Description

If you are looking for a relatively safe short idea that will benefit from any or all of an increase in interest rates, a widening of credit spreads, or a return to rationality, you are looking in the right place.

This idea proposes shorting a basket of publicly listed high yield (HY) funds that trade at material premiums to NAV and employ leverage to enhance returns.

Firstly, spreads have not been this low since mid 1998, and likely represent excessive complacency. Secondly, as Buffet wrote in his latest annual, the next move in interest rates will likely be up. Thirdly, many of these funds are held by retail investors (eg. unsophisticated yield seekers) who are oblivious to the premium versus NAV, and are ignoring or underestimating the eventual principal risk that would follow from an adverse change in rates/spreads. A potential short position in this basket profits from any of the above, and potential downside at this point in the HY cycle could arguably be described as the cost of carry.

The specific recommendations are as follows (hopefully the table doesn't get messed up when posted):

Zenix Scudder CSFB Van Kampen
Berg Ticker ZIF KHI DHY VIT
Premium to NAV 30.2% 20.2% 12.8% 16.3%
Leverage 42.8% 27.6% 32.0% 43.4%
Duration 4.2 5.2 4.6N Not disclosed
% Port <=B rated 64.3% 70.0% 87.4% 32.5%
Current Yield 9.4% 8.8% 11.2% 8.4%

The last major shakeup in the HY market took place in July 2002. At that time the premium to NAV for each of these funds evaporated, not to mention the NAVs rapidly eroded as the value of the underlying holdings declined. If such a situation were to present itself again, one should at worst make 2-4x the cost of carrying depending on the timing and the fund. As such one could view these shorts as relatively inexpensive insurance in a time of irrational exuberance.

Similarly, one could also go long protection via credit default swaps. The reason I suggest these shorts as an alternative is the currently irrational premiums at which these funds trade, the potential for gains in an increasing rate environment (unlike CDS which are priced solely on spreads), and the existence of leverage which will work against the funds if rates rise.

In the interest of full disclosure I originally read about this trade in Grant’s Interest Rate Observer. Despite the fact that Jim Grant is typically at least a year early in his calls, my humble opinion is that the time is ripe to put on this trade. As for borrow, we have found some at two of the better known brokerages, so the idea is actionable.

Catalyst

1. Reduction in distributable income if the yield curve flattens, which in turn will cause selling of the shares (possibly even resulting in shares trading at a discount to NAV)
2. Amplified reduction in NAV in a rising-rates market environment due to use of leverage
3. Potential for sharp price erosion in the event that distributions are reduced
4. Probable elimination of premiums and widening of discounts as rate rise, exacerbating the yield-driven loss of capital