High yield and high drama define the last few months at Neuberger Berman High Yield Strategies Fund (NHS). The fund still trades at a ~7% discount in spite of solid historical returns and recently increased distributions. It's possible that the fund's relatively high leverage, high fee structure, and lack of management stock ownership are negatively impacting the market valuation. Saba is trying to replace the manager, and force a tender offer. If Saba's plan is successful, investors can profit from further closing of the discount, while collecting monthly dividends along the way.
NHS’ high yield strategy uses as a benchmark the ICE BofAML U.S. High Yield Constrained Index, a modified market cap index of US dollar denominated below investment grade corporate debt. They generally don’t stray too far from this benchmark. As a result, the fund's junk bond portfolio is well-diversified across industry:
Source: Fund Fact Sheet
The average maturity in their portfolio is 6.8 years. In the past year they’ve shifted away slightly from CCC credits towards more B and BB credits. Here is the credit quality breakdown as of the latest disclosure:
Source: Fund Fact Sheet
Although it isn't investing in the riskiest part of the high yield space, the fund uses quite a bit of leverage to enhance returns. Leverage is about 33% according to the latest fact sheet, and consists of senior notes and mandatory redeemable preferred stock, both due 2023.
The fund pays monthly distributions and the yield is slightly over 9%. In April, they announced a 38% increase in the monthly distribution rate. The latest distribution was about 70% from investment income, and the rest from return of capital. Management increased distributions to a level higher than investment income in an attempt to close the fund's persistent discount.
Performance and Valuation
Compared to their benchmark, the fund has delivered good performance to investors over the past decade:
6 months ended 04/30/2019
At Market Price
ICE BofAML US High Yield Constrained Index
Source : Semi annual report
However the fund depends on relatively high leverage to achieve his return.
Additionally he fund has traded at a fairly high discount over the years:
Source: Fund Fact Sheet
So there is potential value left to be unlocked. This high discount has attracted an activist investor.
The Proxy Battle
Saba has held NHS shares for several years, but it started to build up its stake again in August 2018. In late 2018, when there was a general selloff in the closed end fund space, NHS’s discount widened to as much as 20% and Saba accelerated its buying. As of the most recent filings, they own 19.3% of shares. They filed a 13D in March 2019, and have launched a proxy battle going into the October 3 annual meeting. Saba is seeking to elect three of its representatives as trustees to the 12 member board, replace the management company, and force a large self tender offer. Saba and NHS management have been going back and forth in an increasingly hostile war of words.
Saba’s main criticism of NHS is that the discount has been consistently wide. They cite CEF Advisors and note that the five year average discount for NHS is 11.1%, almost double the 5.7% average for high yield closed end funds. The fund traded at an average discount to net asset value of -14.5% in 2018 As of August, the trailing one year average discount is 11.6%, vs 7.1% average discount for high yield funds. Ironically, Saba’s aggressive buying and management’s increasing distributions in response have closed the discount to around 7%.
Saba hasn’t complained about the market or NAV performance of NHS. However, they attribute the wide discount to the market’s negative perception of management. Additionally, they have been critical of the relatively high fees. The advisory fees are charged on total managed assets, rather than net assets. Consequently management has an incentive to use higher leverage. This is extremely risky with a portfolio full of junk bonds (although it also makes the high dividend possible). The overall expense ratio was 2.96% in 2018. With a lower fee structure, the fund could pay a similar distribution, while taking less risk.
As a result, Saba has proposed terminating the management agreement with Neuberger. If this proposal succeeds, the board will need to find a new manager, or the fund will need to become internally managed. They need a majority of shareholders to approve this proposal. They would then approve a an interim manager, and have 150 days to get stockholder approval for a new management contract. If they aren’t able to find a new manager, the fund would become internally managed. Saba states in its proxy materials that they believe there are many fund managers who would be willing to take on the contract at a lower fee than Neuberger is charging. Given how much the asset management industry is struggling with fee pressure, this seems feasible.
