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Summary High yield bond CEFs are selling at historically large discounts. HYT was consistently the best CEF performer on a risk-adjusted basis among the CEFs analyzed. High yield CEFs are not for the fainthearted since their volatility is substantially higher than HYG. As an income-focused investor, I was a fan of high yield bond funds until the Fed crashed the party by discussing plan to increase interest rates. Then the bear market in oil put additional pressure on energy-related high yielding bonds. Figure 1 shows a plot of the iShares iBoxx $ High Yield Corporate Bond (NYSEARCA: HYG ) ETF. This fund has a portfolio of over 1,000 dollar denominated high yielding bonds, with most coming from the following sectors: telecom (23%), energy (14%), consumer discretionary (13%), and consumer staples (13%). The fund has an expense ratio of 0.5% and yields 5.5%. The price of HYG plummeted over 40% during the 2008 bear market but recovered a significantly before heading south again in May, 2013. (click to enlarge) Figure 1. Plot of HYG The recent selloff in high yields has taken an even larger toll on Closed End Funds (CEFs). The discounts associated with high yield CEFs has widened substantially over the past couple of years. This is evidenced by their Z-score, a statistic popularized by Morningstar to measure how far a discount (or premium) is from the average discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A Z-score greater than 2 is a rare event and is worthy of notice. Figure 2 tabulates the high yield CEFs that have a Z-score of 2 or greater. For a particular CEFs, this will occur less than 2.25% of the time. Figure 2. Z-scores of High Yield CEFs. The CEFs in the table also satisfied the following selection criteria: History of at least 5 years Market cap greater than $150 million Average daily trading volume greater than 100,000 shares. Based on the Z-score, these high yield CEFs appear to be bargains but which ones are “best” value. There are many ways to define “best”. Some investors may use total return as a metric, but as a retiree, risk in as important to me as return. Therefore, I define “best” as the fund that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”. I am just saying that this is the definition that works for me. This article will analyze these high yield CEFs in terms of risk versus reward to help you assess which may be right for your portfolio. But before I delve into the analysis, it might be instructive to review the characteristics of high yield bonds, which are popularly referred to as “junk” bonds. From a technical point of view, junk bonds are no different and any other bond. The issuer of junk bonds is a corporation that promises to repay you interest until a specified time in the future, called the maturity date, and at maturity, the corporation will repay you the principal. Default will occur if the corporation, for whatever reason, is unwilling or unable to repay the debt. For example, if the corporation goes bankrupt before the maturity date, the owner of the bond will have to stand in line with other creditors in the hope of receiving some payment. It is therefore critical for bond investors to assess the probability of default. This is not an easy task, especially for retail investors. Therefore rating agencies, such as Moody’s, Standard and Poor’s, and Fitch have come to the rescue by assigning a rating for most bonds. The ratings range from AAA to C (or D depending on the rating agency). The lower the rating, the higher the probability of default. Bonds rated Ba or below by Moody’s (which corresponds to a BB rating by Standard and Poor’s and Fitch) are considered to be “below investment grade” and are called junk bonds. Since it is harder to sell junk bonds to investors, the corporations need to “sweeten” the deal by offering higher interest rates, hence the term high yield. The CEFs listed in Figure 2 are summarized below: Western Asset Managed High Income (NYSE: MHY ). This CEF is selling for a discount of 16.4%, which is a much larger discount than the 5-year average discount of 2.6%. The fund has a portfolio of 349 securities with 85% in high yield bonds and 6% in investment grade bonds. About 75% of the bonds are from companies domiciled within the U.S. The effective duration is 3.8 years. The fund does not use leverage and the expense ratio is 0.9%. The distribution is 8.9% with only a small amount (less than 1%) coming from Return of Capital (ROC). Wells Fargo Advantage Income Opportunity (NYSEMKT: EAD ). This CEF sells at a discount of 14.2%, which is a much larger discount than the 5-year average discount of 1.5%. The fund’s distribution rate is a high 10.5% without any ROC. The portfolio consists of 344 securities, mostly (81%) high yield bonds. About 7% of the portfolio is invested in investment grade bonds and another 7% in senior loans. Most (80%) of the securities are from companies domiciled in the U.S. The effective leveraged duration is 5.1 years. The fund utilizes 25% leverage and has an expense ratio of 1.2%. Western Asset High Income Opportunities (NYSE: HIO ). This CEF sells at a discount of 16.4%, which is a much larger discount than the 5-year average discount of 3.1%. The distribution rate is 8.9% with only a small amount (less than 3%) coming from ROC. The fund has 350 holdings, most of which (84%) are high yield bonds. About 6% are investment grade bonds and 77% of the securities are domiciled within the U.S. This fund does not use leverage and has an expense rate of 0.9%. The effective duration is 3.8 years. Western Asset High Income Fund II (NYSE: HIX ). This CEF sells at a discount of 13.1%, which is unusual since over the past 5-years this fund has averaged a premium of 4.3%. This fund distributes a high 12.2% with only a small amount (less than 1%) from ROC. The fund has 402 holdings, with 83% in high yield bonds. About 23% of the bonds are rated CCC or lower, which is one of the reasons for the high distribution. The fund also has 6% invested in investment grade bonds. About 71% of the securities are domiciled within the U.S. The fund uses leverage of 26% and has an expense ratio of 1.4%. The effective leveraged duration is 4.9 years. Alliance Bernstein Global High Income (NYSE: AWF ). This CEF sells for a discount of 15.2%, which is a larger discount than the 5-year average