The DWS High Income Opportunities Fund: The Activists Won

| About: DWS High (DHG)

Summary

DHG is a closed end fund sponsored by Deutsche Asset Management invested in high yield corporate bonds.

The fund is currently yielding an income only distribution of 6.19%, and is trading a discount of 7.91% to its net asset value.

In 2015, activist hedge fund investors came to a resolution with DHG to liquidate the fund no later than March 30th, 2018.

One area of investing that has been getting renewed interest is closed end funds. With new offerings and numerous ETFs investing in closed end funds, its time to take a deeper look.

Closed end funds themselves are not an asset class as many people make them out to be but rather just an organizational tax structure for investing. Much like you cannot just say I want to have an allocation to "ETFs" or MLPs, you cannot just have an allocation CEFs... but then again, that is exactly what millions of people do. You have to look inside the fund to see what it does, and not just at the wrapper.

One advantage closed end funds have is that the investment pool is relatively fixed and not subject to daily inflows and outflows that plague typical open end mutual funds, where the fund manager must keep an allocation to cash in order to finance redemptions.

Because of the stable investment base, CEFs can use leverage. You can find CEFs investing in everything from bank loans, municipal bonds and corporate bonds all the way to bio-tech and energy producing companies. The one thing the funds usually share is their focus on income.

With the ever high equity markets and record low interest rates, investors searching for income are left to start looking outside the box. As such... they are looking at Closed End Funds.

Over the last few articles I talked about municipal bond and infrastructure funds so today I wanted to bring to light a diversified high income fund with a bit of history and an upcoming opportunity.

That fund is the Deutsche High Income Opportunities Fund (NYSE:DHG).

Fund Basics

Because the last time the fund was covered was in 2010 by George Spritzer CFA, let's take a look at where the fund is now 6 years later and the recently presented opportunity.

The Deutsche High Income Opportunities Fund as it is known as today, is a closed end fund launched November 22nd, 2006. At the time, it was known and marketed as the DWS Dreman Value Income Edge Fund. You can see the original prospectus here.

At the time, the fund had a dual mandate to provide total return through investing in an income strategy along with allocating between 10% and 40% into a hedged equity strategy. This was all managed and advised by the Dreman Value Management team founded by the famous contrarian and value investor David Dreman.

Unfortunately over the next few years, the fund's value tilt and sizeable position in energy brought the fund to its knees. The market price fell more than 80% from launch to the bottom of the Great Financial Crisis.

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Source: TradingView.com

While the fund nearly doubled from the bottom over the course of the following year, it was still trading at sizeable discounts to NAV.

This started getting attention from numerous activist hedge funds that purchased the fund in order to try and have the fund either convert to an open end fund or dissolve the fund in order to capitalize on the discount from the Net Asset Value. George has written about it in the past, in the article linked above.

The activist funds were able to get the board to change the fund's objectives to focus on the income bucket, rather than a hedged strategy and were able to force the fund to do a tender offer of up to 25% of the shares at a price equal to 99% of the NAV. DHG also conducted buybacks on the open markets when the market price was below the NAV.

For a short period of time this worked, and the discount to NAV actually turned into a premium for most of 2012. In 2013 however those premiums were again turning into hefty discounts.

So where is the fund today?

Today the fund manages approximately $317 million in assets, including leverage, with net common assets of $222 million. The fund pays an income only distribution that is currently 6.2% with the discount to net asset value of 7.91% at the time of writing. This is slightly lower than the 52 week average discount of 8.66%.

DHG like many CEFs uses leverage and is currently moderately levered about 29.95%. The fund fee is 1.56% with an additional .46% for the leverage for a total fund expense of 2.03%. This is in line with other CEFs.

The biggest difference with the fund today compared to the Dreman days is the portfolio composition. Currently, the fund has over 80% in High Yield Corporates. Even though it is a high yield fund, 68% of the portfolio is rated BBB or BB, and 98% is rated B or higher.

More recently, the fund has been positioning itself as slightly higher quality fund, particularly after a huge run-up in High Yield debt and an unclear economic picture. By moving the portfolio to higher quality names, and having 80% of it in the United States, the fund looks to weather the storm fairly well. More importantly energy makes up only 11% of the portfolio today. You can take a look at the latest portfolio holdings here.

The Numbers

Over the last 5 years, since the removal of Dreman Value team and the change in portfolio strategy, the fund has done quite well.

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Over the last 5 years, the fund has returned a total of 34.63%, inclusive of the distribution, beating out the iShares High Yield ETF (NYSEARCA:HYG). Over the last 6 years, you have had mostly positive returns with a flat 2015.

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Source: CEF Connect

When you annualize the returns, the fund has outperformed the category both in price and NAV. For anyone who has held on since the IPO... they are almost even if you include the distributions.

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Source: CEF Connect

Overall, it is a good performing CEF trading at a discount close to 8%. The real opportunity is still ahead though.

