We interviewed Brian Mitts via telephone on November 22, 2013 in order to gain a better understanding of NHF and why it was challenging for our firm to compare it to other closed-end funds that we track for our weekly Universe data service and for client accounts. Brian is not the named portfolio manager, James Dondero, but we think you will see from the interview that Brian is well aware of the Fund's focus and involved in the investment process in a deep and meaningful way.
Highland Capital Management, headquartered in Dallas, TX, is a SEC-registered investment advisor with 17 funds under management. According to their website, the Firm is one of the most respected and experienced alternative investment managers serving the registered product market. As a manager of managers, we are dedicated to identifying and retaining best in class asset managers to serve as sub-advisers to our funds.
Highland Capital's fund platform includes a diverse set of investment strategies-from broad-based equity and fixed income investments to alternative strategies including long/short and alternative credit strategies. They have only one closed-end fund, NexPoint Credit Strategies Fund (NYSE: NHF).
JCS: Good afternoon Brian. From my notes we have a lot of ground to cover. I would like to get started. Why did you IPO NHF, what was the initial strategy? How often do people talk about the IPO price vs. the current price?
BM: We had a hedge fund with very good performance. We found that a CEF format, although able to utilize less leverage, was a great vehicle to run a similar type of strategy. These days, not many people talk about the current price vs. the IPO price.
JCS: How is your background helpful in managing this portfolio? When you say deep fundamental analysis is your background, I interpret that as really the management team and financial statements. Is that how you focus on the equities or analysis of those investments?
BM: Our president and co-founder, Jim Dondero, has been running credit investments for 30 years. He was a pioneer in the bank loan asset class and a pioneer of CLOs having orchestrated one of the industry's first CLOs in 1994. He has also been managing equities for 15 years. It is important that management teams understand the financials, particularly on the credit side; they need to understand the collateral and risks. We essentially underwrite all credit investments and don't rely on the credit agencies per se. We develop our own risk models and profiles. We get to know the entire space and understand what makes the company and its management team unique. As you can imagine, it takes a lot of man hours, a lot of work, and it's ongoing. You can't just do it once, buy it and then forget about it. It's a constant monitoring of the fundamentals. Jim and Mark overlay the macro picture, which guides the fundamental process. So if they see China is imploding or the European market is not growing as fast as people had thought, then it overlays onto what sectors we want to focus on and where we think we are in the cycle.
JCS: What do you like about the CEF structure to carry out your work in the portfolio?
BM: We like the CEF structure because it gives the manager permanent capital and the ability to use leverage. Our philosophy works best in a "patient" scenario. A CEF provides that. If your leverage is through preferred shares, you can go to 50%. Most of that the CEFs you'll see are carry overs from a long time ago, which are the auction rate preferences and were a very popular means of financing pre '08. It was almost like issuing commercial paper. You could get very, very cheap financing because you were rolling it week to week. It was a very liquid market so investors liked it.
JCS: How would you classify the fund's management style? As fundamental, tactical, value-based or technical? Do you have junior analysts? How do you structure the credit team's work?
BM: We are primarily a value strategy. Our background is in the deep fundamental analysis of companies. We are separated by sector. Our head of credit research has two managing directors reporting into him and each of those directors oversee teams of junior analysts divided up by sector. The guys cover multiple sectors.
JCS: What changes have you made to the fund in 2013? Why? (Investment mandate, corporate actions, etc.)
BM: We did not make any changes to the fund in 2013.
JCS: What areas do you prefer to invest in? We have talked previously about your allocations strategy being unique for CEFs. When you speak about the Fund, how do you define the "other" bucket?
BM: Credit is our preferred area of investment. We have a deep understanding of credit and have been able to find value in that asset class for several decades. However, with the fund's dual mandate of income and capital appreciation, and given where the NHF stock debuted versus where it currently is, we have to utilize our equity and other buckets to get capital appreciation. There's not an asset class out there that we call "other". In this context, I'm just kind of lumping everything that's not really credit or credit oriented into the other bucket.
JCS: I know NHF is a very unique fund, what is the closest fund (open-end, ETF, CEF) to NHF?
BM: The closest fund is going to be an asset allocation fund. We have an OEF that is somewhat of similar, the Highland Global Allocation Fund.
JCS: What are the best indices to track your fund's relative performance?
