Tag Archives: phk

A Rate Hike Will Threaten This Bond Fund’s Reach For Yield

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.

Why I Sold Pimco High Income Fund

Summary PHK has managed to attract a premium near its historical average before its dividend cut. Although another cut is unlikely in the near term, the current premium is overly generous. Historical price trends have created clear buy and sell signals which indicate PHK is too pricey at its current premium. However, if PHK can continue its recent and opaque increase to NAV, a new higher price target may be in order. Pimco High Income Fund (NYSE: PHK ) consistently paid out the same dividend for over a decade, until a 15% cut that management insisted was reflective of the secular stagnation argument for lower global growth that has come to quietly dominate many economists’ thinking. In management’s words: “Generally, the changes in distributions for PHK, PCI and PDI take into account many factors, including but not limited to, each such Fund’s current and expected earnings, the overall market environment and Pimco’s current economic and market outlook.” The market’s response was unsurprising – the fund reached a 52-week low of 6.87 and saw its premium to NAV – once the highest in the CEF universe – fall to zero. This was a tremendous buying opportunity and I heavily added to my position before encouraging investors to not worry about a dividend cut anytime soon . A dividend cut remains unlikely. Since October, the new payout has remained steady. In November, NII covered distributions by 92%, and NII has remained just a hair under 10 cents since April, when NII fell precipitously to about 7.2 cents per share, as it also was in March and January. 92% is still not full coverage, leaving some investors concerned about PHK’s future payouts. However, PHK is preparing for an interest rate hike and the ability to buy new issues at new, higher rates. Prepping for the Rate Hike The duration of PHK’s holdings has fallen to 4.7 years as of the end of September, down from over five years earlier in 2015. The fund has been cutting the duration of its holdings for a long time in anticipation of raising rates, which actually hurt performance in 2014, as management acknowledged in its semi-annual report from September 2014 – and which management attempted to rectify by buying swaps: “Despite the Fund’s short exposure to the long end part of the curve, which has hurt the performance, overall increased duration exposure with interest rate swaps contributed positively to performance as Treasury rates declined.” Now the fund seems to be doubling down on its expectation of an interest rate hike. If Yellen does raise rates in December or early 2016 and high yield issues offer higher yields as a result, PHK will be able to churn into higher yielding debts and fully cover dividends more easily. (For more on how higher rates can be good for PHK, please see my two earlier pieces on the subject: Part 1 and Part 2 ). A Safe Payout – So Why Sell? The market seems to have accepted that PHK’s new distribution is about as safe as the old one, and may last just as long before being cut again. Yet I sold the fund because the market has overpriced the value of PHK’s new payout. As of November 25th, the fund’s premium over NAV was 24.65%, almost at the average premium the fund enjoyed over its lifetime before the dividend cut: In other words, the market is roughly pricing the fund’s ability to fund future payouts at the same premium as it has priced that fund’s future payouts before the dividend cut. At best, the market is punishing PHK with a premium that is 5% below its historical average. Is that sufficient for a 15% dividend cut? The Technical Concern There also is a technical argument to be made against buying PHK now – but keeping it on a watch list in the future. Since 2010, when the fund’s premium to NAV remained sustainably high, PHK has followed a steady pattern of slow appreciation to a peak, followed by a decline, and then a steady appreciation again: (click to enlarge) This pattern held for most of 2014 until the high yield market began to see serious risk aversion and a tightening of credit spreads at the end of the year, partly due to the strong dollar, partly due to rising oil prices, partly due to fears of collapsing liquidity, and partly due to fears of higher defaults resulting in an increase in interest rates: (click to enlarge) While I believe short-term speculation on asset prices is almost always a losing game, in the case of PHK the return to form seems to be congealing, and since the dividend cut the slow appreciation followed by a steep drop-off seems to be coming back to the name: (click to enlarge) However, we are currently not seeing a steep sell off as we did in the middle of September and earlier in November. This trendline, its historical performance, and its new payouts have all given me clear price targets to buy, sell and hold this stock which are currently telling me to wait until returning to the name. A Silver Lining? There is hope for PHK, however, which may help it close the gap on its current premium. In the last few days the fund’s NAV has shot up to its highest point since its dividend cut and the first sign of an increase in NAV since the beginning of 2015: (click to enlarge) It’s unclear how the NAV for PHK shot up so quickly in such a short period of time. Because bonds, especially high-yield bonds, are particularly illiquid, this could be the result of a new mark-to-market for a holding that was temporarily mis-priced due to thin trading. Alternatively, it could be a result of a cumulative appreciation of the high yield market as the fears of earlier in the year briefly fade. A third option is that the fund made a new purchase that was particularly undervalued by the market. In any case, the fund’s NAV shot up after the spread between high yield and U.S. Treasuries widened, giving more opportunities for fund managers to find high-yielding assets to fund distributions: (click to enlarge) This could mean PHK will find more ways to increase its NAV and close that gap between its current premium and the premium that it deserves after a dividend cut. I will continue to watch PHK closely to see if its ability to increase NAV is sustainable, or if the market decides to under-price the fund again. Until then, I’m waiting on the sidelines.