The Alpha

Even after the fund management change, the target placed on the fund by the activist investors has not been removed... merely transitioned to another group.

As discussed earlier, the discounts to NAV started increasing again in 2013, which prompted new calls from hedge funds.

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Source: CEF Connect

In 2015... they were successful. Bulldog Investors, LLC, a hedge fund known for being an activist in the closed end fund space, was able to force another change and perhaps an end to this fund full of history.

On July 10, 2015, the Fund announced that its Board of Directors had approved, subject to stockholder approval, an amendment to the Fund's Articles of Incorporation requiring the liquidation and dissolution of the Fund. Deutsche Investment Management Americas Inc. ("DIMA"), the Fund's investment adviser, proposed the amendment to the Fund's Articles of Incorporation to the Board pursuant to the terms of a Standstill Agreement that DIMA and the Fund had entered into with Bulldog Investors, LLC ("Bulldog"), a large stockholder in the Fund, and certain parties associated with Bulldog. Under the terms of the Standstill Agreement, Bulldog agreed, among other things, to withdraw its stockholder proposals and director nominations for the Fund's 2015 Annual Meeting.

At the Fund's 2015 Annual Meeting held on September 30, 2015, the Fund's stockholders approved the amendment to the Fund's Articles of Incorporation, limiting the Fund's term of existence until March 30, 2018, or such earlier date as may be determined by the Fund's Board, at which time the Fund will be liquidated.

Source: DHG Annual Report

Exactly as discussed in my last article "Nuveen Build America Opp Fund: Make America And Your Portfolio Great Again," we have a fund that has a definitive end date, at which the fund will be redeemed at NAV, and that discount will shrink to 0.

20 months, for a 7.9% gain.

Obviously there are risks as we discussed both in the article and in the comments of the last one. The risk here is that the underlying NAV will go down as the high yield market falls apart be it due to the economy or rising interest rates.

Let's assume that the NAV will stay flat here. We can look forward to the 7.9% pop from market price to the NAV on redemption, along with 2 years of income for another 12% or so... essentially 20% total return from here until March 2018.

As per Deutsche, the portfolio currently has an effective maturity of 5.6 years and an effective duration of 4.35 years. What this means is that an 1% rise in high yield rates, would have about 4.35% negative impact on the NAV. So your break even cushion would be if high yield rates jump between 4% and 5%.

The way that would happen is not necessarily the fed raising interest rates, but due to a slowdown in the economy or a full blown recession with defaults.

Below you can see the relationship of the major rate benchmarks.

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The last time the fed raised interest rates, in the early - mid 2000's, the 10 year treasury barely rose, and the BBB, BB, and B credits rose slightly... until of course the Great Financial Crisis where they spiked. Even still, during the crisis the BBB rates went from 6.89% or so up to 10.17%. BB credit rose 7.86% to 16.20 or about 8%.

The tech bubble of the late 90's early 2000 did have an increase, but far lower impact on rates. In both cases, it was not the Fed Funds Rate... but the economy.

There are two parts here to keep in mind. The first is the actual rate on the debt, the second is the high yield spreads to treasuries and other investments.

Rising interest rates (fed funds rates) would have an impact on investment grade debt, particularly the shorter you get in maturity, however an increase in the overnight rate may not lift the tail end of the curve, much like we saw the last time we had a rising rate environment. We ended up with a flat yield curve.

Secondly, high yield spreads are on the higher side compared to safer investments. So... it is reasonable to fathom that if the Fed raises interest rates... that means the economy is doing better, and thus the spreads on high yield debt should actually come down.

The other aspect to keep in mind is that we may not have to wait until March 2018, it may be sooner.

Fund's stockholders approved the amendment to the Fund's Articles of Incorporation, limiting the Fund's term of existence until March 30, 2018, or such earlier date as may be determined by the Fund's Board, at which time the Fund will be liquidated.

Source: DHG Annual Report 9/2015

In reality... it just may be at the end of this year too.

Today the fund is 50% institutionally owned, with Bulldog Investors & SABA Capital Management being the two largest holders. As of the 3/31/16 filings, they owned 3.4 million shares, or 22.4% of the total outstanding shares... they want to get paid.

Bottom Line

This is a good fund that has beaten the high yield ETF. The portfolio is on the higher quality of High Yield and management plans on keeping it there. There is an attractive income only distribution generated with moderate leverage in a fund currently trading at a near 8% discount to NAV. Most of all, there is a defined game plan to monetize the discount to NAV and return shareholder capital.

With DHG... you have a Bulldog looking out for you. This fund is worth a look.

Final Note: I hope you found this article helpful. I am a believer in active management that works and I am here to help you find those opportunities. Please follow me here on Seeking Alpha as we look for those opportunities and sort out the good managers from the mediocre.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DHG over 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.

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