HYI: Fully Covered 7.55% Yield

Summary

• HYI currently offers investors a 7.55% yield that is fully covered by NII.
• This is also the case when forward projecting the new higher rate based off of the most recent Semi-Annual Report.
• The fund has recently started to trade at a bit of a stretched valuation based on its historical norm, but last weeks volatility changed that.
• Looking for a portfolio of ideas like this one? Members of CEF/ETF Income Laboratory get exclusive access to our model portfolio. Get started today »

Co-produced by Stanford Chemist

Western Asset High Yield Defined Opportunity Fund Inc. (NYSE:HYI) is held in our Income Generator portfolio. In addition to this, we previously held the position in our Tactical Income-100 portfolio as well. This was before our recent trade alert that saw the TI portfolio picking up shares of Western Asset High Income Opportunity Fund (HIO) and Western Asset High Income Fund II (HIX). These are both funds offered by the same sponsor and operate in the high-yield space. HYI has recently published an updated Semi-Annual Report that we can take a look at. What we see is that the distribution is still fully covered on an NII basis. This is positive as the fund has recently had a string of raising its distribution. In fact, even when considering the projected distribution totals, the fund is still at over 100% coverage.

The caveat here is that HYI has recently moved to a higher valuation relative to its historical range. The fund currently trades at a discount of 6.32%. This would normally be positive for a fund of having a discount. However, its averages are steeper than this. Its 1-year average sits at quite a wide 7.26%. The 3-year is at 9.03% and 5-year sits at a 9.49% discount. With that being said, HYI is a term dated fund that is expected to be liquidated on September 30, 2025. This means that the fund should theoretically close that gap the closer we become to liquidation date. That is because the fund will be liquidated at NAV and that's what shareholders will receive. Of course, HYI's NAV could trade in a downward trend, and this is why we see a discount primarily in the first place.

I was actually surprised at the quick turnaround in the discount too as of late. Just as recently as January 13th, 2020, I had put a piece together on "3 'Buy' Rated Holdings" in our portfolios. HYI was one of the three. The fund had just been trading at a discount of 6.56% a couple of weeks ago. Unfortunately, too, this came from convergence in the NAV and share price - as opposed to a higher moving market price that catches up to its NAV. However, this higher valuation was quickly reverted after last week's volatility in the market, once again returning the fund to a 6%+ discount.

The chart below is representing the initial and rapid discount contraction experienced in January.

Data by YCharts

Of course, this isn't necessarily a terrible thing as we previously mentioned, we would anticipate that the fund doesn't have a very wide discount due to the term structure. Of course, we would also enjoy the NAV rising and not falling in the meantime!

I want to touch briefly again on the recent Tactical Income-100 portfolio's change to two other Western Asset funds. HIO and HIX do not have a term structure in place; therefore, we don't have the 'floor' built-in to their discounts. HIO currently trades at a discount of 8.47% and HIX has an 8.08% discount. Which is truthfully much more attractive than HYI's current 3.59% since it is much closer to their averages. Additionally, Stanford Chemist had noted that there may be some activist movements soon on HIX and HIO. In the previously linked trade alert piece he noted that:

... we find that Saba is targeting HIO and agitating for them to self-tender, liquidate or convert to an open-ended fund. At the same time, I also noticed that Saba had a very large position in HIX as well (around 13%) and has sent a similar letter to the board. To spread the risk around therefore, we decided to split our HYI position half-and-half into HIO and HIX.

He also later noted that HIO and HIX are two of the Saba Closed-End Funds ETF (CEFS) largest holdings - coming in at the 2nd and 5th largest allocations.

With that being said, it is a bit of speculation but something could come from this activist group of investors. Therefore, a perfect fit in our Tactical Income- 100 portfolio.

Our Income Generator portfolio does still hold our HYI position. Remember, the Income Generator is a bit more conservative with holding higher-quality funds with more of an emphasis on long-term sustainability and income. Even though it might not be the greatest time to buy, I wanted to take a look at the newly published Semi-Annual Report for those that already hold the position. We have also witnessed that opportunities can come and go quickly - seeing that just a couple of weeks ago HYI was considered a buying opportunity in our portfolio.

Our previous in-depth coverage of HYI can also be found in a publication released on September 5th, 2019.

About The Fund

For a quick refresher, HYI is a high-yield junk bond fund that invests without utilizing leverage. This can be a good or bad thing considering the way an investor may want to look at it. The positive is that we should experience less volatility in the fund's NAV compared to other high-yield funds. Additionally, we also aren't able to participate in the upside that leverage can potentially provide when things are going well though. They also leave the wording in for possibly using reverse repurchase agreements for leverage but haven't done so since I've been covering the fund.

The fund "seeks high income, with capital appreciation as a secondary objective." The team "emphasizes team management and extensive credit research expertise to identify attractively priced securities."

The fund will invest "at least 80% of its net assets in a portfolio of high-yield corporate fixed-income securities with varying maturities."

The fund currently has managed assets of around $374.5 million assets. This isn't that small for a closed-end fund. However, one will want to be cognizant of the fact that volume may be a bit thin on some days.

As of the latest report, HYI is showing an expense ratio of 0.87%, which is very reasonable. I also believe this is below average for a high-yield fund that has global positions as well.

Performance

Currently, HYI trades at $14.95 per share, with a NAV of $15.96 for a 6.32% discount. Since last covering HYI in September, this has moved considerably in our favor - in terms of price and total return both.

Data by YCharts

This rising market share price has been catching up with the fund's NAV, as the NAV hasn't been able to appreciate at a similar pace.

