These Beaten-Down High-Yield Plays Are Poised For A Sharp Rebound

by: Hawkinvest

Over the past few weeks, the market has almost worked itself into a frenzy about the Federal Reserve's plans to potentially taper stimulus and bond buying programs. (Ben Bernanke said the Federal Reserve won't proceed with plans to taper, unless the economy is strong enough). Even so, this has created a significant sell-off in many bonds and certain high-yielding stocks, many of which are at very oversold levels and now offer compelling yields as well as sharp rebound potential. There are a couple reasons why the sell-off in general appears to be overdone and irrational:

Can interest rates bounce off of historically record lows? The answer is clearly yes. However, is the economy so strong that rates are going to move substantially higher from here? I really doubt it and apparently so do plenty of very smart investors like Jeffrey Gundlach of DoubleLine Capital who suggests investors should buy bonds now. A recent Marketwatch article states:

Going forward, however, yields are likely to start falling. And that means the place to make money in the next few months is "everybody's most hated asset class: long-term government bonds," Gundlach said. 'There's really no inflation, no sign of inflation.

The recent rise in rates has pushed mortgage rates higher in recent weeks and that might already be enough to throw cold water on the nascent housing "recovery". Take a look at home builder stocks like Toll Brothers (NYSE:TOL) and others and you will see that the sector has dropped by about 10-15% in the past 3 weeks or so. That is a sign of a potential major cooling off in the housing market, which was one of the few sectors showing strength this year. If housing is already weakening, that could postpone any plans to taper. Look at stocks like Caterpillar (NYSE:CAT), which has been underperforming and Federal Express (NYSE:FDX), which just recently announced results that also indicate weakness in the global economy. These are important signs that a low interest rate and low growth environment is here to stay for now. Furthermore, it's very important to note that in 2012, there was also a spike in the 10-year Treasury Bond to a yield of about 2.4%, which is right around where it is at now. This could be just another head fake and if the yield is unable to push past 2.4% soon, this could be nothing more than a "double top" and turn out to be another great buying opportunity for investors willing to buy the panic sell-off now.

A rise in the 10-year bond from about 2% to 2.4% is relatively meaningless if it stabilizes at these levels or trends back down again as it has in the past. A 2.4% yield is not going to make stocks that can provide sustainable yields of 10% to 12% less attractive and that is why the across the board sell-off is creating a buying opportunity in select stocks. Here are some high yield plays that appear cheap and may be poised to rebound soon:

Wells Fargo Advantage Multi-Sector Income Fund (NYSEMKT:ERC) shares are now very oversold and it appears that the sell-off is undeserved since this fund has shorter duration bonds. This closed-end fund is managed by Wells Fargo and it invests in high yield bonds, asset backed bonds, government bonds, and corporate bonds, as well as in other bonds and cash.

This fund is an ideal investment to consider now because its investment portfolio has an average duration of just about 5 years, which makes it less sensitive to duration risk. It is also highly diversified with around 700 different holdings in the portfolio. The combination of shorter duration and portfolio diversification reduces risks for investors. It's worth noting that current net asset value is around $16.22 and with the shares now trading for just below $15, this means investors can buy into this well-managed fund at a discount of about 10%, which historically has been near the widest discount seen and therefore a great buying opportunity in the past (and probably now too). With the shares paying a monthly dividend of 10 cents per share, investors can rake in a yield of 8.2%, while limiting duration risk. One risk to consider is that closed-end funds can drop well below net asset value, but this can also create opportunity if you buy at times of market stress as we see now and pick up the shares well below the real value.

Going further into the portfolio data shows that it is about 48% invested in corporate bonds, 23% invested in government bonds, and it follows up with smaller investments in asset-backed and junk bonds as well as other loans. With a monthly dividend, a high yield, diversification, relatively short duration, and deep undervaluation, this is a solid buying opportunity for investors to consider now.

Here are some key points for ERC:
Current share price: $14.70
The 52-week range is $14.50 to $16.89
Earnings estimates for 2013: n/a
Earnings estimates for 2014: n/a
Annual dividend: $1.20 per share or 10 cents per month, which yields 8.2%

Fifth Street Finance Corp. (FSC) shares were trading at about $10.40 just a few days ago and even for nearly $11 a few weeks ago. However, the drop in the market has pushed the stock down to unreasonably low levels, which has created an ideal buying opportunity for investors. This business development company offers investors a diversified portfolio, a yield of roughly 12%, a dividend that is paid every month, and even potential capital appreciation. Here are six reasons why investors should buy the pullback in this stock now:

1) This company makes loans and investments in small to medium sized businesses. It invests in a wide range of industries, which includes healthcare, manufacturing, energy, defense, technology, marketing and others. This diversification reduces risks for investors. In addition, if the real economy is improving, the credit quality of the portfolio is also getting better and that is another reason why the drop in this stock is undeserved.

