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High Yield Carnage And Closed End Funds

Summary High yield bonds are suffering a liquidity crisis that is causing NAVs to fall. Due to their nature, CEFs are less susceptible to a liquidity crisis than bond mutual funds, but they are impacted by the high redemptions elsewhere in the bond market. When the time is right, there will be wonderful buying opportunities in the high yield CEF universe, but that time is not quite yet. With Carl Icahn warning about a “keg of dynamite” in the high yield market and Third Avenue liquidating a high yield bond fund, the so-called “junk bond” market is living up to its name. While markets are victim to volatility every once in a while, the problems in high yield are worrisome for a couple of reasons. Firstly, the high yield market never really recovered from the taper tantrum of 2013, meaning the bad run for high yield has now lasted almost three years: (click to enlarge) Secondly, with a ZIRP environment where retirees are desperate for income, many have been fooled into buying into the high yield market at the wrong time. Many fears around high yield bonds focus on the impact of a rising interest rate environment, but a much greater threat is behind Icahn’s red flag: liquidity. A Quick Introduction to Bond Trading With so much media focus on the stock market, many people translate what they know and learn about equities to the credit markets. This is a huge mistake for several reasons, but right now the mistake revolves around trading. Common stocks trade trillions of times in a day, but bonds do not. In fact, many bonds will not be traded for days, or even months . This is especially true for the high yield market, where investors often hold to maturity to collect the yield. The implications of this are significant. Without frequent trading, a fund that needs to sell its holdings to fulfill redemption demands could suddenly be faced with the worst dilemma you can have in any business: needing to sell immediately with no buyers in sight. When this happens, prices crater. Without the liquidity of stocks or even U.S. Treasuries, high yield bonds are susceptible to a massive decline in values, which is why we have seen the decline in value for these funds accelerate recently. Part of this is because more people are selling out of high yield mutual funds, which is requiring the funds to sell to give investors back their cash. In doing so, they are driving prices down, and the trend is likely to continue. Why CEFs are a Good Thing The timing to buy into high yield is not good; as Icahn rightly says, the devastation is likely to continue. There is still money in high yield funds that is likely to come out, and there are still continued fears about rising defaults in energy that are impacting the credit markets more broadly. But when the time to buy into high yield is right, CEFs may be a better alternative than mutual funds for yourself and the market as a whole. If well managed, CEFs do not face the redemption issue that mutual funds do. Because their total number of shares is fixed upon IPO, investors don’t “redeem” their holdings for cash-they sell their stake in the fund to someone else. This means that there can be a steep decline in the market price of CEFs that will not force the CEF to sell bonds. The only time the fund needs to sell bonds is to pay dividends (if its net investment income is less than its distributions) or to free up capital to lower leverage. A well-managed CEF can avoid both by cutting dividends (as we saw many high yield funds do in the last two years) and by lowering leverage (again, a tactic gaining popularity in these funds). This doesn’t mean CEFs are insulated from the bond market carnage; since they are trading in the same market, they are suffering alongside everyone else. But this suffering can take many forms: it can mean that the NAV of its holdings declines, but if the fund holds the bond to maturity, it will get its already invested capital. If the fund doesn’t need to sell the bond prematurely to pay dividends or lower leverage, it can weather the storm of a collapsing high yield market. I believe this is partly why the Pimco High Income Fund (NYSE: PHK ) made its unprecedented dividend cut a few months ago. Predicting a need for cash on hand and a need to stay as far out of the high yield market as the fund’s mandate will allow, it has lowered leverage and lowered distributions to effectively lower its liabilities and liquidity needs. This is prudent, and affirms my confidence in management if not in the wisdom of buying PHK right now. Other funds have made similarly wise decisions, as I discuss below. Picking through the Carnage So where does that leave us now? Several high income CEFs are down massively and will be well positioned to buy when the liquidity crisis in the market is over. But which to choose? (click to enlarge) A comparison of eight funds with relatively similar mandates and investment strategies reveals a lot of similarities and some telling differences. Most significantly, the Deutsche High Income Opportunities Fund (NYSE: