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.
Over the past week, the situation around the high-yield closed-end funds was calm and we observed relatively low trading volume during the sessions. The benchmark of the high-yield bonds, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) finished the week in green territory with $0.11 increase of its price. Most of the market participants remain focused on the possible resolution of the bruising trade war between the U.S. and China. If we see a positive outcome we may expect additional increases in the stock market and the high-yield closed-end funds.
Source: Barchart, iBoxx $ High Yield Corp Bond iShares
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
The spread is simply the compensation a bond investor receives over the risk-free rate, which in this case is the U.S. Treasury rate. On a weekly basis, we notice a decrease of 0.24 bps. As we can see, the current levels are significantly lower compared to the ones of the financial crisis.
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 HYG and the iShares 20+ Year Treasury Bond ETF (TLT). As discussed, we observe a low correlation between the two sectors - it is only 0.01 points for the last 200-day period:
Source: Author's software
On the other hand, we have a statistical comparison between HYG and the SPDR S&P 500 Trust ETF (SPY). There's definitely a strong relationship between them.
Source: Author's software
Source: Yahoo News, High Yield Closed-End Funds News
Over the past week, two of the funds announced their regular dividends:
- Pioneer Diversified High Income Trust (HNW) $0.0950 per share.
- Pioneer High Income Trust (PHT) $0.0675 per share. The change from the prior dividend is by $0.0025 per share.
Review Of High-Yield CEFs
Weekly % Changes In The Sector
1. Lowest Z-Score:
The above sample represents the most statistically undervalued closed-end funds in the sector. Based on the Z-score indicator, the table provides us with interesting "Long" opportunities. Usually, I am interested in the funds which have Z-score below -1.00 point or at least to be pretty close to that value. In our case, we have only Credit Suisse High Yield Bond Fund (DHY) which meets the statistical requirements. Last week, DHY was again on the first position and discussed the situation around it in more depth. The management team decided to decrease the dividend in December from $0.0200 to $0.0190 per share. Respectively, this reflected on the price and we saw а widening between the price and the net asset value. Currently, the fund is traded at 7.11% discount and it is one of the highest discounts for the past decade. My personal opinion is that it can be reviewed as a potential "Buy" candidate due to its statistical edge and because of its relatively high yield. Yes, we saw a dividend cut but DHY still has 9.70% current yield.
From the rest of the funds, I am a fan of Wells Fargo Advantage Income Opportunities Fund (EAD). It has relatively low Z-score and you can buy it at 12.49% discount on its net asset value. Additionally, it is very interesting to notice that EAD achieved one of the highest returns on net asset value for the past five years. The closed-end fund managed to outperform its peers by its 6.23% annualized return on NAV.
2. Highest Z-Score:
On the other hand, I have plotted the funds which pretend to be statistically overpriced. We find a lot of closed-end funds traded at Z-score which is enough high to catch our attention but we need to take into account the fact that they are still traded at high discounts. So, we would like to have candidates traded at a premium and relatively high Z-score to review them as potential "Short" trades. It is still a challenge to find interesting "Sell" candidates but if you have a good portfolio with funds from the sector you may want to have a hedging reaction. I would suggest reviewing Invesco High Income Trust II (VLT). Definitely, a pretty high Z-score of 2.90 points and relatively low discount.
I am not surprised to find Pioneer High Income Trust (PHT) in this table. Over the past week, its dividend was increased and it reported an increase of 1.62% in its price. The net asset value of the funds remained unchanged on a weekly basis.
The average Z-score of the high-yield CEFs is 0.68 points. On a weekly basis, we do not have a change of the average value. It's been a very long time since we saw a positive average Z-score in the sector.
3. Biggest Discount:
Most of the funds from the sector are traded at discount. Over the past two months, they increased their prices and most of the statistical edge has vanished, but at all the period remains favorable for seeking potential "Long" positions. The above sample represents the funds from the high-yield sector with the highest discount. As you see, only a bunch of them have a negative Z-score.
Prudential Short Duration High Yield Fund (ISD) is sitting in the first position with a discount of 14.29%. Over the past week, its price fell by 0.86% but its net asset value went up by 0.25%. As you see in the chart below, ISD seems undervalued compared to its peers and the spread between its discount and the average discount of the sector is one of the highest for the past decade.
It is true that the current yield of 7.36% is not among the highest ones for the sector, but need to take into consideration the credit quality of the portfolio, as well. Most of the investments owned by this CEF are with rating "BB" which is very satisfying for that sector.
