonds, at 45.75% of the fund’s portfolio concentration. Today, this asset class is listed at 45.07% of the fund’s assets. Meanwhile, the fund’s allocation to bank loans has increased slightly, going from 29.28% to 30.61% of the fund’s assets over the period. This does make a certain amount of sense given the comments that were made following last week’s meeting of the Federal Open Market Committee.

Bloomberg offers an excellent summary of the announcement by the Federal Reserve:

• The “dot plot” of Federal Open Market Committee rate projections shows the median official expects three quarter-point cuts in 2024, similar to the previous round of quarterly forecasts in December; however, the median forecast for 2025 rises to 3.9% from 3.6%.
• Officials also lifted forecasts for where they see rates settling over the long term, boosting their median estimate to 2.6% from 2.5%; the change implies rates will need to stay higher for longer in the future.

A look at the dot plot that was released by the central bank reveals that the most dovish members of the Federal Open Market Committee have been retreating. Prior to the March meeting, there were a greater number of members who expected more than three interest rate cuts this year. As of right now, only one member expects four rate cuts, and nobody expects more than that. This is a change from earlier in the year and it suggests that a pivot from the Federal Reserve could be further off than the market was previously anticipating. This is generally bad for bonds, which is why we have seen the bond market retreat somewhat year-to-date. It does, however, also mean that senior leveraged loans and other variable-rate instruments should continue to deliver attractive returns for longer than was previously expected. This explains the increased concentration of bank debt in the portfolio of the Guggenheim Active Allocation Fund. It is also a smart move on the part of the fund’s management.

As the Morningstar classification of the Guggenheim Active Allocation Fund suggests, this fund does not exclusively invest in American assets. Unfortunately, neither the website nor the fund’s fact sheet states the percentage of the fund’s assets that are invested in domestic versus foreign assets. This is rather irritating as this information could be very important to investors given that foreign assets are likely to perform differently than American securities. After all, most foreign nations have their own central banks that set their own interest rate policies, which has a far bigger impact on the performance of fixed-income assets issued by that country’s institutions than the Federal Reserve’s policies. CEF Connect states that 50.57% of the fund’s assets are invested in American fixed-income securities along with a 5.31% allocation to American equities. The remainder would then be in foreign securities. However, that is a third-party data source, and it may not be accurate. Interestingly, the fund’s semi-annual report does not provide any breakdown of the fund’s assets by either currency or country so we pretty much have to go with the CEF Connect data. The fact that the fund’s own documentation does not provide this information is very disheartening and does not reflect well on it from a transparency perspective.

If we assume that the CEF Connect data is correct, then somewhere between 40% and 45% of the fund’s assets are invested in foreign fixed-income securities with Canadian, United Kingdom, and French assets making up the largest allocations:

This means that the policy rate decisions of the Bank of Canada, the Bank of England, and the European Central Bank will have noticeable impacts on the performance of the assets in this fund. Of the three, the European Central Bank might be the most important because of the combined weighting of securities from France, Germany, the Netherlands, the Czech Republic (a member of the European Union but not using the Euro), Italy, and others. The Swiss National Bank and Bank of England also consider the policies of the European Central Bank in their rate decisions due to the substantial amount of trading activity that takes place between those nations.

Last week, both the Bank of Canada and the Bank of England said pretty much the same thing as the Federal Reserve. Officials at both institutions want to cut their benchmark interest rates but the data is not supportive of such a move right now. Meanwhile, the European Central Bank hopes to cut its benchmark interest rate in June, unless the data deteriorates over the next few months. However, it reiterated that it is very uncertain about the direction of interest rates beyond that date.

If we assume that these central banks are able to execute these goals as stated, it should be positive for the assets held by the fund over the remainder of the year. However, as is the case with the Federal Reserve, there is no guarantee that this will be the case as inflationary pressures remain fairly strong over most of the developed world. However, there may be some reason for optimism from the foreign portion of this fund’s portfolio.