2) The company announced good news on June 13, which the market seems to be ignoring for now due to the recent sell-off. Fifth Street Finance said it acquired Healthcare Finance Group for $114 million and it expects that deal to be immediately accretive to net investment income. That could mean a boost for profits and even perhaps the dividend in the future.

3) Some analysts are bullish and not only believe that the dividend payout is secure but that the stock is worth more. Not long ago, analysts at J.P. Morgan (NYSE:JPM) upgraded the rating on this stock to overweight based on competitive advantages and a secure dividend that it sees for Fifth Street. The price target was set at $11 per share, which means that investors who buy now could potentially collect a 12% yield over the next year plus about 10% in capital gains if the stock was to reach the target price in a year. Earlier this year, analysts at UBS also put a buy rating and raised the price target to $11.50, which implies even larger potential capital gains.

4) This company pays a monthly dividend of nearly 10 cents per share. This is ideal for many investors because getting paid every month sure beats having to wait for a quarterly dividend, which is the case with many stocks. Furthermore, the yield is very attractive at roughly 12%.

5) Fifth Street Finance has positioned itself to benefit if interest rates rise and this is another reason why investors are wrong to sell this stock along with more interest rate sensitive investments like bonds. On June 20, the company released an update to investors which confirmed that the company is poised to benefit from the recent rise in rates since the vast majority of its debt investments were floating rate, (while it issues fixed rate debt to keep borrowing costs low). It also said deal flow had increased recently and that it expects growth from the recent acquisition of Healthcare Finance Group. In the recent release, it stated:

"Several BDCs, including Fifth Street, have taken steps to prepare their balance sheets for higher interest rates by investing in floating rate assets and issuing fixed rate debt. As of March 31, 2013, 74% of our debt investments were floating rate and over 90% of our capital was not directly sensitive to interest rates, taking into account our equity and unsecured notes offerings in April and May.

We expect our portfolio to be incrementally more profitable as short-term interest rates rise because the interest rates on our floating rate loans should reset higher while a portion of our borrowing costs remain at fixed rates."

6) Multiple insiders have been recently loading up on shares, which could be a sign that the market is significantly undervaluing this stock. On May 28, 2013, Leonard Tannenbaum (an officer) bought a total of 25,000 shares at about $10.37 each for a total transaction value of roughly $250,000. On May 22, Bernard Berman (an officer) bought 1,000 shares at $10.47 per share for a total value of $10,470. On May 15, Ivelin Dimitrov (an officer) also bought 1,000 shares at $10.71 for a total of $10,710. On May 14, Richard Dutkiewicz (a director) purchased 4,000 shares at $10.79 each for a total value of $43,160 and there have been other significant insider buys throughout 2013 and even in 2012.

A downside risk to consider would be another recession as that could reduce the credit quality of the portfolio, but this seems unlikely now. Management execution risk is another factor to consider but this exists with any company and this firm has an experienced team that is also invested in the stock. The positives appear to greatly outweigh the downside risks and with a 12% yield, growth prospects, and the potential to benefit from rising rates, this stock is too cheap now. With multiple insiders making recent and significant purchases at higher prices, this could be a major sign that the sell-off is overdone and therefore presents an ideal buying opportunity.

Here are some key points for FSC:
Current share price: $10.03
The 52-week range is $9.65 to $11.13
Earnings estimates for 2013: $1.11 per share
Earnings estimates for 2014: $1.18 per share
Monthly dividend: 9.6 cents per share, which yields about 12%

SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK) is an exchange traded fund that invests in high-yield bonds. Exchange traded funds trade close to net asset value and this one offers significant liquidity due to the high volume it trades on a daily basis. This fund also pays a monthly dividend and the current yield is just under 7%. There is also a shorter duration ETF offered, which is called: SPDR Barclays Capital Short Term High Yield Bond ETF (NYSEARCA:SJNK) that investors may also want to consider.

These junk bond ETFs are ideal for the liquidity offered although this fund yields considerably less than the two other picks mentioned above and it also probably has less rebound potential. However, this is another way to add diversification to a portfolio in the high-yield sector. Furthermore, if a slight rise in interest rates is signaling a strong economy, this means that the credit quality of junk bonds should also be improving. A primary risk for junk bond investors would be if another recession were to occur, but that does not appear likely at this time.

Here are some key points for JNK:
Current share price: $39.46
The 52-week range is $38.77 to $41.95
Earnings estimates for 2013: n/a
Earnings estimates for 2014: n/a
Annual dividend: about 20 cents per month, which yields nearly 7%

Data sourced from Yahoo Finance. No guarantees or representations are made.

Disclosure: I am long ERC, FSC. 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.

Disclaimer: Hawkinvest is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult a financial advisor.