- ISD is yielding 8.54%, after several boosts over the last year.
- The latest discount of 8.61% is much less than its 1-year average of -11.56%, this could be explained by a recovering NAV.
- The discount contraction could also be explained by a changing mandate the fund went through at the beginning of 2019.
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Co-produced by Stanford Chemist
PGIM High Yield Bond Fund (NYSE:ISD) enjoyed quite the total market returns in 2019. The fund put up a 28.40% total market return as compared to its total NAV return of 17.47%. That can be explained by the fund boosting its distribution twice in 2019, as well as a mandate change that happened in March of 2019. With this type of return, we also saw a steep drop in the fund's average historical discounts. However, there may still be opportunity left as we see an increasing NAV for the fund and high distribution coverage. ISD also provides diversified exposure by utilization of a wide selection of sectors.
ISD is similar to Western Asset High Yield Defined Opportunity Fund Inc. (HYI), except for two key differences. ISD doesn't utilize a term structure like HYI and ISD also utilizes leverage, whereas HYI does not. After recently covering HYI, it is time to take a look at the updated report for ISD as they released around the same time.
ISD "seeks to provide a high level of current income by investing primarily in below-investment-grade fixed income instruments." Also known as high yield or junk bonds. These types of bonds are issued by companies that are smaller and less financially stable relative to their generally larger counterparts. They will tend to be a bit more volatile during periods of panic. However, ISD holds 239 issues as of December 31st, 2019. The fund also holds issues from 31 different sectors and subsectors. This should provide quite the diversification should we get continued uncertainties going forward. Of course, the latest being the Coronavirus that has given the market quite the volatility over the last several weeks.
The fund is a healthy size at about $742 million in total managed assets, composed of $180 million in leverage. This works out to the fund being leveraged at 24.25% levered. Adding leverage to a CEF can help boost overall performance. However, it can also do the opposite when times aren't so good - creating more volatility and further drawdowns. This can be compared to HYI, which utilizes no leverage. If an investor is sensitive to leverage, they may find HYI more appealing.
The fund's latest reported expense ratio is 1.15%, which I believe is quite reasonable for an actively managed fund. When we include leverage expenses this climbs to 2.09%. The average interest rate on the $180 million outstanding loans for the period was 2.84%. As expected with the Fed cutting interest rates through 2019, this was a decrease from the average interest rate throughout their fiscal 2019. For their fiscal 2019, they reported average interest rates of 3.11%. I would suspect that this dips even a bit further going forward when the interest rate decreases are fully factored in.
Prior to March 8th, 2019, the fund had a mandate of investing higher - but still junk-rated - bond issuances. They also scrapped the mandate of investing in shorter duration and maturity bonds. This allows them greater flexibility. After the announcement, the fund had started to recover its downward trend since inception.
This was also helped by a rally in bond prices overall as investors are searching for reliable income. As the higher-rated treasuries and munis have also been rising over the last year - this has pushed investors lower down in the credit spectrum to find yields.
Reflected above is the chart for the U.S. 10-year Treasury's rate. We can see a noticeable dive as the Fed had begun cutting rates throughout 2019 based on uncertainties of U.S.-China trade wars. We now have the Coronavirus that has been adding much more uncertainty going forward. Though, it has prodded the Fed to project keeping current rates maintained throughout 2020.
ISD is held in our Tactical Income- 100 portfolio at the CEF/ETF Income Laboratory. The fund is currently rated as a 'Hold.' This is based on the fund's current discount of 8.61%. We would be looking to change this to a 'Buy' rating if the fund reached a 12% discount. Though, I have serious reservations that we would see this level without some great volatility in the broader market as a whole. This is especially true as we mentioned that the Fed intends to maintain current interest rates going forward.
Briefly touching on the performance for ISD as we already mentioned above, ISD had quite the phenomenal 2019. The fund currently trades for $14.76 per share, with a NAV of $16.15 - good for a steep discount of 8.61%. This is at a time when many funds are trading at even tighter ranges and we have to be selective with the funds worth investing in. With that being said, ISD shows a 1-year average discount of 11.56%. Which is, in fact, steeper than its 5-year average discount that sits at 10.62%. That is interesting to point out as we have witnessed the fund's contraction in its discount since implementing its investment changes last March.
(Source - CEFConnect)
Over the longer-term, the fund has put up respectable numbers. However, the fund hasn't gone through a severe recession like 2008's GFC. The fund's inception date is 4/26/2012. Though that does mean the fund had gone through the junk bond crisis of 2015 and survived.
(Source - CEFConnect)
We also have to remember that since the fund's mandate change in early 2019, the past returns should be lower than going forward. At least this is in theory if we had the same projected 5-year performance going forward than the last 5-year period. This is due to the fund extending maturity and duration. Also playing a role is that the fund can go lower down the credit spectrum that should garner potentially higher yields for the fund. Increasing the risk for the fund could also see more volatility than the fund has previously witnessed too.
Another factor that probably played a role in the funds contracting discount is the fact that in 2019 we saw the fund increase its distribution twice. The most recent was on August 26th, 2019, which saw a small boost from $0.10 to the current $0.105. That small increase was good for a 5% boost in overall income for shareholders.
The larger 17.6% increase came on March 19th, 2019. This was in connection with the fund switching their investing mandate. With that increase, we saw the distribution go from $0.085 to the prior $0.10.
