Weekly Review: High-Yield CEFs - The Relative Analysis Makes Me Think This Fund Is Undervalued

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About: Pioneer Diversified High Income Trust (HNW), Includes: AIF, CIF, DHY, DSU, EAD, EHT, HIO, HYB, HYG, HYT, IVH, NHS, SPY, TLT, VLT
by: Arbitrage Trader
Summary

Review of where high-yield closed-end funds and their benchmark ended the week.

Comparison with the iShares 20+ Year Treasury Bond ETF (TLT) and spread review.

Recap of news related to the sector.

Comparison among the funds using several important metrics.

Pair trade idea for those interested.

Introduction

The opportunities in closed-end funds over the last few months caught the eye of many investors. Most of these products are designed to provide a steady stream of income, usually on a monthly or quarterly basis, as opposed to the biannual payments provided by individual bonds. And this feature continues to attract market participants even when the overall market looks unstable.

In spite of CEFs being mostly of interest to income investors, we have found our path to approach them as active traders and we are constantly monitoring them. As a testament to this, you will be kept up to date with Weekly Reviews such as the one below.

The Benchmark

On a weekly basis, the price of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) increased by $0.03. Of course, it is important to notice that on 1st of November the benchmark paid out its monthly dividend of $0.4150. So, taking this fact into consideration, we can conclude that the past week was relatively positive for the sector. As the main reason behind the performance of the index, we can highlight the stabilization in the stock market. Over the past several weeks, the market turmoil led to sell-off in the high yield closed-end funds as the investors were concerned about the credit risk of the companies and their risky bonds.

Source: Barchart, iBoxx $ High Yield Corp Bond iShares

Аlthough the positive impulse from the past week, the prices in the sector remain at their lowest levels for the year. The previous time when the iShares iBoxx $ High Yield Corporate Bond ETF was traded below these levels was two years ago in November 2016. Therefore, the main support level which could be found on the chart is around $83.25.

Source: Barchart, iBoxx $ High Yield Corp Bond iShares

Source: Dividend.com

In my summary, I am going to briefly cover several advantages of high-yield bonds and respectively closed-end funds, which invest in this asset class. As the high-yield sector generally has a low correlation to other sectors of the fixed income market, along with less sensitivity to interest rate risk, an allocation to high-yield bonds may provide portfolio diversification benefits. In addition, high-yield bond investments have historically offered similar returns to equity markets, but with lower volatility.

Statistical Comparison And Spread Review Of The Sector

High-yield bonds are typically evaluated on the difference between their yield and the yield on the US Treasury bond. High-yield spreads are used by investors and market analysts to evaluate the overall credit markets. Higher spreads indicate a higher default risk in junk bonds, and can be a reflection of the overall corporate economy and/or a broader weakening of macroeconomic conditions.

On a weekly basis, we notice an increase of 0.09 bps but the current levels remain one of the lowest for the past decade.

Chart US High Yield Master II Option-Adjusted Spread data by YCharts

Source: YCharts, US High Yield Master II Option-Adjusted Spread and US High Yield Master II Effective Yield

Below, you can find a statistical comparison between the iShares iBoxx $ High Yield Corporate Bond ETF and the iShares 20+ Year Treasury Bond ETF (TLT). As discussed, we observe a low correlation between the two sectors. It is only 0.07 points for the last 200-day period:

Source: Author's software

On the other hand, we have a statistical comparison between the iShares iBoxx $ High Yield Corporate Bond ETF and S&P 500 SPDR (SPY). Definitely, a strong relationship between them.

Source: Author's software

The News

Source: Yahoo News, High Yield Closed-End Funds News

Over the past week, several funds from the sector announced their regular monthly dividends:

  • Invesco High Income Trust II (VLT) $0.0964 per share.
  • Neuberger Berman High Yield Strategies Fund (NHS) $0.0658 per share of common stock.
  • Ivy High Income Opportunities Fund (IVH) $0.1000 per share.
  • Eaton Vance High Income 2021 Target Term Trust (EHT) $0.0475 per share.
  • MFS Intermediate High Income Fund (CIF) $0.0202 per share.
  • New America High Income Fund (HYB) $.05500 per share on the company’s common stock.
  • BlackRock Debt Strategies Fund (DSU) $0.0685 per share.
  • BlackRock Corporate High Yield Fund, Inc (HYT) $0.0720

Review Of High-Yield CEFs

Weekly % Changes In The Sector

Source: CEFConnect.com

1. Lowest Z-Score:

Source: CEFConnect.com

Above, I have plotted potential "Buy" candidates based on their Z-score. The purpose of this indicator is to show us how many times the discount/premium deviates from its mean for a specific period. Logically, the calm week for the sector led to an increase in the Z-scores of the funds.

We have only two funds with Z-score below -3.00 points. Our new chart leader Apollo Tactical Income Fund, Inc. (AIF) is even closer to -4.00 points but it is important to notice that this closed-end fund is a little bit different due to its senior loan part of the portfolio. It is appropriate to compare it to other senior loan closed-end funds, as well.

Source: CEFdata.com, Apollo Tactical Income Fund, Inc

2. Highest Z-Score:

Source: CEFConnect.com

From my perspective, none of the above funds could be reviewed as potential "Sell' candidate. The leader of the ranking is a fund with very low average daily volume and the rest of the participants do not provide us with a statistical edge to discuss them. This situation should not surprise us if we take into consideration the fact that the current prices of the funds are much lower compared to the previous year. Nevertheless, if you are seeking a hedging reaction of your long positions, the above funds may be interesting to you.