DHG ) and the Deutsche High Income Trust (NYSE: KHI ) have the best performance of the group-ironic, since DeutscheBank (NYSE: DB ) has had an awful year. But “best” in this case means a negative total return YTD including dividends and an erosion of 10% of capital on average. The worst performer, the Pioneer High Income Trust (NYSE: PHT ), is down over 46% YTD and is at its lowest point in the last year. A dividend cut in February, which now seems like an extremely prudent decision given the liquidity needs of the high yield market throughout the year, is mostly to blame, and has resulted in the stock trading at a discount to NAV consistently throughout the year. In contrast to this is PHK, which is down 32% YTD but is the only fund to trade at a premium. Just a few weeks ago, however, that premium was as high as 30% just a few weeks ago, which is what caused me to sell the fund . A Group of Peers Looking at the others, we see comparable discounts to NAV among the Invesco High Income Trust II (NYSE: VLT ), the Dreyfus High Yield Strategies Fund (NYSE: DHF ), and the Credit Suisse High Yield Bond Fund (NASDAQ: CHY ). Worse than these is the First Trust Strategic High Income Fund II (NYSE: FHY ), a thinly traded fund that has also performed worse than the others. In addition to a reverse split in 2011, FHY cut its dividend earlier this year. Even more distressingly, the fund failed to see its NAV recover after 2008, although many other funds were able to recover against their lowest point in the dark days of 2009: Combined with First Trust’s small size and thus relatively limited buying power in bond markets, these distressing signals indicate this is not a fund to buy on the dip. The Standout Of the rest, DHF is one of the strongest contenders for a variety of reasons. For one, its dividend cut came in the middle of February and it has not cut in 2015. I interpret this as an indication of the managers’ prescience; simply put, they saw the liquidity crisis before others. Additionally, the fund’s effective duration of 3.72 years is extremely short for the high yield CEF universe and only 5.67% of its portfolio is in energy: (click to enlarge) Finally, to cover dividends, DHF will need to earn a 10.88% yield on its portfolio since it is trading at a discount. This is easy to do even in a ZIRP environment, and is getting easier now that junk bond yields are rising: (click to enlarge) A high yield fund starting today could get that yield with only 20% leverage–much lower than the level many bond CEFs maintain. Leverage is my main concern with DHF, however; at over 30%, it is excessive in this cratering high yield market, which is why I am not buying DHF now and will not for a while. However, when the time is right this fund may be one of the best options in the high yield market, although if the premiums shrink and discounts grow for other historical strong performers like PHK and PHT, they may become attractive too. For now, however, I am fully out of the high yield market and will likely remain so for several months.

Weiss Funds Launches Alternative Balanced Risk Fund

By DailyAlts Staff Weiss Funds launched the Weiss Alternative Balanced Risk Fund (MUTF: WEISX ) on December 1. The fund’s objective is to pursue returns with moderate volatility and reduced correlation to traditional asset classes, such as stocks and bonds. The fund’s “balanced risk” allocation strategy consists of: A long-only portfolio of stocks (“the equity component”); A long-only portfolio of debt securities (“the bond component”); and A diversified, multi-strategy long/short portfolio of stocks, bonds, and/or derivatives (“the long/short component”). The Weiss Alternative Balanced Risk Fund’s equity component will generally invest in U.S. large- and mid-cap stocks and is designed to approximately track the stock market as a whole. The fund’s fixed-income holdings, including those in the bond and long/short components, will target weighted average maturity of 9 years, and will consist of only highly-rated securities. Portfolio managers Jordi Visser, Charles S. Crow IV, and Edward Olanow are responsible for the day-to-day management of the fund. Mr. Visser is President and CEO at Weiss and oversees the investment management process. Mr. Crow is responsible for the fund’s quantitative methodologies, and he and Mr. Olanow are in charge of trading. Together, the managers allocate across the fund’s three components according to the expected contributions to overall portfolio risk for each. In the words of the prospectus, these allocations can “fluctuate widely.” Currently, the Weiss Alternative Balanced Risk Fund is available in I ( WEISX ) and K (MUTF: WEIKX ) classes, with respective net-expense ratios of 3.33% and 3.23%. A and C class shares, with respective net-expense ratios of 3.58% and 4.23%, are listed in the fund’s prospectus but are not yet available for purchase. The minimum initial purchase levels for I and K shares are $250,000 and $2 million, respectively. A and C shares, when available, will have a minimum initial purchase of $5,000. For more information, visit the fund’s web page .