BM: The best index over time would be a hedge fund index. We typically refer to the Credit Suisse Hedge Fund Index.
JCS: How does the current Fed policy impact the portfolio?
BM: The current Fed policy creates uncertainty and fear in the credit markets. The low rate environment created by the Fed has put pressure on rates across the yield curve. Everyone knows that at some point rates will rise. No one knows when. We had a head fake in May and when it shook out we ended higher than where we started. But it appears people are leaving bonds for lower duration assets. We take advantage of these movements by positioning the fund's credit portfolio in lower duration assets. We also believe the Fed's policy creates opportunity in the equity markets. We have seen a major rise in equities that we believe will continue until "tapering" begins.
JCS: What is your approach on keeping the portfolio diversified but not over-diversified? What is considered "too many positions" for a fund of your focus and size?
BM: Our philosophy is not only to diversify but also to take meaningful positions in high conviction ideas. We want our investment process and expertise to add alpha to the portfolio. Over-diversification achieves nothing except a beta product. We don't look at diversification in terms of positions as much as we look at what percentage of our portfolio is represented by our top 10 positions. Part of our process is that ideas start from the bottom and bubble up with this macro overlay as the guiding force. Analysts go to the credit committee with ideas and by definition they are supposed to meet certain parameters. Then Jim will come in with, "Give me the 15 best ideas." Or "I want the 3 best ideas in healthcare." So investments come about through a process very purposefully where from a macro view there will be a request for best ideas and very specific goals. The process itself is meant to generate best ideas.
JCS: What is the one item advisers and investors always seem to misunderstand about your fund/sector?
BM: CEFs have become a place for investors to find yield. This has been achieved in ways that are not always healthy or productive. We view the space differently. We believe there are two components to return, income and capital appreciation, of which the capital appreciation piece is more volatile. The mandate of the fund is total return. In pursuit of that mandate we go into areas that most analysts in CEF/ETFs are not used to seeing: real estate, CLOs, equity and credit together. We believe that makes our fund and story misunderstood.
Now let me save you the research and the time on this fund and tell you that prior to Jim taking it over, and he'll be the first to tell you, the fund was underperforming its potential. By that he means a lot of things. One of the things he means is the leverage wasn't appropriately used. You'll find for a very long period of time where the leverage probably moved between 20% and 25%. We weren't going to go any higher, because of an abundance of caution post '08. So my answer is more directed from a firm-wide perspective and what Jim's philosophy is and what he's brought to the fund since taking it over 15-16 months ago.
We've got a model that is updated monthly, based on our macro views of the markets. I mean it's more complicated than this but if we think we're a 10 on the Bullish scale, which would suggest that we should be basically as levered up as we can for the mandate of a particular portfolio or fund. If we're at 1, meaning that we think that things are very bearish, then that would suggest that we should have very little leverage, if any, and maybe even be in cash. So that's kind of how we view it. I think the Fed has a phenomenally difficult job where everybody is listening to every single word, syllable, how they stress, whatever. It's just so micro managed and over analyzed that even small slight slip-ups can be misinterpreted, but we feel very strongly that there's not any catalyst that's going to push rates up through the stratosphere as people fear it will. That dictates and drives a lot of our thinking around leverage and how we use it. We think, because of the loose monetary policies, there's going to be a lot of liquidity in the market and that's going to tend to push asset prices up. When you play in the credit space, you have to be very careful because by its nature credit isn't meant to have a lot of capital appreciation. You lend a buck, you get a buck back plus interest. As things change, maybe stuff trades up above par or trades below par, so you have to be very careful and nimble so you're able to move around. This is one of the reasons we like to not be constrained by a no equity mandate like typical closed-end fund credit funds. We think having a lot of leverage right now makes sense and allows us to take advantage of affordable financing and rising asset prices.
JCS: Can you put the fund's use of leverage into perspective (31%)? How has it changed over time? Give us a breakdown of the type of leverage you employ. What would cause you to increase/decrease your leverage?
