How To Strengthen High-Yield Allocations With Term CEFs

Aug. 14, 2020 12:35 PM ETDCF, HYI, JHAA43 Comments16 Likes

Summary

  • The high-yield sector has proven relatively resilient this year owing to its long duration profile.
  • However, with the bulk of credit spread widening now retraced, it makes sense to take some chips off the table and lighten up on risk in the sector.
  • High-yield CEFs still offer a solid yield pickup over their open-end fund counterparts due to wide discounts and low leverage costs so a CEF allocation still makes sense.
  • Our favorite way to derisk in the CEF space is to increase allocations to term CEFs which provide a discount control mechanism without much yield sacrifice.
  • We highlight the following high-yield term CEFs: HYI, JHAA and DCF.
  • Looking for a portfolio of ideas like this one? Members of Systematic Income get exclusive access to our model portfolio. Get started today »

The high-yield sector has proven to be relatively resilient during the drawdown episode earlier this year, despite a lack of direct Fed support. A big part of this resilience has to do with the fact that the sector is long-duration and so it benefited from the drop in interest rates which partially offset the sharp widening in credit spreads. However now that credit spreads have retraced about 80% of their widening, it makes sense for investors to dial down their exposure somewhat.

Our main takeaway is that closed-end funds remain attractive investments relative to open-end funds in the sector due to a significant yield pickup driven by decent discounts and low leverage costs. However, with a significant rally in both credit spreads and discounts, it makes sense to dial the risk exposure down somewhat. High-yield term CEFs, which we discuss in the article, allow investors to do this without much yield sacrifice, offering a very attractive risk/reward opportunity. This is why our Core Income Portfolio has a significant allocation to high-yield term CEFs. In particular, we highlight three funds:

  • Western Asset High Yield Defined Opportunity Fund (HYI)
  • BNY Mellon Alcentra Global Credit Income 2024 Target Term Fund (DCF)
  • Nuveen High Income 2023 Target Term Fund (JHAA)

The High-Yield Sector Shows Resilience

Over this last drawdown, the high-yield sector has demonstrated resilience in two different ways which we can see in the chart below that plots the normalized price ranges of different income sectors, proxied by benchmark ETFs. All the sectors start with 100 as of 5 years ago.

Source: Systematic Income

The first resilient aspect of the sector observable in the chart is that its overall drawdown (the height of the bar) is fairly muted - below that of many other income and credit sectors such as loans, BDCs and even preferreds - a sector which holds many investment-grade rated securities.

The second resilient aspect of the high-yield sector is that it's bumping against the top of the range, meaning that it has just about recovered from the drawdown of the past year which stands in contrast to many other income sectors that have not.

Another way to visualize this dynamic is in the following chart which shows that while high-yield credit spreads remain wide, the yield of the sector has nearly retraced all the way back. Much of this is, of course, due to the sharp fall in risk-free rates.

Source: Systematic Income

These two resilient aspects of the sector are, in fact, related and, as we suggest here, due to its long duration profile. A typical risk-off drawdown has two features - a widening in credit spreads and a fall in risk-free rates. And while the drop in risk-free rates is usually less than the rise in credit spreads, it serves to dampen or partially offset the drop in high-yield bond prices. Floating-rate sectors like loans or securitized assets do not have this feature to fall back on. This creates a kind of double-whammy for floating-rate sectors - something we saw this time around. They do not benefit from the drop in interest rates and their coupons are cut with the fall in short-term rates. This is one reason why we saw broad-based distribution cuts across the loan sector and not the high-yield bond sector.

Source: Systematic Income

Of course, there is no market law that says that risk-free rates must fall during a period of market weakness, but more often than not they do. And while the level of risk-free rates is quite low in absolute terms and much lower than they were just a year ago, rates in the US are still significantly above most other developed economies and well above zero so there is more room for them to fall if we see further turbulence.

On the off-chance that we see risk-free rates move higher while the market remains weak, more likely than not, the Fed will step in to limit their rise. This is because while the macro economy remains weak, a rise in yields will serve to tighten financial conditions - something the Fed will want to prevent. Other countries have instituted policies of yield curve control and this may very well happen in the US as well.

On the other hand, if risk-free rates rise due to a strengthening economy, then credit spreads are likely to fall, likely causing overall high-yield bond prices to rally. Loan coupons are unlikely to benefit from this dynamic since the Fed will remain cautious in rising policy rates, so floating-rate assets will need to wait quite a long time to see a rise in coupons.

Investors who are looking to take some chips off the table in their high-yield bond exposure have a number of decisions to make. The first one is whether to stick with CEFs, closed-end funds, or move to open-end funds. We have discussed this choice in an earlier article - but in short, one of the key metrics we follow is the average yield spread on offer between CEFs and OEFs. This differential is driven by the yield on underlying bonds, leverage costs and CEF discounts. At the moment, this differential remains at a historically attractive level, so in our view it makes sense to remain at least partly invested in high-yield CEFs.