Leverage

As is the case with most closed-end funds, the Guggenheim Active Allocation Fund employs leverage as a method of boosting the effective yield and total return that it obtains from the assets in its portfolio. I explained how this works in my previous article on this fund:

In short, the fund borrows money and then uses that borrowed money to purchase fixed-rate bonds, leveraged loans, and other income-producing assets. As long as the total return that it receives from the purchased securities is higher than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield that it earns from the portfolio. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, so this will usually be the case.

However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund does not employ too much leverage because that would expose us to an excessive amount of risk. I generally prefer a fund’s leverage to remain below a third as a percentage of its assets for this reason.

As of the time of writing, the Guggenheim Active Allocation Fund has leveraged assets comprising 21.17% of its portfolio. This is well below the one-third level that we would normally consider to be acceptable for a closed-end fund. Here is how the fund’s current leverage compares to that of its peer group:

Fund Name	Current Leverage
Guggenheim Active Allocation Fund	21.17%
Calamos Global Dynamic Income Fund	31.72%
Clough Global Dividend & Income Fund	25.12%
Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund	19.20%
LMP Capital & Income Fund	20.06%
PIMCO Global StocksPLUS & Income Fund	17.20%

Click to enlarge

(All figures courtesy of CEF Data).

As we can see here, it does not appear that the fund’s leverage is out of line with its peers. This is another positive sign, and it reinforces our belief that this fund’s leverage represents an appropriate balance between the risk and the reward. For the most part, we should not need to worry too much with respect to the fund’s leverage.

Distribution Analysis

As mentioned earlier, the Guggenheim Active Allocation Fund has the primary objective of providing its investors with a very high level of total return. In pursuance of this objective, the fund primarily invests its assets in bonds and other debt securities issued by entities all over the world. While the fund does include some stocks and derivatives as well, those securities are such a small percentage of the fund’s portfolio right now that they will not have a significant impact on its return profile. In short, the primary way through which this fund will earn an investment return is by collecting coupon payments from the securities that are included in its portfolio. The fund receives these payments on behalf of its investors and combines them with any capital gains that it manages to realize from the equities in its portfolio or by trading bonds prior to their maturity dates. This fund even takes things a bit further by borrowing money to collect coupon payments from more securities than it could control solely through reliance on its own equity capital. Finally, the fund distributes all of the money that it earns from these various sources to its shareholders, net of its expenses. We might expect that this would allow the fund’s shares to boast a very high yield.

This is indeed the case, as the Guggenheim Active Allocation Fund pays a monthly distribution of $0.1188 per share ($1.4256 per share annually), which gives it a 9.63% yield at the current price. As we saw in the introduction, this yield is competitive with that of many of the fund’s peers. This fund is one of the few that has been remarkably consistent with respect to its distribution over the years:

Admittedly, this fund has a very short history compared to many others in the market, as it was only started back in late November 2021. However, the fund has never once raised or reduced its distribution since that time. As such, it may prove to be appealing to those investors who are seeking to earn a safe and consistent level of income from the assets in their portfolios. It does have the same flaw as many other closed-end funds though, as the high inflation that we have experienced over the past few years has significantly reduced the purchasing power of the fund’s distributions. Of course, this can easily be overcome by simply reinvesting some portion of the fund’s distribution into more shares but that reduces the amount of income that can be spent on lifestyle expenses. This distribution history is still better than many other funds have managed to deliver recently, however.

As is always the case, we should have a look at the fund’s finances in our discussion about its distribution. After all, one major problem that many funds encountered is that the reversal of the Federal Reserve’s (and other central banks’) longstanding monetary policy in 2022 resulted in a high level of losses. This fund may have been able to avoid the worst of that due to its inception in November 2021, but it still probably suffered some losses over time. We need to make sure that it is not distributing more than it can afford, as that is destructive to the fund’s net asset value over time and such destruction of net asset value is not good for the fund’s long-term viability.