BM: Our use of leverage unlike most CEFs isn't related to achieving a predetermined yield. We use leverage opportunistically. When we see opportunities or dislocations in the market, we tap the leverage to take full advantage. When we see trouble in the market, we de-lever the fund and wait for a new opportunity to arise. We are in the minority in that we believe rates won't appreciate materially in the next few years. Although Congress has done questionable things that we believe has created uncertainty, the Fed for the most part has been consistent in their message: that rates will stay low until employment and growth are back to acceptable levels. With Yellen taking over, we think the Fed will definitely lean on the side of too much QE versus not enough. Because of this, we think rates will remain low for several years. As a result, we prefer shorter-term leverage as it is much cheaper than long-term leverage. We can get this in 90-day evergreen margin facilities and 364-day bank revolvers. If we're in that stage where we think things are still very bullish, maybe we'll go from 30 to 28. So as the picture changes, we can opportunistically get back in and inflate that up. We don't expect you would see this go from say 31% to 18% in a very short period of time. It's hard to justify that kind of move. If we really believe the market has gotten so bleak so quickly, we would do it [in] theory, but it's hard to see what would precipitate that.
JCS: How does the Board of Directors go about setting the dividend policy? What is the PM's input on this factor?
BM: The board reviews a detailed analysis of our earning assets each month in determining where to set the rate. They also understand the importance of a consistent and growing dividend. They look to the manager to frame the portfolio for them, and to provide insight as to why we believe we will earn our dividend and how we plan to grow it over time. Setting of the dividend is a collaborative effort between the board and the manager; and the PM has enormous input. We do a monthly press release where we announce our dividend, but then we also use it to do two other things. The first thing we do is talk about the UNII balance and the second thing we do is talk about our earnings so that we can show how we are earning our dividend.
JCS: As you know, we organize CEFs into major and sub-groups and also collect a large amount of data on all CEFs. How would you classify and organize your fund in the world of CEFs?
BM: Because of our focus on credit I would start there. Then I would group us into an asset allocation category. Unfortunately, CEFs have become fairly binary. We are convinced this will change, albeit slowly, as more institutional managers come to see what we have known for years, and that is that the best structure in which to manage money is a CEF. As that change occurs, we think analysts and investors will begin to view CEFs differently and our fund and strategy will be less of an outlier and more of the norm.
JCS: Please help us understand how the fund monitors its UNII (undistributed net investment income) balance and NII (net investment income) over time. How should these data points be viewed by investors?
BM: The UNII balance was built up over time to protect against defaults in the portfolio. We believe this served us well, despite the fact that we had multiple reductions to the dividend. It would have been worse without a UNII as a cushion. The UNII is a prime input into our monthly dividend setting meeting with the board, so it is constantly monitored. Because of our heavy emphasis on credit, we still use the UNII as a cushion against defaults; however, we are also using it as a cushion that allows us to allocate more assets to capital appreciation investments without a concern of how that will affect our ability to pay the dividend (or increase it) longer term. We quote the UNII as being unaudited and it's a raw number. We don't smooth it out. It is what it is. It comes right off our financials.
You ask a pretty detailed question on how the data points should be viewed by investors. How does the process work in setting your distribution? We have a very detailed calculation that shows every position, sort of its normalized rate of return for the year, and so we back into, "Okay, if we're going to earn this over the year, what are we going to pay this month," type of process. You'll see UNII move for things like that but UNII in general, the way we view it, aside from these kind of one off things, is a cushion in a credit fund. We believe it is prudent in any portfolio that holds a lot of credit, below investment grade, to keep some sort of UNII balance for rainy days. And, that's what we try to do.
JCS: How does NHF balance the need for NAV performance with payments of earned dividends to shareholders? Income vs Total return growth? Walk us through the three dividend increases since Feb 2013.
BM: We view both income and total return growth as vitally important, but we put a larger emphasis on income. As mentioned previously, we believe a large UNII cushion gives us more flexibility to pursue investments with capital appreciation potential. The dividend increases this year were a recognition that the income portion was too small.
JCS: With CEFs known for yield, how do you compete against other funds?
BM: I think we compete fairly well. Even with the stock up 43% by the end of 2013, the fund was yielding 6.7% based on current price and current per share distribution rate. Also, we don't achieve that via return of capital where we give shareholders their principal back and call it yield. Many funds paying a higher yield may be riskier or unsustainable situations due to their current distribution model.
Editor's Note: According to our CEF Universe data, for the full year 2013 NHF's net asset value (NAV) total return was +59.7% and its market price total return was +50.1%. We use the methodology of dividend taken as cash vs. reinvested.
