CEF Analysis: High-Yield Sector Update

Mar. 04, 2021 7:00 AM ETARDC, AWF, BGH, BGIO, CIK, DHHAX, DHY, EAD, FALN, HIO, HIX, HNW, HYB, HYI, HYT, JCO, JHAA, KIO, MCR, NHS, OSTIX, PHT, RA, VLT23 Comments13 Likes

Summary

  • The high-yield CEF sector has done well though not as well as other sectors in terms of discount returns in the last month (+1.3%).
  • The sector as a whole is near its long-term fair value with a discount of -5%. But with spreads near the pre-COVID tightest levels, there isn't much upside for NAVs.
  • When there's not much upside for NAVs and discounts are relatively tight, it may make sense for those risk averse or more tactical to make swaps.
  • Here we list some clear sells, marginal sells, and on watch to sell funds along with the funds we like best to swap into.
  • Another option would be to look at a high-yield bond mutual fund to hide out until discounts blow out.
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(This report was issued to members of Yield Hunting on Feb. 15).

The high-yield sector has seen some stark improvements in valuation (tighter discount) in the last month. The price of the sector as a whole is up 2.9% in the trailing month. NAVs are up 1.4% implying a discount closure of about 1.3%.

The average discount is now just over 5% which is about average for the long-term (five-year) time frame. Obviously discounts have been much wider in the last year so the current levels seem expensive, but looking more long-term shows that we are actually closer to fair value.

Still, there are funds that are clearly overvalued in the space and are good swap out of candidates. Conversely, there are funds that haven't seen much if any of discount tightening. In the space we would keep it safe by looking at term and target term fund to maintain the discount (not much upside but little to no downside as well). We like BGIO in the space. Also, some perpetual funds made the list that have been left behind that are good "swap into" candidates. The full list is below. We like:

  • Blackrock 2022 Global Income Opp (BGIO)
  • Western Asset High Income Opp (HIO)
  • Wells Fargo Income Opp (NYSEMKT:EAD)

High-Yield Sector Update

I noted that the BofA US High Yield Option Adjusted Spread ("OAS") was down to pre-COVID levels. Thus the NAV gains we have seen recently are unlikely to continue. The effective yield on the index continues to hit new record lows almost daily. Today it sits at 4.12%. The downside risk from here is much higher than the upside.

I'm not wild on the high yield space but at this point it is a "necessarily evil"

Clear Sells

  • MFS Charter Income (MCR)
  • Brookfield Real Assets (RA)
  • Pioneer High Income (PHT)
  • Credit Suisse Asset Management Income (CIK)
  • Pioneer Diversified High Income (HNW)

Marginal Sells

For the more tactical investors, they may want to swap or sell but others can wait for further appreciation.

  • Invesco High Income II (VLT)
  • AllianceBernstein Global Income (AWF)
  • Western Asset High Income II (HIX)
  • Neuberger Berman HY Strategies (NHS)

On Watch

  • New America High Income (HYB)
  • BlackRock Corp High Yield Fund (HYT)
  • Western Asset High Yield Defterm (HYI)

Potential Swap Candidates

I would not consider these outright buys all alone. However, some investors do not want to give up the income stream and rotate into lower yielding (but safer) mutual funds. But they can improve a bit by swapping from rich funds to cheaper funds (although not cheap in absolute terms).

  1. Western Asset High Income Opp (HIO): This is a decent non-leveraged high-yield corporate bond fund that is trading at near double-digit discount and carries a yield that is competitive with other leveraged HY CEFs. The discount is near its longer-term average but the rest of the space has rallied and it has not still trading slightly wider than the one-year avg.
  2. Wells Fargo Income Opp (EAD): Another plain vanilla corporate non-investment grade bond fund. This one flies under the radar a bit. It has a higher quality tilt with over half of the portfolio in double BB (highest non-investment grade credit rating) plus another ~5% in investment grade. There's no CCC exposure. And with 25% leverage this one yields over 8% despite the income-only policy for the distribution. That means they regularly adjust the distribution payment on a monthly basis to the actual earnings power of the fund. This way there is no large surprise cut. The discount is -9.3% which is about 1.5 points tighter than average. Still at that large a discount, it's likely to attract some eyeballs and demand for the shares.
  3. Barings Global Short Duration HY (BGH): This one is a bit more energy exposed which has been good for it lately. The discount is -9.4% which is about two points wider than the long-term average but about a point tighter than the one-year average discount. The yield is lower at 7.2% after having to delever back in March 2020. However, the NAV is almost back to pre-COVID levels so they should be able to add leverage and increase the distribution a bit. Leverage today is only 20%. This fund is also one way to play the energy/oil patch without venturing into the MLP minefield. Here you own energy and oil related names from the bond side.
  4. Credit Suisse HY Bond (DHY): This fund pays a rich 8.43% using 25.4% leverage. You get the shares at an attractive discount of -8.2% which is about 2 points tighter than average. So it's not overly cheap but it's better than most of the other options in the sections above. The yield is aided by the 35% weight to CCC rated debt so you would have to want that kind of junky credits. CCC debt is still sporting relatively wider spreads so you can sneak into equity light exposure through the debt side with a fund like DHY. For investors in CIK (a clear sell above), an easy swap would be from there to DHY.

Other Thoughts

Some funds are a blend of high yield and loans. Ares Dynamic Credit Allocation (ARDC) is a good example. While not cheap, that's another great place to swap in to. KKR Income Opps (KIO) is another hybrid bond/loan fund that I've been bullish on but the discount closed some.

There also are term funds to examine. While they are not cheap they are not going to have the downside risk from widening discounts like a perpetual fund. These may ultimately be the best options for investors to swap into given the valuations in the sector.

  • Blackrock 2022 Global Income Opp (BGIO): This one trades at a -1.2% discount and liquidates in a year. The yield is 6.5% (NII yield is lower at 4.9%). The discount is unlikely to widen much given we have about 12 months to go until liquidation.
  • Nuveen Credit Opp 2022 Target Term (JCO): This one is a target term that liquidates June 2022 (15 months). The discount already is tight, so there isn't not much upside, but also not much downside either. NAV is well below target so it appears unlikely to reach that $9.83 level. Yield is 6.8%. Another safer option.
  • Nuveen High Income 2023 Target (JHAA) is another target term like JCO above but it's already at its target payout. This was aided by the fact that the distribution is lower at 4.8%. This is another option though I like the first two better.

Lastly, there are open-end mutual funds in the high-yield space that could be used. These won't experience the discount blowouts should volatility reenter the market. They will experience the NAV decline, however. But that NAV decline is likely to be smaller than a CEF given the lack of leverage in most funds.

For those more risk averse but who still want to maintain their exposure to the high yield sector, consider the following funds:

  • iShares Fallen Angels Bond ETF (FALN)
  • Diamond Hill High Yield (MUTF:DHHAX)
  • Osterweis Strategic Income (OSTIX)

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This article was written by

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Disclosure: I am/we are long JCO, BGIO. 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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