HYT Had An Income Boost And Still Trades At A Discount, But Beware Tightening Spreads

Summary

  • High yield corporate bonds, and HYT by extension, have performed very well this year.
  • The fund has two attributes I believe will help fuel further price gains - a recent distribution raise and a market price at a discount to NAV.
  • However, I expect 2020 to offer more modest returns for high yield as a whole, as spreads have narrowed considerably, limiting potential upside.

Main Thesis

The purpose of this article is to evaluate the BlackRock Corporate High Yield Fund Inc. (NYSE:HYT) as an investment option at its current market price. This is a fund I have recommended in 2019, and I see continued merit to holding it in 2020. The fund still trades at a discounted price, and has recently increased its income stream, which is a rarity among CEFs right now. With interest rates on the decline this year, investors world-wide have been looking to riskier assets for yield, and HYT has directly benefited.

However, I see reasons for caution as well. While HYT does trade at a discount, it is markedly lower than the discount it had for most of 2019. Further, yield spreads in the high yield sector have narrowed considerably throughout the year. While this trend could certainly get even more pronounced throughout 2020, there is also a chance the bullish momentum could stall. If it does, considering spreads are so narrow, there is plenty of downside risk if those spreads revert back to their historical norms.

Background

First, a little about HYT. The fund's primary objective is "to provide shareholders with current income," with a secondary objective to "provide shareholders with capital appreciation." The fund invests the majority of its assets in high-yield bonds, corporate loans, convertible debt securities and preferred securities which are below investment grade quality. Currently, HYT is trading at $11.29/share and pays a monthly distribution of $.0779/share, which translates to an annual yield of 8.32%. HYT is a fund I have been bullish on for a while, and its performance this year has impressed. As we approach 2020, I am reevaluating all my areas of coverage, to determine if I should change my outlook at all. After review, I still believe HYT's next move will be positive, but I believe the gains will be more modest. This reality is making me change my rating to "neutral", and I will explain why in detail below.

HYT Was One Of My Better Calls In 2019

To start, I want to first discuss HYT's performance over 2019, as we are about to wrap up the year. This is a fund I recommended on two separate occasions, for a variety of reasons. One, I believed the fund's discounted price to NAV was attractive, especially considering the rising cost to own many stock and bond funds this year. Finding value has been a challenge all year and, as we enter 2020, it will continue to be a challenge going forward. Two, HYT offered an above-average income stream, which I expected to become increasingly in-demand as the Fed began cutting interest rates in the U.S. This development was expected to continue, along with other central banks expected to adopt similar measures around the world. Three, high yield defaults had been low, and I foresaw that as likely to continue. Further, while there was a risk of downgrades from the investment-grade sector due to the rising level of corporate debt, I expected the impact on underlying prices in the high yield sector to be modest, because I did not see wide-spread downgrades occurring.

Now that the year is almost up, looking back in review of these predictions illustrates that the primary reasons for buying HYT did indeed materialize. Interest rates declined, HYT's income was in-demand, and downgrades and defaults did not occur on a wide scale. The result has been a strong total return from HYT, which has gained over 10% since my June review and over 7.5% since my September review, as illustrated below, respectively:

Source: Seeking Alpha

Clearly, HYT has been a winner, but so has the sector as a whole. In fact, from the start of this year through 12/13, high yield corporate bonds have been the second best performing sector in the fixed-income market, as shown below:

Source: Charles Schwab

My point here is there is plenty of bullish momentum in this sector, and the rationales for buying-in have indeed panned out as 2019 has gone along. While the outlook for 2020 is more important at this point, I think highlighting recent performance is important to understand why we are where we are in terms of valuation, spread, and yield, to forecast what next year will bring.

Spreads Have Narrowed, Yields On The Decline

While recent performance has been overwhelmingly positive, and I see some valid reasons why HYT could trend higher, I do want to highlight a key risk to the high yield corporate bond sector as a whole. Clearly, on the backdrop of such large price gains, investors may be feeling a bit nervous that a correction could be around the corner. While the fundamentals of positive economic growth, rising corporate earnings, and low interest rates will all continue to support high yield asset prices, downside risk certainly exists. In fact, because of the strong performance of the sector, further upside could be limited in the short term. What I mean by that is, on a relative basis, high yield bonds can only rise so much before other asset classes begin to look more attractive.

And we may be reaching that point. If we look at yield spreads between below-investment grade corporate bonds in the BB-rated category and investment grade corporate bonds in the AA-rated category, we see a couple of distinct trends. One, the spread has tightened considerably, falling from about a 3% spread this time last year, to just over a 1% spread at current levels, as shown in the graph below:

Source: Bloomberg

As you can see, this is an aggressive narrowing, and has accelerated a bit in the short term, which should make investors cautious. Further, the second point of concern here is the respective absolute yields. What is particularly striking is the BB-rated bonds are now yielding what AA-rated bonds offered at the end of last year. This suggests the compensation for the risk investors are taking may not be adequate going forward, although that is an individual decision each investor needs to make on their own.