Distribution Cuts: Threats And Opportunities For Income CEF Investors

Summary Closed-end funds are often targeted to the income investor. A predictable and stable income stream is among a CEF investor’s highest priorities. When funds are forced to cut distributions, the market response will frequently be an immediate sharp decline in the fund’s price and its premium/discount. In this article, I look at five income CEFs that have cut distributions from 15% to 33%. For the most part, CEFs are designed for and targeted to income investors. For the income investor, closed-end funds are hard to beat. Average distribution yields are in the 8%-9% range for taxable funds (general equity, 8.99%; preferred stocks, 8.09%; fixed-income, 8.55%). Tax-free national municipal bond funds pay an average yield of 5.92% with no federal tax liability. Many funds make an effort to maintain stable distributions; others pay out variable distributions based on the fund’s earnings. Distribution increases are rare for funds that maintain stable distributions. Managers often prefer to issue special distributions when earnings exceed regular distributions in part because they can do so without creating potentially unrealistic expectations. Decreases are uncommon as well, but managers are often find themselves in situations where there is no choice but to cut payouts to shareholders. One could argue that modest distribution cuts, when they are essential, are not completely negative. It may be preferable to the alternative, which is a return of investor capital at the expense of the fund’s net asset value. Income investors, however, can be a fickle lot and will react when a fund that has maintained a stable distribution reduces that payment. On the other hand, others who are not invested in a fund that cuts distributions (and therefore not subject to the cut in income) may find opportunities in such cases. For CEF investors, especially those who have not experienced the aftermath of a sharp distribution cut, a look at some recent occurrences may be instructive. The topic is timely because it is clear that at some point in the near future, interest rates will begin going up. When that happens, it is not unlikely that many funds will feel the pinch on their holdings and from rising leverage costs. One consequence may well be distribution cuts by CEFs, especially fixed-income CEFs that have been paying out unsustainably high distributions. One highly visible case occurred just last week when PIMCO High Income Fund (NYSE: PHK ) cut its payout amount on Sept 1. PHK has maintained an exceptionally high distribution yield over many years. Investors flocking to that high yield drove the premium for the fund into the 80% range. The fund had many detractors, but shareholders who enjoyed the high income the fund generated were often vigorous advocates. The fund’s share price and premium had been declining for months. Then PIMCO declared a 15% reduction in the distribution (the first distribution deduction in fund’s history), and there was a strong sell-off. The high yield, extraordinary premiums and regular controversy surrounding it made PHK’s plight highly visible. But it is not the only fund to have cut distributions this month. Two Allianz funds, AGIC Convertible & Income (NYSE: NCV ) and AGIC Convertible & Income II (NYSE: NCZ ), did so as well. I want to look at those three funds and two other examples. Two tax-free municipal bond funds from Pioneer: Pioneer Muni High Income Advantage (NYSE: MAV ) and Pioneer Municipal High Income (NYSE: MHI ), which cut their distributions in May. This chart illustrates the extent of the distribution cuts for these five CEFs. Distribution cuts ranged from 15% to 32.35%. These are drastic cuts. Anyone depending on the funds’ distributions for stable income would find a 15% income cut difficult and a 32% cut devastating. The first thing that comes to mind is the importance of diversification. Obviously, a portfolio with a high allocation to one or more of these would have delivered an income shock well in excess of a portfolio where they fill a moderately small fraction of the income holdings. This is such a primary factor in portfolio building; I will not discuss it here other than to point out how these actions underscore the need for holding a diversified portfolio. The second is to ask if an investor might have anticipated the cuts, a point I recently considered ( here ) for PHK with an eye on other PIMCO funds. And the third involves the aftermath: How might the cuts affect new investment decisions in the funds? What these CEFs had in common is high distributions and