With Carl Icahn warning about a "keg of dynamite" in the high yield market and Third Avenue liquidating a high yield bond fund, the so-called "junk bond" market is living up to its name. While markets are victim to volatility every once in a while, the problems in high yield are worrisome for a couple of reasons. Firstly, the high yield market never really recovered from the taper tantrum of 2013, meaning the bad run for high yield has now lasted almost three years:
Secondly, with a ZIRP environment where retirees are desperate for income, many have been fooled into buying into the high yield market at the wrong time.
Many fears around high yield bonds focus on the impact of a rising interest rate environment, but a much greater threat is behind Icahn's red flag: liquidity.
A Quick Introduction to Bond Trading
With so much media focus on the stock market, many people translate what they know and learn about equities to the credit markets. This is a huge mistake for several reasons, but right now the mistake revolves around trading. Common stocks trade trillions of times in a day, but bonds do not. In fact, many bonds will not be traded for days, or even months. This is especially true for the high yield market, where investors often hold to maturity to collect the yield.
The implications of this are significant. Without frequent trading, a fund that needs to sell its holdings to fulfill redemption demands could suddenly be faced with the worst dilemma you can have in any business: needing to sell immediately with no buyers in sight. When this happens, prices crater.
Without the liquidity of stocks or even U.S. Treasuries, high yield bonds are susceptible to a massive decline in values, which is why we have seen the decline in value for these funds accelerate recently. Part of this is because more people are selling out of high yield mutual funds, which is requiring the funds to sell to give investors back their cash. In doing so, they are driving prices down, and the trend is likely to continue.
Why CEFs are a Good Thing
The timing to buy into high yield is not good; as Icahn rightly says, the devastation is likely to continue. There is still money in high yield funds that is likely to come out, and there are still continued fears about rising defaults in energy that are impacting the credit markets more broadly.
But when the time to buy into high yield is right, CEFs may be a better alternative than mutual funds for yourself and the market as a whole. If well managed, CEFs do not face the redemption issue that mutual funds do. Because their total number of shares is fixed upon IPO, investors don't "redeem" their holdings for cash-they sell their stake in the fund to someone else.
This means that there can be a steep decline in the market price of CEFs that will not force the CEF to sell bonds. The only time the fund needs to sell bonds is to pay dividends (if its net investment income is less than its distributions) or to free up capital to lower leverage. A well-managed CEF can avoid both by cutting dividends (as we saw many high yield funds do in the last two years) and by lowering leverage (again, a tactic gaining popularity in these funds).
This doesn't mean CEFs are insulated from the bond market carnage; since they are trading in the same market, they are suffering alongside everyone else. But this suffering can take many forms: it can mean that the NAV of its holdings declines, but if the fund holds the bond to maturity, it will get its already invested capital. If the fund doesn't need to sell the bond prematurely to pay dividends or lower leverage, it can weather the storm of a collapsing high yield market.
I believe this is partly why the Pimco High Income Fund (NYSE:PHK) made its unprecedented dividend cut a few months ago. Predicting a need for cash on hand and a need to stay as far out of the high yield market as the fund's mandate will allow, it has lowered leverage and lowered distributions to effectively lower its liabilities and liquidity needs. This is prudent, and affirms my confidence in management if not in the wisdom of buying PHK right now. Other funds have made similarly wise decisions, as I discuss below.
Picking through the Carnage
So where does that leave us now? Several high income CEFs are down massively and will be well positioned to buy when the liquidity crisis in the market is over. But which to choose?
A comparison of eight funds with relatively similar mandates and investment strategies reveals a lot of similarities and some telling differences. Most significantly, the Deutsche High Income Opportunities Fund (NYSE:DHG) and the Deutsche High Income Trust (NYSE:KHI) have the best performance of the group-ironic, since DeutscheBank (NYSE:DB) has had an awful year. But "best" in this case means a negative total return YTD including dividends and an erosion of 10% of capital on average. The worst performer, the Pioneer High Income Trust (NYSE:PHT), is down over 46% YTD and is at its lowest point in the last year. A dividend cut in February, which now seems like an extremely prudent decision given the liquidity needs of the high yield market throughout the year, is mostly to blame, and has resulted in the stock trading at a discount to NAV consistently throughout the year.
In contrast to this is PHK, which is down 32% YTD but is the only fund to trade at a premium. Just a few weeks ago, however, that premium was as high as 30% just a few weeks ago, which is what caused me to sell the fund.
A Group of Peers
Looking at the others, we see comparable discounts to NAV among the Invesco High Income Trust II (NYSE:VLT), the Dreyfus High Yield Strategies Fund (NYSE:DHF), and the Credit Suisse High Yield Bond Fund (NASDAQ:CHY). Worse than these is the First Trust Strategic High Income Fund II (NYSE:FHY), a thinly traded fund that has also performed worse than the others. In addition to a reverse split in 2011, FHY cut its dividend earlier this year. Even more distressingly, the fund failed to see its NAV recover after 2008, although many other funds were able to recover against their lowest point in the dark days of 2009:
Combined with First Trust's small size and thus relatively limited buying power in bond markets, these distressing signals indicate this is not a fund to buy on the dip.
Of the rest, DHF is one of the strongest contenders for a variety of reasons. For one, its dividend cut came in the middle of February and it has not cut in 2015. I interpret this as an indication of the managers' prescience; simply put, they saw the liquidity crisis before others. Additionally, the fund's effective duration of 3.72 years is extremely short for the high yield CEF universe and only 5.67% of its portfolio is in energy:
Finally, to cover dividends, DHF will need to earn a 10.88% yield on its portfolio since it is trading at a discount. This is easy to do even in a ZIRP environment, and is getting easier now that junk bond yields are rising:
A high yield fund starting today could get that yield with only 20% leverage--much lower than the level many bond CEFs maintain.
Leverage is my main concern with DHF, however; at over 30%, it is excessive in this cratering high yield market, which is why I am not buying DHF now and will not for a while. However, when the time is right this fund may be one of the best options in the high yield market, although if the premiums shrink and discounts grow for other historical strong performers like PHK and PHT, they may become attractive too.
For now, however, I am fully out of the high yield market and will likely remain so for several months.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.