JCS: Why do you make changes in the portfolio? How does the firm/fund cut out of a position?
BM: It depends on the asset class, but changes are made for one of two reasons: 1) the thesis that led to the investment has played out (either for the positive or negative) or the fundamental assumptions have changed or 2) the risk profile has changed and the portfolio needs to be repositioned. It depends on why the position was entered into in the first place. If it was a value-based trade then typically we'll set a price target. If the trade is entered into more for diversification, it's not a highly concentrated position. So the thesis on it is not as fully developed or strongly believed. If you see a movement in the position that seems to be outside the norm, that's when you will say, "Okay, is it time to get out of this position?" Every analyst is in charge of their positions and their sectors, and is constantly updating them and monitoring any changes. A lot of data is collected there and models rerun and the thesis is revisited, etc.
JCS: How did Young Broadcasting come into the portfolio? How about AMR Corp? We don't usually talk about specific positions, but these are too interesting. Also, why are you so bullish on silver? What would change this?
BM: Young was a credit investment that got in trouble. Because of our large distressed and restructuring team, we are likely to maintain these positions and work them out, and in some cases even increase our exposure. AMR was a value play where we saw that the market was not taking the whole picture into account: through consolidation, the airline industry has become an oligopoly. American is too big, pervasive and valuable to fail. The US needs the additional competitor. Based on that, we viewed the company worth $10-$12/share when it was trading for less than $1. There was too much value there for us to pass up. The original thesis for the American Airlines Equity Trade came up through the credit side from our guys' analysis of American Airlines, the bankruptcy, that whole process, and we actually were buying prior to the US Air merger announcement. So when the DOJ came in, saying they were going to challenge the merger, we knew they were just trying to get more concessions where they thought they needed them, which we had fully baked into our analysis from the beginning. So when the stock dropped we added to our exposure but all that came in from sort of the basic credit analysis done day in and day out. That's how it permeates throughout the firm. It began with a junior analyst and bubbled up through his managing director, made it to the head of credit research, and then from there it goes to a credit committee.
Our silver position is less about our view of silver and more of a macro hedge. We are a believer that over time, as the Fed continues QE, hard assets will rise in value. Jim believes silver is a better metal because it has more uses. It's got industrial uses. He feels that it's not like a lot of other metals, it has some other intrinsic value to it.
JCS: Has the fund ever paid investors dividend that are classified as return of capital (ROC)? If there's return of capital, does NAV performance keep up with NAV yield?
BM: No, we are fundamentally against the concept of return of capital. I think Cecelia had first of all done a good job saying there's good return of capital and then there's destructive return of capital. So I wouldn't call somebody who's doing good return of capital or has good intention, but there are other funds that are clearly just playing the game. They're playing the system.
Editor's Note: Visit our blog (CEF-Blog.com) for an article published in October 2013 on Destructive Return of Capital.
JCS: NHF's discount has been between -15% and -18% in past month. For a fund with 3 dividend increases this year, over $2MM a day in liquidity and 1-year NAV TR of +50% do you have any idea why?
BM: I think the NAV performance has been a driving factor the past few months. Stock price hasn't been able to keep up. I think because we were toward the end of the year and people were focused on tax-loss harvesting, we haven't popped up on advisors radar's yet. I think that begins to change as we start the New Year.
JCS: Have you had a default in the portfolio for the bond exposure? How do you model the risk/reward relationship?
BM: We have not had a default in the portfolio for quite a while. Although, TXU will likely have some sort of a credit event in the next 6 months or so, but we believe there is value in that company. We model risk reward by first doing deep fundamental analysis of every company we invest in and each position. Second, we compare our estimate of value and risk with what the market perceives it as. If cheap, we buy, if expensive, we pass (or sell if we own it). We are less concerned about defaults in and of themselves but instead are more focused more on what we believe the ultimate value of an investment is based on the facts at hand.
JCS: Give us the background on the Shareholder Loyalty Program. I believe it is the first time a CEF has done such a measure, what is the reason? What is the cost?