moderate to high premiums relative to their peers. Income CEFs tend to modulate discounts/premiums to adjust payout at market price to a point near some market equilibrium level. This creates a feedback loop: A manager does a good job generating high returns. The high returns drive investors to bid up prices into premium ranges. The high premiums mean that the distributions on NAV that fund managers have to earn to pay those high distributions on premium market prices are even higher. Eventually it becomes impossible to sustain such high NAV yields and managers are forced to cut distributions. Because it was the high yield that drove investors’ decisions to own the fund, many take a quick exit when that yield drops. Market price declines and premiums shrink or go to discounts to bring market distribution yields closer to the equilibrium value. PHK PHK is an extreme example. From the chart above, we see the distribution was cut 15.1%. The price dropped 10.4% the next day and 15.6% by the week’s end. NAV stayed completely stable, thus the premium dropped from 32.9% to 12.1% at Friday’s close. The net result was that distribution yield at market price remained stable. Obviously, this is a short window. Deeper losses may be in the offing, or the share price may stabilize near the 15.5% yield point. There were clear predictors of PHK’s cut and many observers have been pointing them out for a long time. The most glaring was PHK’s failure to cover its distribution. I’ve discussed this in detail in a recent postmortem analysis of the cuts in the article linked above and will not repeat that. As for opportunity, I do not see anything approaching opportunity in PHK’s slide. The 15% distribution cut may not have been adequate to stabilize the fund as its coverage ratio prior to the cut was only 65%. As I’ve said previously, more cuts may well be on the horizon for PHK. NVC and NVZ Distribution cuts for the two Allianz funds came the same day as PHK’s cut. These were much steeper than PHK’s: distribution for NCV was sliced by 27.8% and for NCZ by 32.4%. The market’s response was equally rapid. NCV’s share price dropped 11.3% in a day and was down 8.82% at the week’s close. NCZ, which suffered even larger distribution cuts, lost 12.8% the first day. It too picked up a bit by the week’s close. NCV was priced at a small premium (0.83%) prior to the cut; it fell to a discount (-8.94%) but still above the average for fixed-income CEFs (-11.9%). NCZ’s 3.12% premium went to a discount of -9.72%. For both funds the distribution yields at market price ended the week at 11.8%, well off the yields before the cut, but still in the upper reaches of their category, ranking 10 and 11 among the 146 taxable income funds in the cefconnect screener. Note that after the initial drop, each fund saw a meaningful uptick. This suggests that there may be opportunity in NCV and NCZ. I will be researching both in more detail with an eye to determining if the distribution cuts were sufficient to bring the funds into a sustainable position. Others interested in income CEFs may want to do the same. On first look, it’s hard for me to decipher what drove the sharp decreases in payout for these two funds and I certainly will want a clearer picture here before I consider any moves into either. Undistributed net investment income or UNII certainly does not raise red flags. For NCZ, it was slightly negative (-$0.0667) at the end of February, and for NCV, it was slightly positive ($0.0319) (both from cefconnect.com). For the August distributions, NCV management estimated “that approximately 22% is from net investment income and approximately 78% is from net profits from the sale of portfolio securities or other capital gains.” For NCZ , “$0.0652 per common share [77%] of this distribution is from net investment income and $0.0198 [23%] is from paid-in capital in excess of par.” These factors need to be looked at more closely. Michael Foster addressed this issue in July, and for NCZ, he tells us that “these payments are not returns of capital; they are profits from sold bonds and convertible notes that the fund has held and liquidated.” He did not consider this to be cautionary with regard to the sustainability of NCZ’s distributions. The UNII numbers would seem to support his conclusion, but the distribution cuts call that into question. Most importantly, I see none of the indicators I (and others I’ve looked to for knowledgeable input on CEF investing) look to as signs of pending distribution cuts other than a subjective reaction to the fact that the funds had to generate high, possibly unrealistically high, returns on