Additionally, Saba’s proxy includes a nonbinding vote to self-tender for all outstanding stock at NAV or close to NAV. If more than 50% of shareholders tender their shares (likely to happen, given the discount), the fund would be required to liquidate or convert to an open end mutual fund. Saba would likely sell as many of its shares as possible if there was a tender offer like this. Since Saba purchased most of its shares when the fund discount was near the maximum, and its collected a decent yield along the way, they would earn a healthy return. This proposal would be nonbinding, so the board technically wouldn’t technically be required to do anything, even if it passed. However Saba points out that Neuberger’s governance and proxy voting guidelines state that it will withhold support from management of portfolio companies when they act against material stockholder proposals. It wouldn’t be a good look for management to ignore a proposal like this that from shareholders at their own fund.
NHS management has called the Saba nominees inexperienced, and pointed out the fund's historical performance as a reason to keep the current management. Additionally, cancelling the management agreements would actually be considered an event of default under some of the fund’s credit agreements. Consequently the board would either need to sell assets or quickly renegotiate with lenders if the proxy campaign was successful. Provided they are able to identify another manager, I doubt this would be a major issue. Additionally, they argue that a large tender offer would be unlikely to improve fund valuation. However, it would allow investors to profitably exit part of their positions.
The rhetoric got even more heated when management sent a letter to shareholders with the all caps headline “SABA CAPITAL MANAGEMENT, L.P. IS ATTEMPTING TO DESTROY YOUR FUND.” Saba and Neuberger have been trading accusations of impropriety. NHS management accused Saba of improperly managing its ETF by abusing an exemptive relief order that allows it to provide different baskets of securities to as part of the creation/redemption process. Saba responded by pointing out that Blackrock, State Street, Vanguard use the same practice. Further, they noted that the SEC has approved of this practice of “basket flexibility”, and a proposed rule would formalize their approval. Additionally, Saba has no discretion over voting of the ETF shares- they must vote proportionally to exactly mirroring the ratio of shareholder votes in the election. So the ETF shares won’t impact the proxy fight results. Saba also brought up some of Neuberger’s dirty laundry. In letters to shareholder they have highlighted the 2018 fine that Neuberger paid for overcharging fund expenses.
There are a couple corporate governance nuances that will have a major impact on the ultimate result of this proxy fight. The fund has stated that they intend to prevent Saba from voting more than 9.9% of shares, even though it owns 19.3%. This is allowed under Maryland corporate law, but against the 40 act according to SEC guidance, so it creates an interesting problem. Saba says they expect to be able to vote all of their shares, but its not guaranteed at this point. Even if they can vote all their shares they’ll still need another ~32% or so to get all their proposals through. According to WhaleWisdom, Bulldog and Rivernorth own shares, although Buldog trimmed their position in the most recent quarter. No matter what, Saba will need to round up a large chunk of retail shareholders. However, NHS management has refused to provide Saba with the names of non objecting beneficial shareholders, which will make rounding up a majority a bit more difficult. Hence the intense proxy campaign.
Implications for Other Shareholders
So what does this all mean for a small shareholder who just wants to make a bit of money without taking too much risk? A 9% yield with the potential for a closure of the NAV discount is tempting. The fund’s performance has been decent, but it is mainly the result of high leverage, which will make the fund highly sensitive to any serious recession or disruption to the credit markets. Additionally the high fees and lack of board investment in the stock is a cause for concern. Long term, lower management fees could also improve investor returns, although there is no guarantee that a new manager would maintain the same level of performance. Given that most of the portfolio is probably illiquid, this fund really doesn’t make sense as an open end mutual fund. A large tender offer would make it easy for Saba (and other investors) to exit at least part of their positions at a profit, and if it's done at a slight discount it would be accretive to shareholders who stay. A better solution for long term investors would be for management to buy back shares at the market discount until the discount closes, however that is not on the ballot for the annual meeting.
An investor who takes a position can collect a decent yield regardless of what happens with the proxy battle. If Saba’s proposals succeed, one can exit at least part of their position at a premium in a subsequent tender offer. However, it's possible the discount will widen again if Saba exits. Additionally, the fund's leverage level and investment strategy would leave it extremely exposed in the event of recession. We’re staying on the sidelines for now, but will look to buy if the discount widens again.
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.