Tracking The Sequoia Fund: Q3 2015 Update

Summary Year-to-date, the fund is up 1.97%, versus -5.29% for the S&P 500. Top 10 holdings (65.2% of the fund): Valeant Pharmaceuticals, Berkshire Hathaway, TJX Companies, O’Reilly Automotive, Fastenal, Precision Castparts, MasterCard, Idexx Laboratories, Mohawk Industries, and Google. During the third quarter, the fund was adding to its positions in Rolls-Royce, Constellation Software, and Jacobs Engineering. An update on Valeant Pharmaceuticals. Since its inception on 7/15/1970 an investment in the Sequoia Fund (MUTF: SEQUX ) has returned 14.34% annually versus 10.65% for the S&P 500. The fund is noted for its long-term value investing style, portfolio concentration, and outperforming in down years. For more background on the fund you can check out my original article here . The big news for the Sequoia Fund is the Valeant Pharmaceuticals controversy. The fund started accumulating shares in the second quarter of 2010 and by the end of the year held 11.3 million shares. The stock price during this period ranged from $14 to $30. You can find the fund’s reasoning for getting into the company in the 2010 annual report, which you can find here . Valeant quickly became the fund’s largest position. It said at the time: Valeant and Biovail merged during the year, and on December 31 the combined company, called Valeant, was our second largest holding. In recent weeks, rapid appreciation in Valeant shares caused it to surpass Berkshire and become Sequoia’s largest holding. It is the first time in nearly 20 years that Berkshire has not been the largest investment in the Fund. Speaking of Berkshire, it was Charlie Munger that first sounded the alarm that all might not be up to snuff. Munger is Chairman of the Daily Journal Corporation and was asked about Valeant at the last annual meeting. He responded: Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time. For those unfamiliar with the ITT story you can check out this article , which gives a nice summary. Basically, like Valeant, ITT was built up on acquisitions and debt. And what was once a growth story turned into a mish mash of debt laden businesses. Despite Munger’s warnings Valeant’s stock continued its upward trajectory, reaching a high of $263.81 on August 6th. Munger wasn’t the only one suspicious of the stock. On August 13 blog AZ Value Investing published an article on Valeant, calling it a dangerous story told well. You can find the article here . Trouble for Valeant was just around the corner. On September 17th infectious disease website Healio reported that Turing Pharmaceuticals raised the price of its Daraprim drug from $13.50 per tablet to $750. The USA Today followed up with its own article the next day and did the math for us, noting the price hike was 5,000%. Then Hillary Clinton jumped on board, tweeting on September 21st: Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on. That put all specialty pharma companies in the crosshairs, including Valeant. In a week the stock dropped from $245 to $155. But the pain wasn’t over. On September 28 Citron Research, a specialist in unearthing frauds and terminal business models, published a report saying a congressional subpoena to Valeant on price gouging should be granted. Plus it gave a short term price target of $130 with the stock in the $170-$180 range at the time. The initial report didn’t move the stock much. But sure enough on October 14 subpoenas were issued. And then Citron wrote another report detailing the whole Philidor RX issue. By the time the dust had settled Valeant had dropped 50%, from $180 to $90, in just a few days. On October 28 the Sequoia Fund addressed the issue in a letter to shareholders which you can find here . Key comments: The short seller Andrew Left (of Citron Research), writing as Citron Research, exploited the negative sentiment surrounding Valeant. Our consultations with lawyers who specialize in the pharmaceutical industry lead us to believe there is no legal reason Valeant can’t advise, control or own Philidor. We work hard to understand Valeant and its business model. Our belief has always been that Pearson is honest and extremely driven. He does everything legally permissible to maximize Valeant’s earnings. At a recent price of $110, Valeant trades for about seven times the consensus estimate of 2016 cash earnings, which does not strike us as a rational price for a company with a diverse collection of product lines and strong earnings growth. So it appears the Sequoia Fund is sticking with Valeant. As of 