My outlook on this is to be careful here about adding to new positions. While interest rates have declined on treasuries, making higher yielding assets still look attractive, be mindful of how low yields are getting on riskier asset classes, like below-investment grade corporate bonds. With spreads tightening and absolute yields having fallen quite a bit in a one year time period, this tells me further upside will be much more difficult to come by going forward.

HYT's Discount Helps Limit Downside Risk

I now want to shift to some of the positive attributes for HYT specifically, and discuss why I think this is a good CEF option for investors who continue to find the high yield corporate bond sector attractive. First, if one wants to play this sector, especially with CEFs, then valuation is an attribute that should always be considered. HYT has consistently traded at a discount to its NAV on the open market, and that has been one of the key reasons why it fell on my radar to begin with, and why I have been recommending it. Fortunately, despite the strong share price gain this year, the fund still sports an attractive discount to its underlying value. While the discount has shrunk over the past six months, I still find it appealing, considering many other CEFs are trading at premium prices. Further, while the discount has narrowed, it's still fairly high, at over 6%, as shown below:

Source: BlackRock

Clearly, HYT offers a relative value compared to many other funds. However, it is worth noting the discount was closer to 10% earlier in the year, and HYT has a history of trading near double digit discounts. Therefore, it is certainly possible the fund could see some selling pressure, even if the high yield sector performs well. Simply, many funds have a habit of trending back to longer-term averages over time, and that would mean a good bit of downside for HYT.

My takeaway here is still positive, but less so than my previous reviews. Similar to the spreads, which I discussed in the preceding paragraph, there is room for continued narrowing of the discount, which would help boost total return. Further, HYT's discount, even if it does not narrow, should limit the downside potential going forward, in my view. However, I do not find it likely that a fund with a long-term history of trading at a discount will suddenly start trading at a premium, just because we enter a new year. Therefore, I still see HYT as a reasonable value to play the high yield sector, but would caution investors to expect more modest returns next year due to the more expensive valuation on the fund that we see now compared to six months ago.

Income Boost A Positive Sign

My second positive point is something I did not expect to see this year from HYT. Specifically, this was a recent distribution increase, which was quite surprising to me given how interest rates have markedly declined this year. While HYT does have a history of distribution cuts, this latest development has been a reverse of that trend, which was an extremely welcome sign. And the increase was fairly substantial, with an income boost over 8%, shown below:

Distribution As of September Current Distribution Increase
$.072/share $.0779/share 8.2%

Source: BlackRock

My takeaway here is very positive. This income boost comes at a time when many funds are seeing their income streams come under pressure, due to declining interest rates and refinancing of existing debt. The fact that HYT was able to boost its already high income stream by a healthy margin gives me confidence this fund is comprised of the right types of assets for our current economic environment.

Despite Income Boost, Keep an Eye on UNII Figures

While I just discussed the recent income raise positively, I do want to note an area of concern for me, that I believe investors should carefully monitor going forward. While an income raise is typically a welcome move, I want to be sure of its sustainability before adding more capital to a fund. For now, I believe this new distribution rate will indeed be here for a while, as fund managers will rarely increase a distribution just to lower it again in the short term. Such decisions can have a dramatic effect on a share price, and almost always cause volatility. Therefore, I still view this move positively, but I will be critically monitoring the fund's income metrics until this new distribution rate has been paid for the longer term.

The reason for my caution here is because, based on the most recent UNII figures, HYT does not seem to be over-earning its distribution level, which makes me wonder why management felt now was a good time to raise the distribution level. Specifically, HYT has a distribution coverage ratio just under 85%, as shown below:

Source: BlackRock

My point here is to keep an eye on this figure, as well as the UNII balance, over the next few months. Fortunately, HYT has positive UNII over $.01/share, although that does not leave a whole lot of breathing room. As I mentioned, I feel pretty good about the distribution raise, because management must believe it can be sustained. But the coverage ratio casts a little bit of doubt on that, and I will want to see it improve markedly in the very short term.

Bottom line

HYT has been delivering, and I see a bright future for it ahead. However, as with most corners of the market right now, caution is likely warranted. Valuations have been rising, as share prices are rising faster than earnings, broadly speaking. Similarly, in the fixed-income market, corporate debt continues to rise, as management is keen to borrow more on the backdrop of lower interest rates. In this environment, investors need to be especially selective on new entry points, but I think HYT offers a reasonable one now. With a discount to NAV, a recent distribution hike, and bullish momentum, the fund could certainly move higher from here. However, my "neutral" rating is there to caution investors from going "all-in" at these levels, as high yield spreads indicate there is plenty of downside risk out there right now.

This article was written by

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Macro-focused investor, working for a major U.S. bank. I grew up in New York, but escaped to North Carolina. I was a D1 athlete in college (men's tennis) and compete competitively to this day. My Bachelor's and MBA are both in Finance.

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