Data by YCharts

Even further, looking back at its discount since inception, we haven't seen this narrow of a discount for years. There was a period of time between 2011 and 2013 that HYI traded at premium levels, but we haven't seen that since. The persistent discount since that time has dragged the funds 5-year discount average to a wide 9.49%. With the chart above, we can also see that over the last 1-year period HYI has been closing its discount sharply. Enough for the 1-year z-score to come out at 2.43. This would indicate that the fund is overvalued relative to its historical range - though that doesn't mean it is a terrible fund to own since a shareholder will still be collecting an attractive monthly distribution.

Distribution

HYI currently has a distribution rate of 7.55%, with a NAV rate of 7.07%. Even better is the fact that the fund has raised its distribution twice after years of declining payouts. Best yet, the distribution is fully covered from NII. This is important as a fixed-income investment will rely significantly on NII for a sustainable distribution.

(Source - Seeking Alpha)

This is true even when factoring in the projected new rate that they just raised the distribution to.

Here are the current numbers.

(Source - Semi-Annual Report)

At the latest NII and payout to shareholders, the fund's distribution was covered at 105.55%. However, we can do a bit of calculating to find out what the fund's new distribution amount will come out to.

For this, it is simply finding out the number of shares outstanding and multiplying by the current distribution rate. They reported that they have 22,749,468 shares outstanding. Based on their current monthly payment of $0.094, this works out to a projected annualized rate of $1.128. This then puts out the estimated distribution payment to shareholders at $25,661,399 for the year. Based on the latest NII figure, we could anticipate NII coming in at $25,863,342. Thus, we still maintain a fully covered distribution at 100.8%.

Of course, income could go down over the next year or new shares become issued or any number of negatives that would put pressure on the coverage. This does look like a continuation of the rising NII trend since 2018. We also have to factor in that rates have been going down lately too, this could put additional pressure when they have to reinvest the proceeds of matured bond holdings.

Holdings

As noted above, HYI is a junk fund that invests in a broad base of different sectors. The majority of its assets are invested in BB and B rated bonds.

(Source - HYI Website)

This is quite similar to its last reported credit quality allocation.

(Source - HYI's Earlier Fact Sheet)

This is important to note since high-yield can add an additional risk factor at the later innings of a market cycle. Typically, we would anticipate great volatility and defaults from companies on the lowest end of the spectrum. CEFConnect puts HYI's holdings total at 269 positions though. This should help mitigate against single company risks. Additionally, the company is spread out across multiple sectors - though we note that the fund does concentrate a bit higher in the communications and energy sector.

(Source - HYI Website)

This should be noted as the energy sector itself is quite volatile as it is a cyclical business that needs strong global economies and demand to help propel the sector and companies higher. So far, we haven't seen that be the case as we continue to see the energy space struggle. Even at the beginning of 2020 it is now the lagging sector. This is even on the back of the last two years being the worst-performing sector.

Hello energy, my old friend.

(Source - Fidelity)

The latest top ten holdings are relatively unchanged since we last looked at the fund. The top three positions are still the same and the others have just shifted around as market values have fluctuated. Again here we can note that no single position is very large, with the top position 2.21% of total outstanding assets.

(Source - HYI Website)

This is important as we wouldn't want to be at the mercy of one individual position in the high-yield space. We would be looking for diversification within the high-yield sector to help mitigate the underlying risks overall.

The current asset allocation of the fund leans heavily in the high-yield corporate bond space - as we would anticipate. They also offer almost 20% exposure to emerging market debts. These emerging market percentages have changed very little since the last publication we wrote on HYI.

(Source - HYI Website)

This is also important to note as the fund will potentially have additional volatility due to economies that aren't as established as developed markets.

Conclusion

Overall, HYI has been an attractive place to invest for monthly distributions. Though we have seen them adjust aggressively downwards when they have had to, we are now also seeing some small increases. This isn't necessarily a bad thing as I believe longer-term sustainability is more attractive than the absolute highest yields. That is why I particularly focus on an 8% yield on my portfolio. True, HYI is 'only' 7.55%, but it was getting harder and harder to find quality funds to hit that 8% level since last year we have seen an absolute home run in the market overall! Even after the sharp moves lower we still haven't given up all that much. Though, we could still see moves lower from here.

Therefore, I feel like targeting a 7-7.5% range would be particularly prudent for now. This would be until we see a significant and healthy pullback or correction. The other thing to consider for HYI is they have been able to fully cover this distribution from NII, with no leverage utilized. This can be a significant feat as they are still able to pay out 7.55%. Even though their NAV distribution works out to 7.07%, thanks to the discount in the fund we see that they have to earn less than we can actually receive.

Finally, the discount is hitting an attractive level once again at 6.32%. This was after last weeks tumultuous selloff that saw a sharp reversion from its higher level. Even though it does still offer an investor the benefits of receiving a higher distribution than the fund has to actually earn - historically speaking, HYI has traded at better valuations when looking at the 5-year average. Although it is worth noting the term structure imbedded in the fund that should see the fund liquidate come September 2025. This liquidation would take place at NAV and that's what shareholders would receive. As we approach closer to that date we should anticipate no discount to be present. The risk here is that the fund's NAV could continue to fall though, thus receiving a smaller payout than the original purchasing price.

Analyst’s Disclosure: I am/we are long HYI. 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.

This article was originally published to members of the CEF/ETF Income Laboratory on February 3rd, 2020. It has been edited to account for last week's market volatility.