NAV to sustain those high distributions. I would certainly appreciate hearing any insights readers may have here. MAV and MHI I want to turn my attention to the two muni bond CEFs which have a bit of history following their cuts. Here again there is a tale of sky-high premium valuations coming down to earth. Fours months ago, the funds announced distribution cuts of 15.8% and 17.7%. Both funds were posting distributions above the peers, sufficiently above to generate premium valuations for each: 24.5% for MAV and 10.6% for MHI. Investors were paying those premiums for 9.1% and 7.7% yields on NAV, either without asking or answering to their satisfaction the question of how the managers were getting those returns from low-yielding municipal bonds. Here again, it is hard to find, even in retrospect where it’s usually easy, what might have predicted the distribution cuts and warned investors that a fall was coming. UNII was strongly positive for both funds. UNII was reported for MAV as $0.2021 at the end of March 2015, and $0.1622 for MHI in April. I suspect neither of those reports were in investors’ hands on May 5 when the axe fell, but I think it’s safe to say UNII would not have provided a clue that cuts were imminent. Neither fund was holding the highest-quality bonds, but that was nothing new for them. Duration was moderately long, but not out of line with peer funds that were returning lesser distributions. Sure the funds were on the riskier end of the muni-bond spectrum, but both had been handling that position for some time. If investors were concerned, as well they might be, there was little in the obvious data to heighten that concern in April. The most telling point might have been the exceptionally high distributions on NAV required to fund the payouts to shareholders. Muni-bond portfolios simply do not earn 9.2% or even 7.7% sustainably in the present ultra-low interest rate environment. MAV and MHI are leveraged, which would enhance their income-generating potential, but at 33% and 25%, neither is leveraged to a degree sufficiently above its peers to account for those exceptional yields. Unlike the other funds, we now have a four-month, post-cut record. Both funds continued to fall. MAV’s price has fallen 16.7% from its pre-cut level. It still maintains a premium (5.6%), albeit reduced substantially from its pre-cut level of 24.5%. MHI’s market price is 15% below its pre-cut level, and its premium is now down to a -5% discount. Both funds saw premium/discount levels pop a bit after their initial falls but then decline sharply. This chart shows MAV’s YTD premium/discount status. And this shows MHI’s. Are the funds offering buyers opportunity at these prices? Perhaps a case can be made that they are. Management has shown the ability to outperform peer funds over time. Distributions have been brought down to levels more consistent with their muni-bond fund peers. Bottoms seem to have been set for market price and possibly for discounts. The funds may well falter, but I think that’s more likely to be as part of a broad, sector-wide downturn for muni bonds rather than something specific to these funds. As a muni-bond CEF investor, I had considered MAV as the discount was falling but I am loath to buy any CEF at a premium valuation. Regardless, I did take the plunge in early August when the premium was close to zero and looked like it may have reached bottom. So far, that has turned out to be a reasonably good call but it’s still early days. Meanwhile the 7.5% distribution, free from federal taxes, is a welcome addition to my income stream. MHI with its lower leverage, similar portfolio and deeper discount may be the preferable opportunity at this time. I began this exercise in pursuit of a cautionary tale. Regrettably, the only one of these five funds that showed clear signs of imminent disaster is PHK, where the situation was so ripe for a crash that anyone should have been able to see it. For the others, the indicators are more subtle, sufficiently so that I would certainly have been taken by surprise had I been invested in any of them. The most I can infer is that if it looks too good to be true, it likely is. Not very satisfying, but the most noteworthy lesson I can take away from NCV, NCZ, MAV and MHI is that funds selling at premium valuation and turning in exceptional returns on NAV to support those valuation are best avoided even if there is no obvious marker for trouble ahead. I would appreciate any input from readers who have more substance to put on those sketchy bones. Disclosure: I am/we are long MAV. (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.