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Summary HYT has moved towards higher duration issues to maintain distributions, making it more heavily exposed to a rate hike than other high yield funds. HYT’s dividend history and its current failure to earn income to cover distributions indicate a rate cut in 2016. Nonetheless, there is an opportunity to purchase HYT when the market discounts its underperformance too heavily — although that time has not come quite yet. BlackRock Corporate High Yield Fund (NYSE: HYT ) is a thinly traded and often overlooked closed-end fund that seeks consistent high income to shareholders through active capital allocation in the high yield taxable bond and debt derivative universe, with a smattering of equity on the side. To its credit, the fund has a solid track record of paying special dividends that have driven its total yield above 8% for most of its history since inception. This must be counterbalanced by a consistent decline in dividends and a fall in NAV that make it suspect for the income-seeking investor. Currently, the fund deserves attention because a recent dividend cut for HYT and turmoil in the high-yield market as a whole have generated interest in just about any high-yielding CEF. But there is cause for caution. The Dividend History Unfortunately, regular dividends have been consistently falling for this fund for a long time: (click to enlarge) In 2015, shareholders faced a 7.3% dividend cut after similar cuts came to the fund in 2012, 2013, and 2014. Dividends have fallen 41% since the fund’s inception, and the fund’s market price has fallen by a third. The Capital Losses Some CEF investors like to catch funds that trade at a discount to NAV using the logic of value investors: get dollars when they’re on sale for 80 cents. In addition to the falling dividends HYT pays out, there is another reason why this strategy will not work with HYT. The fund’s overall capital losses are not abating. According to the fund’s most recent annual and semi-annual reports , the fund has lost 7.4% of its value from June to September. Over a one-year period to September, the fund lost 3.14% of its NAV. Since then, the fund has lost another 0.6% of its NAV. Greater Exposure to Rising Rates We can largely attribute these losses to a cratering in the high yield market, which has also caused a distressing decline in the NAV of high yield funds such as Pimco High Yield Fund (NYSE: PHK ) and caused me to sell my holdings in that fund (I discuss this decision here ). In the case of PHK, management seems to be preparing for this fall in junk debt values by shifting the portfolio towards shorter duration holdings at higher yields. In theory, this will free up capital for new issues at higher rates if the Federal Reserve raises rates in December or early next year. In the case of HYT, this is not management’s strategy. In September, HYT had 75% of its holdings with maturities ranging between 3-10 years, with over half having maturities between 5 and 10 years. In June, 68% of its holdings were in the 3-10-year maturity window, with 44% in the 5-10-year maturing range. This means there is now a higher risk of HYT losing more of its NAV if the Federal Reserve raises interest rates and rates for high yield debt goes up as well. Even if the Fed doesn’t raise rates, if the market worries about higher default rates due to declining profitability on the stronger dollar, or because of cheap oil, or any other of the myriad reasons that have driven a fall in the high yield market in 2015, HYT is more exposed than PHK and other actively managed high yield funds. The CLO Bet HYT is also making another small bet by moving into CLO investments. In its last annual report, HYT disclosed approximately $24.5 million in CLO investments, which is over half of its $49.5 million invested in asset-backed securities. On the plus side, CLOs remain only 2% of HYT’s total portfolio. There is potential for credit spreads to narrow if the Federal Reserve does raise interest rates and causes other interest rates, such as LIBOR, to follow suit, but this will have significantly less impact on HYT than on other high yield funds, both in the CEF and BDC universe, which have invested more aggressively in CLOs to boost returns. A good example of a much higher risk high yield fund that has seen weak NAV growth and high market value declines based on CLO exposure is Prospect Capital (NASDAQ: PSEC ). Their high CLO holdings are discussed in this prescient article by BDC Buzz. PSEC has fallen 12.7%, excluding dividends, since BDC Buzz’s article (although it was by no means his first warning on the dangers in that company). For HYT, this means its CLO holdings are relatively conservative. On the surface, this sounds good; but they are in fact so conservative that it is difficult to determine the purpose of holding such a small portion of the portfolio in these volatile assets. Additionally, many of those CLOs are in small and middle-market companies or BDCs that service the small and middle-market companies, again compounding HYT’s exposure to companies that are more likely to suffer higher default rates. For example, as of its September report, HYT held $2.1 million in asset-backed securities whose counterparty is Ares CLO Ltd. and another $877,000 to WhiteHorse subsidiaries of H.I.G. Capital, a diversified private equity investment firm. Matching Income to Distributions Since CLOs pay a higher yield than market-issued bonds, these are part of the fund’s overall strategy to make income match distributions. Unfortunately, the fund is still falling slightly short of its payout. Since March, the fund has paid $1.21 million of its distributions as a return of capital and its dividend coverage has remained below 85% for five months. Its current ROC is a small fraction of the overall value of the fund and is by no means a cause for alarm at the present time. However, it does indicate the strong likelihood of another dividend cut in 2016 as we have seen over the past few years, meaning investors should calculate their expected income from this fund not based on its current yield but on its likely future yield. Also, because of the long duration of the fund’s holdings, its ability to churn into higher yielding new issues will be limited, making it even less likely to enjoy a higher rate of income on its holdings if yields on corporate debt rise next year. Discount to NAV When deciding whether to purchase HYT or not, investors should also consider the fund’s discount or premium to NAV and how this is likely to trend in the future. Except for a brief spell in 2012, the fund has always traded at a discount, and its current discount is the steepest it has been since 2008. (click to enlarge) The fund’s current 13.47% discount is slightly above the 52-week average of 12.37%, although the last year’s tumultuous and volatile high yield bond market may make the last year’s average a less reliable indicator of timing a purchase in this fund than in the past. While investors looking for mean reversion may be tempted to buy as its discount seems curiously low, the above considerations about portfolio duration, ROC, and poor positioning for rising rates should make investors pause before jumping in. Conclusion HYT is not positioning itself for a rising interest rate environment and has seen a steep discount to NAV priced in as a result. Additionally, the fund’s consistent dividend cuts mean that it cannot be purchased as a source of reliable income. However, it can be purchased when the market undervalues its income potential. A careful analysis of the fund’s shift of its bond holdings by duration and a closer understanding of its allocations to CLOs and its exposure to smaller companies is necessary before making a purchase on this name. Scalper1 News
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