Fortunately, we have a reasonably recent document that we can consult for the purposes of our analysis. As of the time of writing, the most recent financial report for the Guggenheim Active Allocation Fund corresponds to the six-month period that ended on November 30, 2023. A link to this report was provided earlier in this article. This is a more recent financial report than the one that was available to us the last time that we discussed this fund, which is quite nice to see. After all, this report will cover most of the second half of 2023, which was a rather volatile time for the bond market. As we can all remember, over the summer of that year, investors began to become accustomed to the fact that interest rates may remain high for a long period of time. Market participants lost their former hope about a late 2023 pivot by the Federal Reserve and started selling off bonds and equities, which drove bond prices down and rates up. That may have caused this fund to suffer some realized or unrealized losses. This situation changed in late October 2023, when bonds and stocks began to stage an epic rally that continued through to the end of the year. While this report will not include any information about the performance of this fund in December, it might have still had some opportunities for profits during the early stages of the end-of-year rally.

For the six-month period, the Guggenheim Active Allocation Fund received $22,757,929 in interest and $1,558,179 in dividends from the assets in its portfolio. The fund had no income from any other source, so this gives it a total investment income of $24,316,108 for the six-month period. The fund paid its expenses out of this amount, which left it with $15,096,681 available for shareholders.

That was, unfortunately, not enough to cover the distributions that the fund actually paid out during the period.

The Guggenheim Active Allocation Fund distributed a total of $23,498,309 to its shareholders over the course of six months. At first glance, this is likely to be concerning as we would ordinarily prefer a fund that is primarily invested in fixed-income securities to fully cover its distributions with only its net investment income.

However, there are other methods through which a fund can obtain the money that it requires to cover the distribution. For example, this fund does have a small allocation to common equities so that could have allowed it to realize some capital gains. The fund might also be able to earn some money via the exploitation of the price changes that bonds exhibit in response to interest rate movements. Realized capital gains such as these are not considered to be investment income for tax or accounting purposes, but they obviously represent money coming into the fund that could be distributed to the shareholders.

The Guggenheim Active Allocation Fund had mixed success at earning money via these alternative sources, but overall, it did okay. The fund reported net realized losses of $10,128,280 which was fully offset by $24,933,498 net unrealized gains during the period. Overall, the fund’s net assets increased by $6,403,590 after accounting for all inflows and outflows during the period.

Technically, the Guggenheim Active Allocation Fund did manage to cover its distributions during the period as its net assets went up despite not issuing new shares. However, as we can see from the provided numbers, the fund only managed to cover its distributions because of a substantial number of unrealized gains. As we all know, unrealized gains can be erased in a market correction so they cannot always be counted on to ensure a sustainable distribution. The fund’s net asset value has been down since the start of the year, so it is failing to fully cover its distributions so far in 2024. We should keep an eye on the fund, as the fund may have some problems sustaining its payout if interest rates do not decline in the near future.

Valuation

As of March 21, 2024 (the most recent date for which data is currently available), the Guggenheim Active Allocation Fund has a net asset value of $16.59 per share but the shares currently trade for $14.78 each. This gives the fund’s shares a 10.91% discount on net asset value at the current price. This is not nearly as attractive as the 12.78% discount that the shares have traded at on average over the past month.

As I have pointed out various times in the past, a double-digit discount is generally a reasonably good entry point for any closed-end fund. As such, the current price appears to be reasonable despite not being as good as the fund’s valuation in the recent past.

Conclusion

In conclusion, the Guggenheim Active Allocation Fund is an interesting fund that invests in assets all over the world. The fund technically invests in both common stocks and bonds, but the current asset allocation is almost entirely debt securities. This could work out okay though as this fund does not appear to be betting the farm on near-term interest rate cuts as it maintains a sizable allocation to assets that will perform pretty well even if the Federal Reserve does not cut at all in 2024, which some market analysts suggest is a very real possibility. The fund also trades at a discount on net asset value, so the price is very reasonable.

The biggest potential problem with the Guggenheim Active Allocation Fund could be the fund’s ability to sustain its distribution, as further degradation of its net asset value could cause it problems.

I am going to maintain a hold rating on this fund for now. The bond market right now is priced based on the guidance of the developed market central banks. The real risk to this fund today is that the economic data will continue to come in hot and the Federal Reserve will not be able to deliver on its expectations of three interest rate cuts this year, prompting other central banks to backtrack on their own promises of interest rate cuts in order to preserve the relative values of their currencies against the U.S. dollar. It is a fool’s errand to actually predict the likelihood of that scenario right now, but know that it is a risk today.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.