The closed-end funds from the high-yield sector significantly increased their prices over the past months. Currently, most of them are traded at positive Z-scores, which is an indication that they have lost most of their statistical edge. Still, they are traded at high discounts, but we are cautious when we select our positions due to the lack of statistical edge. For me, personally, I am in a waiting mode to see a statistical opportunity to review some of the funds.
Definitely, one of the most volatile weeks in the last months. The first part of the week was extremely negative for the sector after the weaker than expected economic data and respectively recession worries. However, the market participants found optimism in the next several days as the unemployment rate fell to its 50-year low.
Over the first week of October, the main benchmark iShares iBoxx $ High Yield Corporate Bond ETF (HYG), which we use to track the high-yield bonds, fell by $0.64 per share and finished the Friday session at $86.43 per share. Also, it is important to mention that the main index distributed its monthly dividend of $0.35 cents per share.
The main event next week will be the meeting between the two largest economies. On the 10th of October, the U.S and China will hold a fresh round of talks in Washington, D.C. I think the outcome of this meeting will have a significant impact on the riskier assets such as high-yield bonds.
Source: Barchart, iBoxx $ High Yield Corp Bond iShares
Statistical Comparison And Spread Review Of The Sector
High-yield bonds are typically evaluated on the difference between their yield and the yield on the U.S. Treasury bond. High-yield spreads are used by investors and market analysts to evaluate the overall credit markets. Higher spreads indicate a higher default risk in junk bonds and can be a reflection of the overall corporate economy and/or a broader weakening of macroeconomic conditions. On a weekly basis, we notice an increase of 0.33 bps.
Source: YCharts, US High Yield Master II Option-Adjusted Spread and US High Yield Master II Effective Yield
Below, you can find a statistical comparison between HYG and the iShares 20+ Year Treasury Bond ETF (TLT). We observe a correlation between the two sectors of 0.76 points for the last 200-day period:
Source: Author’s software
On the other hand, we have a statistical comparison between HYG and the SPDR S&P 500 Trust ETF (SPY). There is definitely a stronger relationship between them for the last 200 days. As you see, it is 0.98 points.
Source: Author’s software
Source: Yahoo News, High Yield Closed-End Funds News
Several funds from the sector announced their dividends:
- Pioneer Diversified High Income Trust (HNW) $0.0950 per share.
- New America High Income Fund (HYB) $0.0550 per share
- MFS Intermediate High Income Fund (CIF) $0.0204 per share.
- Invesco High Income Trust II (VLT) $0.0964 per share.
- Ivy High Income Opportunities Fund (IVH) $0.1000 per share.
- Neuberger Berman High Yield Strategies Fund (NHS) $0.0905 per share.
Review Of High-Yield CEFs
Weekly % Changes In The Sector
1. Lowest Z-Score:
A tough week for the high-yield closed-end funds. The last five days were marked with increased volatility and a decrease in the prices and net asset value of the high-yield closed-end funds. The only exception that we saw was the price of the New America High Income Fund (HYB). A little bit surprisingly this CEF managed to increase its price in such a week by 2.72%.
Although the closed-end funds from the area reported decreases in their prices, they continue to be traded at positive Z-scores. In other words, from a statistical perspective, most of the CEFs remain relatively overpriced. Usually, the Z-score makes sense to me when it is below -2.00 points and I receive a signal for a potential buying opportunity or when it is above 2.00 points, it sends me a message to close my long positions and to consider a short one if the period is favorable. Another situation when the Z-score indicator can catch my eye is when a fund has a very different Z-score from its peers.
From my perspective, a fund that can be reviewed as a potential “Long” candidate is Apollo Tactical Income Fund, Inc. (AIF). It is one of the interesting options which I see in the above table. Its attractive discount of 10.39% which is accompanied by a relatively low Z-score of 0.80 points is a strong foundation to review the fund as a potential “Buy” candidate. The current yield is 8.12%.
Another important fact is the positive earning/coverage ratio of the fund which signals that the management team can fully cover the dividend with the earnings from the investments. In other words, based on this ratio, the fund is able to keep the current dividend unchanged.
The positive UNII/Share balance is another fact which should be taken into consideration when we are talking about the protection of the dividend. In combination with the earning/coverage ratio, it is an important factor for the distributions.
