ACP: A High-Yield CEF With A 10% Yield
Summary
- ACP is a closed end fund that invests in global high yield.
- High-yield CEFs are not created equal - ACP offers a 10% yield by investing predominantly in the riskiest type of debt (high CCC bucket) with leverage on top.
- The fund has toggled its funding recently by issuing debt via preferred equity (positive development) but has a low historic Sharpe ratio.
Thesis
Aberdeen Income Credit Strategies Fund (NYSE:ACP) is a closed end fund investing mostly in dollar high yield debt from the UK, Europe, and North America. The fund has a very high concentration in the riskiest type of junk debt (CCC rated) with the exposure here accounting for about 43% of the fund. This high concentration in CCC junk debt will make any sell-offs exhibit very steep downward moves. Although ACP has a 10.55% yield, the fund has a fairly poor track record and a low Sharpe ratio of 0.34 (5-year ratio). With high yield historically overstretched, the technicals are really poor for ACP. A savvy investor would be best served to wait for a market sell-off before considering this fund.
CEF Metrics
This section details some closed-end fund specific metrics that one would not necessarily find for an ETF and overall fund analytics:
Leverage Ratio: 32%
- fairly standard for the HY CEF space, in line with other equivalent funds
Expense Ratio: 3.06%
- on the high side, ACP seems to justify this because of the high portfolio turnover
Funding
- has both Repos/TRS as well as Preferred Equity (OTCPK:ACPPP) which was priced extremely low back in May 2021 (positive for the fund)
Manager: Standard Life Aberdeen
- premier international asset manager with a solid track record
Premium / Z-stat: 3.74% premium, 1.2 1-year Z-statistic
- the fund is trading at a premium
- the premium is high when comparing the historical premium for this fund (Z-stat)
- the setup here is very poor for this fund in terms of premium/historic average for it
Source: Author
Portfolio Composition - Credit Risk
In this section, I will discuss in more detail the aspects of the ACP portfolio that relate to credit risk - i.e. the probability of non-timely payment of interest and principal, and generally, the risks that arise from the credit quality of the underlying debentures.
Source: Aberdeen
ACP is really focused on the bottom of the credit spectrum with a high concentration in CCC debt (42.9%). What does this mean? It means it buys the most risky investments in the high yield space which, although provide a higher yield, are the ones to lose value the fastest and the most likely to default in an economic downturn.
How likely are they to default, you might ask. As a quantitative way of looking at probabilities of default from ratings, please find below an S&P study on defaults based on ratings:
Source: S&P Ratings
Generally speaking, high yield is all debt rated BB+ and below. The lowest of the low in terms of credit quality is the CCC bucket. For the 3-year tenor bucket (the fund has a duration of 2.43 years), a BB+ portfolio has 2.02% probability of default, while a CCC portfolio has a 41% probability of default. Quite different, I would say. ACP has a very risky portfolio with a very poor credit quality.
Source: Aberdeen
What is particular about this fund is that the focus is not exclusively on North American credits, but the portfolio is composed of UK and European credits as well with a roughly 1/3rd split to each jurisdiction.
Source: Aberdeen
Top 10 holdings account for roughly 25% of the fund with an industry concentration in Consumer Discretionary.
Credit Risk Summary
- portfolio is overweight the riskiest kind of debt, namely CCC (extremely high default probability)
- default exposure is spread between Europe, UK and North America
- Top 10 holdings account for roughly 25% of the fund
Portfolio Composition - Market Risk
In this section, I will discuss in more detail the aspects of the ACP portfolio that relate to market risk - i.e. fluctuations in risk free rates and credit spreads that can cause upward or downward pressure on the ACP portfolio NAV.
In respect to risk free rates, the fund is fully exposed to interest rate risk, meaning that, in a rising interest rate environment, the underlying bond prices decline. The fund has the ability, if it chooses to, to enter into interest swap transactions to hedge duration, but as of the 2020 Annual Report, it had chosen not to:
Source: Aberdeen
The fund runs a very short duration of 2.43 years, so I would not be very concerned about interest rate risk here (i.e. movement in prices due to an increase in risk free rates).
Credit Spread Risk - the risk that overall B and CCC credit spreads widen is the real risk here.
Source: The Fed
The above graph shows you the spread (think about it as yield) of CCC junk bonds. If there is an economic downturn/recession, the spread increases (i.e., it is more expensive to raise debt); in a mild economic cycle, that spread compresses.
If you look closely, we are almost at a record tight level in the past ten years! A step back and pragmatic thought process would indicate that the next move is going to be up. Because of the low interest rate environment, fixed income is extremely overstretched right now. We are at historic lows for compensation for risk right now in junk bonds.
Market Risk Summary
- fund has a low duration exposure of 2.43 years and is currently choosing not to hedge interest rate risk, although it has the ability to do so
- credit spread risk is very significant due to high concentration of CCC
- CCC spreads are at historic lows
Returns
Source: Author
ACP exhibits three years with negative returns, out of which two of them are particularly sharp (>15% loss for the year). This is partially explained by the portfolio composition - when you invest in the riskiest debt, sell-offs tend to be very sharp.
From a "months with negative total returns" perspective, ACP also exhibits poor results. The fund has on average 5 months per year when it loses money. Basically, half the year, on average, the fund will lose money based on the past 10 years of data.
Conclusion
Coming from a premier investment manager in Standard Life Aberdeen, ACP is a CEF investing in UK, European and North American high yield. With a very high concentration in CCC debt and 32% leverage on top, ACP is set up for a very sharp move lower on the back of a risk-off environment. The fund has a low historic Sharpe ratio and a high volatility profile as observed from its standard deviation. Given historic lows in CCC junk bonds spreads, a savvy investor would be best served to wait and not buy a potential top here.
This article was written by
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