Why We Sold NHS + 20% Off Sale

Summary

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• NHS was another post-tender purchase to take advantage of an anomalous discount to NAV.
• In an alert today, we notified members of another post-tender trade and another sell plus a buy alert.
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NHS is was a "repositioning trade" made at the start of this year. The shares at the time were at an -8%+ discount. I also liked the CCC area as it was one of the last bastions of value left in the high yield space. Lastly, we bought because the fund had conducted a tender offer in November/December of last year and the shares sold off in typical post-tender selling.

At the time we were swapping from BWG to NHS. We made the following comments about the trade:

BWG is trading near our fair value estimate for the fund. While the 52-week high is much tighter, that was driven by the recent tender offer. Nothing really wrong with the fund per se. The rationale for the trade is to move into something cheaper with more upside. NHS is a junkier fund relative to BWG but offers up a lot of upside. The shares trade wide to NAV because of the recently completed tender offer. Shareholders jumped into the fund to participate and are now selling their remaining shares. The portfolio is a little junkier in terms of credit quality with 22% in CCC. The data on CEFConnect is wrong.

Discount Tightening

Since that posting, the discount has tightened up materially hitting my sell target of -4%. At the same time, the NAV has been flat net of the distributions [we've received two in the mount of $0.0905 each]. But the price has climbed from $11.59 to $12.27 for a total return of 7.42% in about six weeks. If only we could replicate that every six weeks!

Portfolio Notes

The NAV has been flat despite lower quality bonds doing quite well in the last couple of months. The option-adjusted spreads ("OAS") [or the additional yield required to hold a risk bond of this credit rating compared to the comparable treasury rate] have been falling precipitously. In fact, they are at their lowest levels of the last five years despite the fact that defaults are up yoy.

The image below shows that spread over the last five years. The level of complacency in the junkiest areas of the high yield market is truly astounding at this point.

(Source: FRED)

For now, we will want to be a bit more measured in our exposure to the junkier areas of the market. I don't want to be entirely out but would prefer my exposure come from funds that still have a nice discount to NAV for at least some downside protection.

CCC – B corporate spreads are now at the lowest levels since 2006 (the height of the credit bubble).

(Source: CreditSights)

For a high yield fund, it has a bit higher duration than is typical. 67% of the portfolio holdings do not mature for at least 5 years and 6.5% actually have maturities beyond ten years. That is rare for the high yield space which typically issues notes of five to seven years. Now they hedge some of that back using interest rate swaps to get down to a 4.67 year duration.

Distribution Notes

The other reason we sold is that the distribution is not earned. In fact, coverage was just 68.3% as of the end of the last reporting period on October 31, 2020. UNII is negative -10.8 cents.

The average yield-to-maturity is 5.3% so even with the leverage and no fees, they are not achieving that 8.80% return. The most recent 19a notice shows that $0.0254 of the distribution was a return of capital. The fund does NOT have a managed distribution policy.

Concluding Thoughts

NHS has a decent track record in the high yield space with the NAV total return ranked seventh out of the 30 funds in the space using the 3yr total return metric. More recently, it has lagged a bit falling into the bottom quartile in performance rank.

Investors should consider other options in the space that do not have a combination of junkier portfolio (large amount in CCC rated debt) and a tight discount to NAV. For instance, KKR Income Opps (KIO) is one of my favorites in this area. While it has a lot in CCC also (almost 20% more than NHS), I believe you are being more adequately compensated for the risk with a covered yield of 9.60%