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Summary KKR Income Opportunities is a closed-end fund that invests in high-yield debt. A weak market in 2015 pressured the stock price and caused the discount to NAV to widen. Broad diversification, a large discount to NAV and a 10% yield make the current price a very compelling entry point. KKR Income Opportunities Fund (NYSE: KIO ) is a name that I have been watching with interest over the last few months. In this article I’m going to provide an analysis of the portfolio of this closed-end fund and explain why I think it is an interesting buying opportunity for income focused investors. What is KIO? KIO is a closed-end fund that provides a high level of current income by investing in a portfolio of loans and fixed income securities in the high-yield space. The fund makes use of leverage in order to enhance its yield and has a credit facility in place for this purpose – at the moment leverage stands at 32%. The company invests predominantly in BB – B – CCC rated securities and is almost evenly split between high yield bonds and leveraged loans, as you can see in their latest factsheet : The portfolio As we enter 2016 a characteristic that I search in a fixed income portfolio is a low exposure to interest rate risk. The portfolio’s duration is 3.4 years even though the average maturity is eight years. This low duration is achieved thanks to the allocation to leveraged loans, which generally offer a spread on top of the LIBOR rate and therefore have limited interest risk exposure. I believe the portfolio also is reasonably diversified, with a total of 95 positions and a concentration in the top 10 names of 32% of NAV. Sector concentration is a bit higher (44% for the top five industries) but what I particularly like is the absence in the top five of the energy sector. Considering how much money energy companies raised in the last few years and the weight of energy in high yield benchmarks (around 12%) I’m very pleased to see that exposure to this sector is below 6%. Credit to the management for that! As of the end of September the yield to maturity in the portfolio was 15.6% while the average coupon stood at 10.6%. As mentioned earlier the portfolio is leveraged with a loan to value of 32%. As of April 30th (date of the latest semi-annual report ) a credit facility was in place for a total of 145 mln at LIBOR + 0.825%. This facility expired on August 28th. I could not find the terms of the new facility but I suspect there must have been some worsening in the spread. The publication of the Annual Report (fiscal year ends on October 31st) will give some insight on this. One last thing that deserves to be mentioned is the management fee: KKR manages the fund and receives a fee of 1.1% of the Fund’s average daily managed assets. That means that also all the assets acquired thanks to the credit facility will pay the management fee. At the current 32% loan to value that means the fee is roughly 1.6% of net asset value. Investment thesis KIO currently trades around $14.4, a 13.9% discount to the most recent NAV. That compares with an average discount since the 2013 inception of 8.9%. I believe closed-end funds should trade at a discount to NAV given the often elevated fees and expenses associated but I believe such a discount should be between 5% and 10%. A 13.9% discount certainly has some appeal. Other two elements make that discount even more appealing to me: This is an income distribution fund: the yield currently stands at 10.45% and dividends are paid monthly. That means that you get a significant portion of your investment back at NAV even though you are investing at a large discount. The discount is close to peak in a disappointing year for high-yield securities. That means you are entering into a market that became cheaper during the year and you are doing so at a larger than usual discount. My biggest concern as I look at this investment is the possibility that the weakness in high yield/leveraged loans is not over yet. If we look at the S&P Leveraged Loans Total Return Index we see a peak to trough of 2.8% this year over six months. That compares with a 5.5% decline in 2011 over one month – in that occasion the decline was completely re-absorbed within six months. For the purpose of giving a complete picture I also have to add 2008: in that case the peak to trough was a massive 29% over six months. Although we can’t exclude a repeat of 2008 I have to say that I find it extremely unlikely. Credit conditions certainly relaxed over the past few years but they are not at the level of pre 2008 and, more importantly, banks have much higher capital cushions and are not as involved in the high-yield space as they used to be. In any case even in the dramatic situation of 2008 the S&P Leveraged Loans Total Return Index re-absorbed all losses within 11 months. Conclusions I believe the quality of the portfolio (measured in terms of diversification, exposure to the now “toxic” energy sector and duration) makes me comfortable in getting long KIO. However I can’t rule out further weakness in the months to come. As a result I’m starting a new position with an amount equal to 50% of my target allocation. The objective is to add to the position over the next few months in case of further weakness or keep it at current levels in case the decline in the market is over. Scalper1 News
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