Source: Fund Sponsor Website
The average discount/premium of the high-yield CEFs is -8.33%. Last week, the average spread between prices and net asset values was -8.47%.
4. Highest Premium:
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 difficult task, and the sample above proves it. The Barings Participation Investors (MPV) looks like the only possible choice, but be aware of its relatively low average daily volume of 14,000 shares.
Here is the full picture of the funds from the sector. Below, we have depicted their discount/premium and their Z-score:
5. Highest 5-year Annualized Return On NAV:
The aim of the above ranking is to show us the high-yield funds with the highest return based on the net asset value for the past five years. Combination of the return with the other metrics that we have is a foundation of our research for potential "Long" candidates. The average return for the past five years is 4.84% for the sector. As you can see, the current yields on price and net asset value are much higher than the historical ones. The fact can be easily explained by the sharp decline in the prices at the end of 2018.
6. Highest Distribution Rate:
Only Barings Global Short Duration High Yield Fund (BGH) offers a yield on price above 10.00%. We still do not have a participant with a yield on net asset above that border. The average yield on price for the sector is 8.32%, and the average yield on net asset value is 7.61%. Earlier in the article, we discussed the opportunity to include DHY to your portfolio. Here, we can see its yields and their positions compared to its peers. As I said, DHY offers one of the highest yields in the sector and deserves our attention.
7. Lowest Effective Leverage:
We have two funds that are not leveraged and three which use leverage below 10%. The average leverage for the sector is 26.22%. Below, you can see the relationship between the effective leverage of the funds and their yield on net asset value.
Statistical Comparison And Potential Trades
Throughout the review, we saw that KKR Income Opportunities Fund (KIO) has one of the highest current yields in the sector. The current yield is 9.80% and the return on the net asset value is 9.07%. The price of the KIO bounced from its bottom but we still see an upward potential. The fund may be a very interesting buying opportunity for those of you who want to include a high return investment in their dividend portfolio.
The fund seeks to achieve its investment objectives by employing a dynamic strategy of investing in a targeted portfolio of loans and fixed-income instruments of U.S. and non U.S. issuers and implementing hedging strategies in order to seek to achieve attractive risk-adjusted returns. Under normal market conditions, the Fund will invest at least 80% of its Managed Assets in loans and fixed-income instruments or other instruments, including derivative instruments, with similar economic characteristics (the “80% Policy”).
The current distribution rate of the fund is $0.1250 per common share and its paid on a monthly basis. Actually, this is one of the most stable dividends in the sector. As you see, it remained constant over the past five years. Also, the earning coverage ratio is above 100% which is another good sign of the retention of future payments.
The investments owned by this CEF are well diversified between different credit ratings. Most of the assets are with ratings of "B", "B-" and "CCC+". A brief overview of the sectors shows that the portfolio is mainly comprised of assets from "Metals & mining" and "Health care providers & services" sectors. The portfolio is constructed by issuers located globally, but 89.7% of the assets are located in the United States.
Source: Fund Sponsor Website
Source: Fund Sponsor Website
The effective duration of the KIO portfolio is 2.32 years and it is one of the lowest durations in the sector. A portfolio with a relatively low duration may be beneficial in a rising rates environment.
Below is the statistical comparison of the main index the iShares iBoxx $ High Yield Corporate Bond ETF and KKR Income Opportunities Fund for the last 200 days. As it is stated, we observe a correlation of 0.68 points. Currently, we do observe two standard deviations between their prices. So, if you need a hedging reaction for your position in KIO you can use directly the benchmark.
Source: Author's software
The high-yield sector does not provide us with significant arbitrage opportunities at present. Most of the CEFs are trading at discounts, and it is difficult to find reasonable "Short" candidates. On the other hand, many of the funds provide us with a statistical edge to review them as potential "Buy" candidates.
Based on the data that I have reviewed, KIO can be a potential addition to your portfolio. Also, you can use the benchmark HYG as a hedging reaction.
Note: This article was originally published for our subscribers on February 10, 2019, and as such, some figures and charts might not be entirely up to date.
Trade With Beta
At Trade With Beta we also pay close attention to closed-end funds and are always keeping an eye on them for directional and arbitrage opportunities created by market price deviations. As you can guess, timing is crucial in these kinds of trades; therefore, you are welcome to join us for early access and the discussions accompanying these kinds of trades.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in KIO 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.