BM: The idea behind the shareholder loyalty program is rooted in a standard DRIP program. As a publicly-traded company, we believe it is our goal to provide the best return for our shareholders. The problem is that some of our shareholders are only there for a few days while others are shareholders for years. Our focus is on long-term holders and the loyalty program is intended as a way to give incentives to be long-term holders of our stock. Secondarily, we believe the program, over time, may be an effective and healthy way of keeping the discount low. The costs of the program are borne 100% by the advisor. We are currently providing shareholders a 2% gross-up if they make a purchase and then hold it for 12-months.
JCS: You recently filed an N-2 with the SEC for a rights offering. Why did you do this and how would it look once implemented? What assurances can you give current shareholders?
BM: The filing is intended as a shelf offering. Our goal is to narrow the discount and, in combination with the loyalty program, issue new shares through at the market offerings. We believe any shares issued under the offering will benefit current shareholders as opposed to a rights offering below NAV that is dilutive to shareholders not participating.
JCS: What is your market outlook for 2014? Where might you take the portfolio's allocations or what will drive investment decisions?
BM: We are cautious in the near term with regard to the markets in general. We think the equity markets will have a pullback in the short term. We think longer dated credit will continue to struggle as rates inch higher, or as the market fears it will. Regardless of what the markets do, we feel there will be pockets across some asset classes that will be oversold or dislocated and thus provide a value opportunity.
JCS: What is next for the fund or firm?
BM: We think the fund will continue doing more of the same (i.e. seek to grow NAV and income, although we obviously cannot guarantee that). The firm began a large scale focus on retail investors in 2012 and that will continue going forward. In particular, we are heavily focused on permanent capital vehicles as we believe that is where the most patient money is allowing us to play out our investment thesis in a more controlled manner.
JCS: How often do you update investors on the fund's financials/holdings? Quarterly, Monthly? What is your investor relations / press relations strategy?
BM: We produce a monthly fact sheet that shows top holdings and performance information. We release financial data quarterly as required by regulations but not more frequently. Our IR strategy is to target fund analysts as the most efficient way to educate our audience. Our wholesaling team discusses the fund and story when they are in offices.
JCS: Can you address the expense ratio on NHF? We calculate it at about 3%, which is about twice the CEF average. How much does leverage cost impact the ratio?
BM: Yes, I think that's about right. Just so I can break it down. I would say it's closer to 2.1 if you look at expenses over total assets. The reason I would do it that way is because it's easier to break down. Leverage is actually fairly cheap. It used to be much more. This is based on 6/30 financials and a 55 basis points interest expense. 33 basis points for other, which is comprised of board fees, legal, printing, etc., which gives you 2.08. Now that's based on managed assets which is your NAV plus leverage. It's still a pretty high number that gets quoted, but it's come down pretty significantly. The run rate is considerably lower than 2.1 or 3.1. We did not lower it by reducing our management fee, which we have a history of doing, or capping our management fee to get a specified expense ratio, but we were able to reduce costs by refinancing the credit facilities. Again, back to our theory on interest rates, we will borrow short on a floating basis all day long because we're not fearful of rates spiking significantly.
Editor's Note: CEF Advisors does not ignore expense ratios but we tend to care more about relative NAV performance, which nets out expenses. We also make the decisions if we want access to this sector or manager.
JCS: When I think about the investment management business, I think about the work that goes into research and the work that goes into trading. How do you all balance the resources between the research and the trading on the portfolio to get the resulted performance?
BM: We have a dedicated trading desk both on the credit side and the equity side. They do research from a market perspective. They're not doing any fundamental research. You could call their research more technically based. Whether it's coming up from the credit side or the equity side, those orders get input into the OMS and then executed by the trading desks. So they're really serving as execution traders but they're also doing their own technical analysis.
JCS: Did we miss a question you think is important to answer for our readers?
BM: Let me tell you one other thing. We touched on the subject but we didn't delve into it. As part of the real estate that we have, we have created a private REIT underneath the fund. We've been out buying actual real estate in this REIT. I wanted to point that out to you. You can see it briefly in the 6/30 financials that we put out.
JCS: Brian, we would like to thank you for your time on the phone today and for your insight into NHF. We wish you the best for 2014. For more information on the Fund, please visit their website: www.highlandfunds.com
Disclosure: I am long NHF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As of the interview date and publication date, CEFA clients and managers own shares in NHF. The views and opinions herein are as of the date of publication and are subject to change at any time based upon market or other conditions. None of the information contained herein should be constructed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed.