Vanishing Premiums In High-Yield CEFs

by: Adam Aloisi

Six months ago, I published an article examining what I considered unreasonable levels of premium found in high-yield bond closed-end funds. Since that time, the landscape has dramatically changed and I decided it would be worthwhile and instructive to re-examine the space.

That Was Then....

In the article, I advised that while I liked the fundamentals of the space, I cautioned that it was probably a foolish idea to chase after junk debt via a CEF because around 90% of the funds were currently trading at a premium to NAV. I thought the fact that income investors appeared to be chasing after yield combined with the leverage most high-yield CEFs employ made investment a poor idea at the time. This was a chart I provided at the time.

Fund Current Premium Disc/Prem. 7-29-11 Positive Change Leverage Yield at Market
EAD 8.50% -2.01% 10.51% 24.76% 8.62%
HYT 5.85% -7.45% 13.30% 23.42% 8.06%
HIO 7.11% -3.79% 10.90% None 7.51%
NHS 8.18% -3.63% 11.81% 28.91% 7.33%
DHY 8.39% 2.33% 6.06% 28.80% 9.85%

Sure enough, by the end of the summer most high-yield CEFs started to trade lower and see their premiums narrow. Then in the middle of November we had a mini-panic with many income related investments, particularly higher yielding ones. Many CEF bond products lost five percent or more of their market value in a single day, despite the fact that net asset values (NAV) remained rather static. Large discounts were instantly created in funds where we had seen large premiums just a few weeks prior.

This Is Now

While most high-yield CEFs quickly stabilized and gained back most of the market value lost in the "panic," many trade substantially lower than they did six months ago. Statistically speaking, about 40% of high-yield CEFs now trade at a discount to NAV, compared to 10% six months ago. Another 20% trade at less than a 2% premium to NAV.

Here is an analysis of the vanishing premium phenomenon with the funds we looked at six months ago.

Fund Premium 8/31/12 Prem or (Disc.) 3/4/13 Premium Lost 6 mos. NAV Return 6 Mos. Net Market Price Gain (Loss) Current Yield
EAD 8.50% 1.20% 7.3% 0.7% (6.6%) 8.05%
HYT 5.85% 0.16% 5.69% 4.5% (1.19%) 8.14%
HIO 7.11% (0.31%) 7.42% 4.03% (3.39%) 7.27%
NHS 8.18% (2.70%) 10.88% 4.62% (6.26%) 7.67%
DHY 8.39% 4.81% 3.58% 4.34% 0.76% 9.72%

The takeaway results from this chart are rather interesting. We see that two of the five funds, Western Asset High Income and Neuberger Berman HY, now trade at discounts to NAV. This would be consistent with the broader 40% finding above. The Neuberger fund, interestingly enough, performed the best of the five on an operating basis, but was the second-worst market performer, only slightly bettering the market performance of bottom-dweller EAD, Wells Fargo Income Opportunity.

Credit Suisse HY performed the best out of the group and was the only fund to post a positive gain during the analysis period. It boasts the loftiest premium currently and yields 1.5% more than the Western Asset fund.

Should You Buy Junk CEFs?

Despite the obvious valuation correction over the past six months, I'm not sure I'd back the truck up just yet. I believe that one might take the opportunity to dip into the space as long as one understands the overriding risk of both junk debt and owning bond mutual funds.

After the correction last year I personally bought into the space, executing a swap out of Western Asset Emerging Markets Debt (NYSE:ESD) and into another Western Asset Fund, High Yield Defined Opportunities (NYSE:HYI). I saw the chance to pick up 200 basis points more yield while taking on maybe only marginally higher risk. HYI, after trading for as much as a 9% premium last year, flipped to a discount following the November panic. Though HYI holds virtually all of its assets in B and C rated paper, it is unlevered and yields 8.6 percent despite lowering its dividend marginally over the past year.

HYI price chart (12 months)

The discount buffer the fund provides is quite attractive as well as its overall risk/reward profile compared with group peers. I feel Western Asset Credit Management is top notch and at 89 basis points, the fee is not cheap, but comparatively fair. This fund is not for everyone, but it could fit a good niche in your portfolio.

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Disclosure: I am long HYI. 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.

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.