2. Highest Z-Score:
In this paragraph, we want to see if some of the funds are traded at a very high Z-score. A fund is expected to trade between a Z-score of -2.00 points and 2.00 points for 95.5% of the time. From my perspective, if there is no fundamental reason behind the high Z-score, I will close my “Long” positions in these funds which have a statistical parameter close or above 2.00 points. Currently, I do not see something which raises a red flag for me. None of the high-yield CEFs is traded at extremely high Z-score or premium, but, based on my principles, I will not buy PGIM High Yield Bond Fund (ISD) and First Trust High Income Long/Short Fund (FSD) at such high Z-scores.
The average Z-score of the high-yield CEFs is 1.08 points. On a weekly basis, we find a decrease of 0.07 bps of the average value. It is pretty interesting to notice the drastic change. At the end of December 2018, we had -3.43 points average Z-score, and now, it is around 1.00 point.
3. Biggest Discount:
The next factor, which I consider as important, is the spread between the net asset value and the price. Most of the funds are still trading at a discount and the period remains favorable to include some of them to your portfolio based on this criterion. No doubt, if you combine the attractive discount with relatively low Z-score, the chances for a capital gain are even higher.
I suppose some of the above funds are traded at a discount just because their latest earnings were not high enough to cover the monthly distribution. A factor that is a concern for most of the market participants due to a potential dividend cut. However, according to CEFConnect, Apollo Tactical Income Fund, Inc. (AIF), New America High Income Fund (HYB), and Ivy High Income Opportunities Fund (IVH) continue to keep good levels of their earnings/coverage ratios. In other words, the latest earnings of their portfolios are high enough to maintain the dividend. Therefore, from my perspective, these funds have the quality to be analyzed in more detail.
The average discount/premium of the high-yield CEFs is -5.66%. Last week, the average spread between prices and net asset values was -5.59%.
4. Highest Premium:
The two funds sponsored by Babson Capital Management are the ones that are traded at higher premiums. The trust in the management team and solid past performance are the reasons for this situation. If you believe that the past results are very important for the future performance, then Barings Corporate Investors (MCI) seems the more reasonable choice for each of the uses if we compare it to its brother Barings Participation Investors (MPV). Both of them offer very similar yields on the net asset value, but MCI is traded at a much lower premium and offers higher current yield on its price.
Here is the full picture of the funds from the sector. Below, we have depicted their discount/premium and their Z-score:
5. Highest 5-year Annualized Return On NAV:
Above are the funds that outperformed their peers by return on net asset value for the past five years. The average return on NAV for that period is 5.31% for the sector. As you can see, most of the current yields on price and net asset value are higher than the historical ones. The situation seems justified because, last year, we saw two sharp declines in the prices of the funds.
6. Highest Distribution Rate:
Five funds offer yield on price above 9.00%. The average yield on the price for the sector is 8.33%, and the average yield on net asset value is 7.84%. We have already seen that most of the funds are trading at a discount, so this difference should not surprise us.
I know that most of the market participants include the high-yield closed-end funds to their portfolio to increase its return, but I want to mention that the funds with the highest yields are not always the best choice. We need to analyze if the earnings/coverage ratio of these CEFs is close or above 100% and what is the UNII/Share balance. If these two metrics are positive, the risk of a dividend cut is limited.
7. Lowest Effective Leverage:
We have two funds which are not leveraged and three which use leverage below 10%. The average leverage for the sector is 26.41%. Below, you can see the relationship between the effective leverage of the funds and their yield on net asset value.
The high-yield sector does not provide us with significant arbitrage opportunities at present. Most of the CEFs are trading at discounts, and it is difficult to find so many potential “Short” candidates. On the other hand, there are still interesting funds which provide us with an attractive valuation based on the discount, and we can review them as potential “Buy” candidates if their Z-scores are not too high. However, we should be careful when the situation in the market seems unstable and the riskier assets such as high-yield bonds, CEFs may be affected by the volatility.
Note: This article was originally published on October 06, 2019, and, as such, some figures and charts might not be entirely up to date.
Trade With Beta
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IVH over the next 72 hours. 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.