6/30/15 Valeant was a $2.5 billion position in the fund, and its largest, accounting for 28.7% of the fund. As of 9/30/15 Valeant was a $2.0 billion position in the fund, and its largest, accounting for 24.8% of the fund. Based on my numbers, assuming the fund didn’t sell any shares, the position is now worth about $1 billion at a price of $90. It will be interesting, to say the least, to see the fund’s activity in Valeant during the fourth quarter of 2015. Here’s the fund activity for the third quarter of 2015. New Stakes: None. Stake Disposals: None. Stake Increases: Rolls-Royce ( OTCPK:RYCEY ) designs, develops, manufactures, and services integrated power systems worldwide. The company is known for its expertise in making engines for wide body jets. The fund has been in Rolls-Royce since 2007. It built up the position to over 12 million shares by the end of 2008. Since then it’s held, save very minor selling. Despite continuing to hold, the fund is very concerned over the position. While it admires its jet engine business, it questions the board of directors recent decisions to diversify into marine engine and power generation businesses. It’s also concerned the company is abandoning its Total Care service contract selling model which was very successful under the former CEO. As for the current CEO, John Rishton, the fund says, “… in our meetings with him, has shown minimal awareness of the returns on capital his acquisitions have generated.” The fund was selling in the second quarter of 2015, trimming the position by 437k shares when prices traded between $13.75 and $16.00. Rolls Royce announced in April that John Rishton was retiring and be replaced by John Rishton. The fund must like East’s plan as they did an about face in the third quarter of 2015, adding just over 7 million shares as prices ranged from $9.75 to $13. Constellation Software ( OTCPK:CNSWF ): Constellation Software, based out of Toronto, acquires, manages, and builds vertical market software (VMS) businesses. The fund likes the company because the software they provide tend to be essential to the customers’ operations. It also likes Constellation for being an adept acquirer and then increasing the cash flow of acquisitions. During the fourth quarter of 2014 the fund acquired 257k shares for a 1.09% position. Prices for the fourth quarter of 2014ranged from $240 to $300 for the ADR. During the third quarter of 2015 the fund added another 165k shares boosting its position by 64%. Prices ranged from $380 to $460. This is now a 2.19% position in the portfolio. Jacob’s Engineering (NYSE: JEC ) provides technical, professional, and construction services to industrial and government clients. The fund first established a position in the fourth quarter of 2013, picking up 743k shares when prices ranged from $56 to $64. That turned out to be near the high point for the stock which has been falling since January of 2014. The fund added another 716k shares in the second quarter of 2014 when prices traded between $53 and $65. This past quarter the fund added another 764k shares. Prices traded between $36.50 and $44.50. This stock is a 1% position in the portfolio. Stake Decreases: None. Kept Steady : Omnicom (NYSE: OMC ), Precision Castparts (NYSE: PCP ), Compaignie Financiere Richemont SA ( OTCPK:CFRUY ), O’Reilly Automotive (NASDAQ: ORLY ), Canadian Natural Resources (NYSE: CNQ ), Sirona Dental Systems (SRIO), Berkshire Hathaway (BRK.A & BRK.B), Danaher (NYSE: DHR ), EMCOR Group (NYSE: EME ), Trimble Navigation (NASDAQ: TRMB ), Mohawk Industries (NYSE: MHK ), Expeditors International (NASDAQ: EXPD ), Perrigo Company (NYSE: PRGO ), Valeant Pharmaceuticals (NYSE: VRX ), West Pharmaceuticals (NYSE: WST ), Zoetis (NYSE: ZTS ), Fastenal Company (NASDAQ: FAST ), Praxair (NYSE: PX ), IMI plc ( OTCQX:IMIAY ), MasterCard (NYSE: MA ), Brown & Brown (NYSE: BRO ), Google (NASDAQ: GOOGL ) and (NASDAQ: GOOG ), Goldman Sachs (NYSE: GS ), International Business Machines (NYSE: IBM ), Waters Corporation (NYSE: WAT ), Admiral Group ( OTCPK:AMIGY ), Hiscox Ltd. ( OTC:HCXLY ), Verisk Analytics (NASDAQ: VRSK ), Costco Wholesale (NASDAQ: COST ), Tiffany & Co. (NYSE: TIF ), TJX Companies (NYSE: TJX ), Walmart (NYSE: WMT ), Croda International ( OTCPK:COIHY ), Cabela’s (NYSE: CAB ), and Idexx Laboratories (NASDAQ: IDXX ) saw no changes from the second quarter of 2015 to third quarter of 2015. Here’s a snapshot of the activity from the second quarter of 2015 to the third quarter of 2015: (click to enlarge) Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.