Closed-end funds are an intriguing, complex, and occasionally worthwhile investment product since they can sometimes be purchased at a discount to net assets. On a regular basis I will scan the space specifically looking for new discounts that have appeared for apparently little or no reason, then conduct further due diligence to determine if the fund has value or not. One sector that I'm seeing strikingly little value and growing premiums in is the domestic high-yield bond space.
Of the 40 high-yield names that CEFconnect.com tracks, only four currently trade at a discount to NAV. Ten of these funds trade at a better than 10% premium to net assets. In other words, investors are currently willing to pay $1.10 for every dollar worth of bonds in the portfolio. While premiums are certainly not unheard of in the closed-end space, and can appear for a variety of reasons, the breadth and depth of premium presently found in high-yield is somewhat startling.
I say this because one short year ago, the situation was quite the opposite, as high-yield CEFs traded frequently for discounts. I randomly selected five funds to investigate, Wells Fargo Income Opp. (EAD), BlackRock Corp. HY VI (HYT), Western Asset High Income (HIO), Neuberger Berman HY Strategy (NHS), and Credit Suisse HY Bond (DHY), to determine if there was a correlation in the discount/premium change over the past year. Each fund currently trades with a high premium and has assets in excess of $250 million. A negative number indicates a discount.
|Fund||Current Premium||Disc/Prem. 7-29-11||Positive Change||Leverage||Yield at Market|
In four of five instances the fund traded at a discount to NAV almost a year ago but now trades at a premium, generating a "stealth" double digit positive return for investors. There is similar leverage, except in the case of HIO which is unlevered, and the yields are comparable, with discrepancy most likely explained by maturity and credit quality divergence.
Why DId the Discount Disappear?
Because of the inherent complexity in CEFs, there are generally no definitive answers as to why premiums and discounts appear, disappear, or remain a permanent fixture, as they sometimes do. My main speculation in this case is, unfortunately, that yield starved investors are starting to chase certain asset categories absent mindedly. I suspect that some CEF investors do simple yield comparisons and pick funds haphazardly based on income potential, with little attention to other important CEF data points, including premium, and perhaps overall risk.
Another theory predicated on a more informed individual could be that investors see high-yield as the sweet spot of current credit markets, that the economy is strong enough to ward off higher default rates, and thus a diversified portfolio of higher yielding bonds is worth paying a premium for.
For me, even if the informed theory is correct and the above funds had quality management, pristine portfolios, and low fees (which are a few of the additionally speculated on reasons for the existence of premiums), personally, I still would not recommend investing in them simply because of the premium. The inherent credit risk in junk bonds coupled with leverage risk (discussed below), and mammoth macroeconomic uncertainties might be okay for a risk-tolerant investor to cope with, but why would you pay a significant premium to be exposed to it?
The Leverage Effect
In comparing the yields in the chart above to HYG, the widely-held iShares High-Yield Composite ETF, we find that they are far in excess of HYG's current 6.5% payout. This is explained somewhat by the fact that four of the five funds, unlike HYG, employ leverage (borrowing) in its strategy. Leverage can be a good or bad add-on for a closed-end fund. It can magnify capital gains and yield when investment strategies are working, but it can also act in reverse. With interest rates remaining low and mainly static, a leveraged high-yield strategy appears to be a positive, for now.
Will the Premiums Disappear?
I'm not predicting a near-term collapse in the high-yield bond market, indeed I actually think thoughtful allocation to the group is not a bad idea for risk-tolerant investors. But, in so far as CEFs go, I think allocating money here presently at a premium is a mistake. A meaningful reversal in sector fortunes could have an impact on net asset values, market perception and pricing, and eventually, premiums. So, while investors who got into high-yield CEFs last year at a discount saw a "stealth" gain the past year, conversely, it's possible for investors to suffer a stealth loss as NAV and premium vanish in tandem on the way down.
But, on the other hand, as we discussed earlier, there's no scientific way to know when or even if that will ever happen. Is it possible that high-yield premiums persist or get even deeper for the next decade or longer? The answer is yes.
The Bottom Line
While not necessarily bearish on the prospects for the high-yield market as a whole, I'm not bullish enough to take a chance on premium priced, leveraged, junk debt investment vehicles. I don't think you should either.
Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.