The closed-end funds from the high-yield sector significantly increased their prices over the past four months. Currently, most of them are traded at positive Z-scores, which is an indication that they have lost most of their statistical edge. Still, they are traded at high discounts, but we are cautious when we select our positions due to the lack of statistical edge. I still see several interesting buying opportunities in the sector, which I am going to discuss with you in this article.
At the end of the article, we will review in more details First Trust High Income Long/Short Fund (FSD) as a potential addition to your portfolio. It uses 21.43% effective leverage which is much lower compared to most of its peers. On top of that, it has one of the highest discounts in the sector and still a very attractive yield of 8.63%. Мore details will be discussed later.
No doubt, the most interesting events from the last week ware related to the U.S.-China trade deal. Currently, most of the market participants are cautious and anticipate to see the outcome of the negotiations. Respectively, the stock market is very sensitive to this topic and it seems the investors preferred to close some of their long positions till they see a solution.
When there is increased volatility in the stock market and some uncertainty we usually see a reflection in the high-yield bonds and high-yield closed-end funds. This time the case is identical and the price of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) declined by $0.34 and finished the Friday session at $86.23 per share.
Still, the situation in the sector seems stable but if you hold long positions in some of the high-yield closed-end funds you may hedge them with some of their peers which are at least statistically overpriced.
Source: Barchart, iBoxx $ High Yield Corp Bond iShares
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 0.28 bps. which is justified compensation if we take into consideration the situation around the trade deal.
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 0.65 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 is definitely a stronger relationship between them for the last 80 days. As you see, it is 0.99 points.
Source: Author's software
Source: Yahoo News, High Yield Closed-End Funds News
Barings Global Short Duration High Yield Fund (BGH) announced its monthly dividend for May 2019 of $0.1482 per share.
Source: Yahoo News, High Yield Closed-End Funds News
Review Of High-Yield CEFs
Weekly % Changes In The Sector
1. Lowest Z-Score:
As usual, I will start our weekly review by presenting the Z-scores in the sector as an indication for statistically overpriced or undervalued funds. Simply put, a Z-score is the number of standard deviations from the mean a data point is. But more technically it is a measure of how many standard deviations below or above the population mean a raw score is.
Despite the volatile and restless week, the high-yield funds are still traded at positive Z-scores. However, compared to the previous time we see slightly lower statistical parameters.
High Income Securities Fund (PCF) remains the only one which is traded at negative Z-score. On a weekly basis, its price the CEF fell by 1.66% which is the main factor for the widened discount. Regarding this fund, it is interesting to mention that it is one of two funds from the area which do not use leverage. However, I am not very interested in PCF at all due to its unattractive current yield. The offered return is 3.95% which is really non-competitive for this sector. Prior to the fund's recently completed self-tender offer, shareholders approved a proposal authorizing the board of trustees to take steps to cause the fund to cease to be a registered investment company (RIC).
- AIF has one of the highest discounts in the sector. In addition to the satisfying spread between the price and net asset value, we should highlight its relatively low Z-score. We do have a yield on the price of 8.24% and yield on the net asset value of 7.28%.
- The situation around IVH is very similar. Once again, an attractive discount and relatively low Z-score which are accompanied by the juicy current yield of 8.68%.
2. Highest Z-Score:
From a statistical perspective, I could say that only the funds which are traded above 2.00 points provide us with a statistical edge to review them as potential "short" candidates. Currently, I do not see a panic among the market participants which can lead to a sell-off in the high-yield sector. As you know, most of the times this sector is one of the first ones which is affected by the credit panic among the market participants due to its lower quality. I still do not feel the panic but if we see a trend reversal Neuberger Berman High Yield Strategies Fund (NHS), Invesco High Income Trust II (VLT) and Pioneer High Income Trust (PHT) will be the first funds which I am going to use to hedge my long positions. All of them meet my statistical requirements to review them as potential "sell" candidates and none of them are traded at a very high discount.
The average Z-score of the high-yield CEFs is 0.94 points. On a weekly basis, we find a decrease of 0.21 bps of the average value. At the end of December, we had -3.43 points average Z-score, and now, it is slightly below 1.00 point.