The current monthly rate of $0.105 is actually declared on a quarterly basis. That means an investor knows at least what to expect for 3-months at a time. The current rate is also good for a yield of 8.54%. The NAV yield for ISD is 7.80% due to its attractive discount.
Even with the fund's distribution raises, we are receiving a lower rate than at inception. However, shares traded higher too as we noted the declining share price basically since inception.
(Source - CEFConnect)
With that in mind, I wouldn't anticipate a distribution again after looking at the current numbers. The Semi-Annual Report they released for the period ending November 30th, 2019, did show an increase from their fiscal year-end of May 31st, 2019 - based on a projected annualized basis.
For the end of their fiscal 2019, we saw they reported $30,112,520 in net investment income. Now for their latest report, we see NII come in at $18,096,350. If they are able to maintain a level rate for another 6-month period we would see this come to $36,192,700 or a tremendous increase of 20.2% in NII!
However, even with this significant boost, they paid total distributions to shareholders of $20,452,885. Since this was in November and for a 6-month period prior to November, this would actually be a bit more going forward.
(Source - Semi-Annual Report)
This gives us NII coverage of 88.48%. This isn't the worst as the fund has been able to capitalize on increasing bond prices. However, this isn't sustainable over the long-term like we might anticipate with an equity fund that can pretty regularly rely on capital gains for paying distributions. Again too, this coverage could drop a bit more too if we calculated out the current distribution rate for the full period.
This is an area we will want to keep an eye on as it is quite important that NII can grow from here. Although, over the last 1-year period we did witness a growing NAV that should help the fund maintain the current level. So, I don't necessarily see a cause for concern that there could be a distribution cut soon either.
We can briefly breakdown the current holdings of the fund as we alluded to above, the number of holdings and sectors. Additionally, lucky for us, they provide a fact sheet for us ending December 31st, 2019. So we don't have to rely on their November Semi-Annual Report.
First, we can take a look at the largest issuers that ISD invests in. We actually see quite a bit of the fund top issuers changed from prior coverage on the fund.
(Source - Fact Sheet)
With that in mind, we can also see that the fund has expanded its total holdings to 239. Before this, they held 216 positions. I'm not sure if that will help further diversify the fund or not, as already having 200+ holdings is quite a bit to keep track of. Although, they must have seen some relative bargains to take advantage of. Further, we see that not position holds over a 1.9% allocation, this was the case too when we last covered the fund.
(Source - Fact Sheet)
The fund's changes in issuers have also been reflected in a changing sector allocation. However, we still see significant diversification broadly speaking to looking at the various sectors the fund invests in. Prior, they held the largest allocation to the telecom sector. This has since shifted to energy taking the top stop. We definitely know that the energy equities space had become quite the value - this apparent shift has also seemed to bleed over into the debt markets. Of course, we now have seen significant pressure on oil and natural gas prices since the Coronavirus has been adding uncertainties.
One other area I want to focus on is the credit quality compared to the fund's last report, to see if they are moving deeper into junk territory.
(Source - Fact Sheet)
Here we see the fund hasn't really changed its overall credit quality, even after making several changes since the July 31st, 2019 reporting. A full 6-months later and we still see the highest allocation to B rated names. Though, it had been 46% of the assets and now comes in at 44%, quite a small change in the grand scheme of things. BBB saw a drop of allocation from 7.3% to 4.8%. For BB-rated we have a rise to 37% from 35.8%. CCC-rated debt has a small uptick from 9.7% to 10.2%.
The largest increase was actually in their cash component, the fund held 0.5% in cash and this has now climbed to 3%. This isn't anything too significant either, even at a 2.5% differential. It is unlikely to change the fund in a significant manner going forward.
ISD has witnessed a contraction in its overall discount over the past 1-year period. However, several factors helped to see this through. These contributors include the mandate change of the fund in 2019, rallying bonds in 2019 and distribution boost throughout 2019.
While the fund has contracted its discount, I still feel like ISD is a relative value at an 8.61% discount. At this discount, shareholders receive an 8.54% distribution yield. At the same time, the fund's NAV only has to earn 7.80%. The latest numbers they reported are worth mentioning that its coverage is slightly less than 90%. However, the rising NAV and underlying positions have helped offset this lack of coverage which has allowed the NAV to rise. So, while it is not a cause for panic, we will be keeping an eye on the fund's coverage going forward. We would eventually like to see coverage go to 100%+.
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This article was written by
Nick Ackerman is a former financial advisor using his experience to provide coverage on closed-end funds and exchange-traded funds. Nick has previously held Series 7 and Series 66 licenses and has been investing personally for over 14 years.
He contributes to the investing group CEF/ETF Income Laboratory along with leader Stanford Chemist, and Juan de la Hoz and Dividend Seeker. They help members benefit from income and arbitrage strategies in CEFs and ETFs by providing expert-level research. The service includes: managed portfolios targeting safe 8%+ yields, actionable income and arbitrage recommendations, in-depth analysis of CEFs and ETFs, and a friendly community of over a thousand members looking for the best income ideas. These are geared towards both active and passive investors. The vast majority of their holdings are also monthly-payers, which is great for faster compounding as well as smoothing income streams. Learn More.
Analyst’s Disclosure: I am/we are long ISD, 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 on February 11th, 2020, to members of the CEF/ETF Income Laboratory.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.