The average Z-score of the high yield CEFs is -1.59 point. A week ago, the average Z-score was -1.87 point. On a monthly basis, we do observe a significant change in the average value.

Source: CEFConnect.com

3. Biggest Discount:

Source: CEFConnect.com

The table above aims to shows us the closed-end funds with the biggest spread between their price and net asset value. Compared to the previous week, there is almost no change among the top ten candidates and once again Neuberger Berman High Yield Strategies Fund (NHS) is leading the ranking with a discount of 16.48%.

The average discount/premium of the high yield CEFs is -10.92%. Last week the average spread between prices and net asset values was -11.16%.

Source: CEFConnect.com

4. Highest Premium:

Source: CEFConnect.com

Here, I am looking for potential "Shorts" based on their premiums and statistical performance. The situation remains the same as we used to see it over the last months. The seeking of "Sells" is still a challenging task, and the sample above proves it.

Here is the full picture of the funds from the sector. Below, we have depicted their discount/premium and their Z-score:

Source: CEFConnect.com

5. Highest 5-year Annualized Return On NAV:

Source: CEFConnect.com

The average return for the past five years is 5.25% for the sector. As you can see, the current yields of most of the funds are much higher than the historical ones. This fact can be easily explained by the sharp declines in their prices over the past year.

Wells Fargo Advantage Income Opportunities Fund (EAD) and Credit Suisse High Yield Bond Fund (DHY) could be reviewed as potential "Buy" candidates. They not only have one of the best performance for the past five years but also have a current yield much higher than the historical one.

6. Lowest 5-year Annualized Return On NAV:

Source: CEFConnect.com

Western Asset High Income Opportunity Fund (HIO) is sitting on the first position of the ranking, but it is important to notice that it has one of the lowest Z-scores and its current yield of almost 7.00%.

7. Highest Distribution Rate:

Source: CEFConnect.com

Above, we saw what was the historical performance of the funds, but probably most of you are interested in the current return which could be achieved and that is the reason why I sorted the funds by the highest distribution rate.

The average yield on price for the sector is 8.39% and the average yield on net asset value is 7.46%. The difference between the two values can be easily explained by the spread between the price and the net asset values of the funds.

Source: CEFConnect.com

8. Lowest Effective Leverage:

Source: CEFConnect.com

We have two funds which are not leveraged and three which use a leverage below 10%. The average leverage for the sector is 26.47%. Below, you can see the relationship between the effective leverage of the funds and their yield on net asset value.

Source: CEFConnect.com

Statistical Comparison And Potential Trades

Combining all of the circumstances, we form a landscape in which it is easier to find potential "Buy" candidates rather than reasonable "Shorts". I will keep your attention only on the closed-end funds where you can consider taking a "Long" position.

The potential "Long" candidate which I am going to review today is Pioneer Diversified High Income Trust (HNW). My personal opinion is that the fund is undervalued relative to its peers and I will try to defend that theory. To gather more information about the fund, I suggest to start with its investment philosophy:

Pioneer Diversified High Income Trust is a closed-end fund designed to pursue a high level of current income, with the potential for capital appreciation as a secondary objective. The Fund invests in a unique blend of higher yielding asset classes, including global high yield bonds, leveraged bank loans and event-linked bonds (cat bonds).

This closed-end fund has one of the highest discounts in the sector and a Z-score below the average for the sector. Both metrics indicating that we have a statistical reason to review it and to consider it as "undervalued."

Source: CEFConnect.com, Pioneer Diversified High Income Trust

Source: CEFConnect.com, Pioneer Diversified High Income Trust

The below chart compares the premium/discount of the fund to the same metric of its peers. Over the past 10 years, we did not see such a widened spread between them.

Source: CEFdata.com, Pioneer Diversified High Income Trust

We do have a yield on the price of 8.17% and a yield on the net asset value of 6.90%. The current distribution is $0.0950 and it is paid on a monthly basis. As per the latest annual report from April, the earn coverage ratio is 109.16%.

Source: CEFConnect.com, Pioneer Diversified High Income Trust

Most of the investments owned by this CEF are with a rating "B." The portfolio is constructed by issuers located globally, but 65% of the assets are located in the United States. A brief overview of the investments shows that the portfolio is well-diversified and that "Bank Loans" and "US High Yield Corp" sectors have the biggest weights. The number of holdings in the fund's portfolio is 459.

Source: Fund Sponsor Website

Source: Fund Sponsor Website

As you know, one of our purposes is always to be prepared for unexpected events and outcomes. Therefore, we insist on having a hedging reaction for our positions. As a hedge to Pioneer Diversified High Income Trust, we can use the Invesco High Income Trust II (VLT). Over the past year, their net asset values tended to move together, but we observe a price deviation.

Chart HNW data by YCharts

Source: YCharts, Invesco High Income Trust II and Pioneer Diversified High Income Trust

Source: Author's software

Conclusion

The high-yield sector does not provide us with significant arbitrage opportunities at present. Most of the CEFs are traded at discounts and it is difficult to find reasonable "Short" candidates. If we see a break of the support or the resistance of the current trading range, we expect significant changes in the funds' statistical characteristics.

Based on the data that I have reviewed, HNW can be a potential addition to your portfolio.

Note: This article was originally published for our subscribers on 11/04/2018, and some figures and charts may not be entirely up to date.

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