3. Biggest Discount:
Only two of the funds reported an increase in their prices on a weekly basis. Expectedly, the spread between price and the net asset value has widened as the price is the metric which is more affected in the short term by the market situation. The average discount/premium of the high-yield CEFs is -6.98%. Last week, the average spread between prices and net asset values was -6.56%.
No doubt, my personal favorite from this table is Wells Fargo Advantage Income Opportunities Fund (EAD). Compared to its peers this fund is undervalued for me. A fact which is a very important part of my analysis is the past performance of the closed-end fund compared to the sector. Inevitably, you will notice that EAD outperformed its peers for the last 10 or 5 years by return on the net asset value. Ultimately, when you invest in closed-end funds the net asset value is what you buy and this metric is more important for me.
4. Highest Premium:
We do not have so many funds which are traded at premiums. After the announcement of the net asset values, even the premiums of Babson Capital Participation Investors (MPV) and Barings Corporate Investors (MCI) do not look so impressive. I believe MFS Intermediate High Income Fund (CIF) may be a very good "short" candidate if we see turbulence in the sector. As you see, we can easily categorize this CEF as overpriced if we use discount/premium as a reason.
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:
As you see, Barings Participation Investors and Barings Corporate Investors are the outliers of the observation and this is the main reason behind their trading at a premium. The average return for the past five years is 4.89% for the sector. As you can see, the current yields of most of the funds are much higher than the historical ones.
6. Highest Distribution Rate:
The average yield on the price for the sector is 8.06%, and the average yield on net asset value is 7.50%. We have already seen that most of the funds are trading at a discount, so this difference should not surprise us.
7. Lowest Effective Leverage:
We have two funds which are not leveraged and three which use leverage below 10%. The average leverage for the sector is 26.87%. 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
If you follow our Weekly Review on a regular basis, you probably notice that after our sector discussion, I try to choose interesting candidates for you and to analyze them in more details. This week I have decided to present to you First Trust High Income Long/Short Fund (FSD) as a potential buying opportunity. This fund is traded at one of the lowest Z-score and is taking the second position when we talk about discounts. Another positive which I find here is the relatively low leverage which is used.
Currently, we find that it is traded at 12.99% discount, which is significantly higher compared to the average 6.98% discount of the sector. One-year Z-score as a statistical indicator is 0.70 point. It indicates that, over the past year, there was a more appropriate moment to include FSD in our portfolio but sometimes it is difficult to buy such an asset in an uncertain period such last December. However, this Z-score is still relatively low so I could say that it is not too late to buy it.
The fund has a relatively high average daily volume of 114 000 shares per day, so you do not need to worry about its liquidity. Usually, I pay attention to this characteristic because of some of the closed-end funds have really low average daily volume which does not meet my requirements.
We do have a yield on the price of 8.63% and yield on the net asset value of 7.51%. The current distribution is $0.1050, and it is paid on a monthly basis. Over the past year, the dividend of FSD remained stable and unchanged.
Usually, I spend some time on the earning/coverage ratio and UNII balance per share. Unfortunately, I was not able to find updated information for these characteristics for FSD and the latest one is from October 2018. However, I consider as positive the fact that since that period the management team continues to maintain the same amount.
Portfolio Quality and Composition
The main distribution is between "BB" and "B" ratings. The assets with investment grade quality are 11% and we do not find assets which are not rated. The portfolio is well-diversified between 282 holdings.
A brief overview of the investments shows that that "Basic Industry" and "Telecommunications" sectors have the biggest weights.
Duration and Leverage
No doubt, the duration and the leverage are other important pieces of our analysis. The duration is a crucial element of the fixed-income instruments and is almost impossible to miss it when are talking about high-yield bonds and high-yield closed-end funds. In our case, the duration of FSD is 3.78 years.
The effective leverage which is used by the fund is 21.43% which is much lower compared to its peers.
As you know, one of our purposes is to be prepared always for unexpected events and outcomes. Therefore, we insist on having a hedging reaction to our positions. As a hedge, we can use the Invesco High Income Trust II. They have a pretty strong correlation between their net asset values. Additionally, VLT has one of the highest Z-scores in the sector at that moment.
Source: Author's software
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 so many potential "short" candidates. On the other hand, there are still interesting funds which provide us with an attractive valuation to review them as potential "buy" candidates.
Based on the data that I have reviewed, FSD can be a potential addition to your portfolio.
Note: This article was originally published on May 12, 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 FSD 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.