Source: Systematic Income

So what are the options to derisk in CEFs? There are several. First, investors can opt for funds with no or low leverage. Secondly, investors can tilt to funds with a stronger credit rating profile. Thirdly, investors can tilt to CEFs that are trading at more attractive discount valuations and providing a greater margin of safety. These are all valid approaches. Our favorite, however, is to use term CEFs over perpetual CEFs, something we use in our Income Portfolios and which we discuss in the next section.

Term CEFs

Term CEFs are an unusual hybrid within the fund world and, in a sense, they take a "best of both worlds" approach. They have the usual benefits of perpetual CEFs - term CEFs can invest in less liquid collateral without facing the possibility of a run on the fund. They can also trade at discounts, providing a kind of fee subsidy or yield enhancement. And they can use significant amounts of leverage. However, unlike perpetual CEFs, they have a discount control mechanism in place so that upon the fund's termination the discount is zero. This not only mitigates the price volatility of the fund but typically provides a performance tailwind into the termination, particularly if the fund is trading at the discount now.

On the service we measure this potential tailwind with something we call pull-to-NAV yield which is just the discount divided by the time to termination. For example, a fund with a 3% discount and 2 years to termination will have a pull-to-NAV yield of 1.5%. Of course, investors should keep in mind that often the termination date can be extended by a short time without shareholder approval or potentially cancelled altogether. However, even in this case, funds will tend to give investors a chance to tender the fund back at NAV, resulting in the same economics as a termination.

Term CEFs have a number of defensive features. First, they have the discount control mechanism just discussed. Secondly, they tend to run at a lower level of leverage. Thirdly, and this is particularly true of target term funds, they tend to hold assets with a lower duration. We have discussed before that these are the main reasons that term CEFs tend to outperform their perpetual counterparts during drawdowns. In the next section, we discuss some term CEFs we like in the high-yield sector.

A Few High-Yield Term CEFs We Like

In the high-yield sector, we currently like the Western Asset High Yield Defined Opportunity Fund (HYI) - a 2025 term CEF which carries no leverage, has a 7.76% current yield and a 1.23% pull-to-NAV yield which together sums up to a very attractive 9% total yield. The fund's coverage looks fairly strong - the last two quarters show EPS above the current distribution and the latest Section 19a showed a nearly zero amount of return of capital. Nearly half of the fund's portfolio is allocated to the BBB/BB rated buckets - another defensive point of the fund.

Source: Systematic Income

Another short-term CEF that is on our radar is the Nuveen High Income 2023 Target Term Fund (JHAA). This fund runs at a healthy leverage of 25% with a covered yield of 5.9% and a pull-to-NAV yield of 1.75%. This fund has been cutting its distributions which is fairly common for target term funds, particularly in the current market. Unlike perpetual CEFs, target term funds often cut distributions despite boasting above 100% distribution coverage ratios (as is the case for JHAA) as a way to conserve NAV in order to hit a certain NAV target at termination.

However, this is actually a welcome occurrence for patient investors because a distribution cut typically pushes the discount wider which only creates a larger expected pull-to-NAV yield into termination. The cut distributions are not actually "gone" - they remain part of the fund as retained cash flow and will eventually go back to those investors either through discount tightening or as part of the termination payment.

Investors worried about a potential inflation spike and who want to shorten up on duration while remaining in corporate credit should consider mixed-allocation funds - those that allocate across both high-yield bonds as well as loans. After all, inflation expectations have jumped right back after cratering during the drawdown in March. Core inflation has also rebounded smartly to 1.6% - well above expectations.

That said, it's important not to get carried away. If interest rates do move up in sync with inflation - a big if as we suggest above, loan coupons will not benefit any time soon. This is because LIBOR - the base rate for loans is likely to remain anchored firmly at current levels. The Fed Chair has famously said that the board is "not even thinking about thinking" about rate hikes. Consensus appears to be that policy rates will stay on hold until at least 2023.

Source: Systematic Income

The BNY Mellon Alcentra Global Credit Income 2024 Target Term Fund (DCF) is a fund that is roughly half bonds and half floating-rate securities like loans and mezz CLO tranches. The fund has deleveraged by about 17% this year and has made a distribution cut to reflect this in April. It closed Thursday at a 7.43% current yield. With a 1% pull-to-NAV yield, it remains another attractive choice in the sector.

Conclusion

The high-yield bond market has remained relatively resilient through the drawdown earlier this year which argues for a continued allocation to the sector. However, now that credit spreads have retraced most of their widening, it also makes sense to take some chips off the table. Investors have a number of ways they can do this from tilting to funds with stronger credit profiles, funds carrying less leverage and funds trading at more attractive discount valuations. Having an allocation to term CEFs remains one of our favorite ways to lighten on risk because the yield sacrifice of doing so is not very large but the potential risk reduction due to tighter discount control is very substantial.

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Disclosure: I am/we are long DCF, 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.

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