discount of 3%. The fund has a “go anywhere” strategy and only has 51% of the portfolio’s 1011 securities are invested in high yield bonds. About 27% of portfolio is invested in Government bonds and 9% in asset backed bonds. Overall about 17% of the bonds are investment grade and 72% are domiciled within the US. The fund utilizes 14% leverage and has an expense ratio of 1%. The distribution is 8.6% with no ROC. The effective leveraged duration is 5.5 years. Credit Suisse Asset Management Income (NYSEMKT: CIK ). This CEF sells at a discount of 16.1%, which is a much larger discount than the 5-year average discount of 2.5%. The holdings consists of 209 securities with 69% in high yield bonds and 24% in short term debt. About 78% of the holdings are domiciled within the US. The fund uses 11% leverage and has an expense ratio of 0.7%. The effective leveraged duration is 3.3 years. The distribution is 9% with a small amount (less than 7%) coming from ROC. BlackRock Corporate High Yield (NYSE: HYT ). This CEF sells at a discount of 15.1%, which is a much larger discount than the 5 year average discount of 4.6%. The fund holds 902 securities, with 83% in high yield bonds, 4% in investment grade bonds, 7% in equities, and 5% in preferred stock. About 82% of the holdings are domiciled within the US. The fund uses 31% leverage and has an expense ratio of 1.3%. The effective leveraged duration is 5.3 years. The distribution is 8.4% with only a small amount (less than 2%) coming from ROC. Credit Suisse High Yield Bond (NYSEMKT: DHY ). This CEF sells at a discount of 12.3%, which is unusual since over the past 5 years this fund has averaged a premium of 2.4%. The fund has a portfolio of 223 securities with 80% in high yield bonds and 15% in debt instruments. About 86% of the holdings are domiciled within the US. The fund uses 33% leverage and the expense ratio is 2%. The leveraged effective duration is 2.7 years. The distribution is 12.2% with a small amount (less than 10%) coming from ROC. To assess the performance of the selected CEFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds over the past 5 years. The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 3. Note that the rate of return is based on price, not Net Asset Value (NAV). (click to enlarge) Figure 3. Risk versus Reward over past 5 years The plot illustrates that the high yield bonds have booked a wide range of returns. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 3, I plotted a red line that represents the Sharpe Ratio associated with HYG. If an asset is above the line, it has a higher Sharpe Ratio than HYG. Conversely, if an asset is below the line, the reward-to-risk is worse than HYG. Similarly, the blue line represents the Sharpe Ratio associated with HYT. Some interesting observations are evident from the figure. High yield CEFs are substantially more volatile than HYG. This is not surprising since CEFs can sell at discounts and many use leverage. The only CEF that had a higher absolute return than HYG was HYT. However, HYT was more volatile than HYG so HYG easily outperformed HYT on a risk-adjusted basis. Among the CEFs, HYT was the least volatile and had the highest return. Thus, HYT easily beat the other CEFs on a risk-adjusted basis. One of the reasons for HYT’s outperformance may have been its equity stake. The volatilities of most CEFs (except for HYT and DHY) were tightly bunched but the returns were widely different. The top 3 CEFS in order of risk-adjusted performance were HYT, AWF, and EAD. DHY came in fourth. The worst performer was MHY. That may be one of the reasons it had the largest negative Z-score. Since all the funds were associated with high yield bonds, I wanted to assess how much diversification you might receive by buying multiple funds. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. The results are presented in Figure 4. (click to enlarge) Figure 4. Correlation over the past 5 years The figure presents what is called a correlation matrix. The symbols for the funds are listed in the first column on the left side of the figure. The symbols are also listed along the first row at the top. The number in the intersection of the row and column is the correlation between the two assets. For example, if you follow MHY to the right for three columns you will see that the intersection with DHY is 0.453. This indicates that, over the past 5 years, MHY and DHY were only 45% correlated. Note that all assets are 100% correlated with themselves so the values along the diagonal of the matrix are all ones. As shown in the figure, the CEFs are not very correlated with HYG or among themselves. This is a little surprising but indicates that you can obtain diversification by purchasing more than one of these funds. As a final analysis, I looked at the past 3 years. From Figure 1, I knew that this period had not been kind to high yield bonds but I wanted to how the funds held up relative to one another. The results are shown in Figure 5. (click to enlarge) Figure 5. Risk versus Reward over past 3 years What a difference a couple of years made! Over the past 3 years, only HYG and HYT were able to keep above water. AWF and DHY almost broke even but the rest had negative returns. Again, if you wanted to establish a high yield CEF position, HYT would have been your best bet. Bottom Line High yield bond CEFs can have a number of benefits as long as the risks are understood. In a robust economy there is the possibility of capital gains when prospect of companies improve and their bond ratings are upgraded. However, the reverse is also true when there is a recession. Currently, high yield CEFs are selling at historically large discounts and if you believe that neither interest rate hikes nor an economic recession is in the cards, then it may be time to consider these beaten down funds. Based on past performance, HYT clearly offered the best value in this sample of high Z-score CEFs. No one knows the future but in the past, HYT has consistently outperformed its peers on a risk-adjusted basis. But make no mistake, these are highly volatile assets and if you decide to add them to your portfolio, they will need to be managed carefully. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HYT over the next 72 hours. (More…) 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. Scalper1 News
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