Description

Fixed Income Alpha, Anyone?

Hi, guys --

Introduction

I guess I am a closed-end fund guy, after all.

DHG is a liquidating closed-end junk bond fund. The thesis is exactly the same as my writeup on GDO:

https://www.valueinvestorsclub.com/idea/Western_Asset_Global_Corporate_Defined_Opportunity_Fund/135970#description

, except with better numbers.

Statistical Summary 

Here's a quick snapshot:

Basics:

Price: $13.62
NAV: $14.71
Discount: 7.4%
Yield: 6.13% -- They're outearning their distribution; this number is based on NII.
Assets: $293MM
Leverage: $70MM
Leverage %: 24%
Expenses (as % of assets): 1.54%
Duration: 4.35

Country Exposure:

USA  80.00%
Canada  8.00%
Luxembourg  3.00%
Netherlands  2.00%
UK  1.00%
Germany  1.00%
France  1.00%
Bermuda  1.00%
Ireland  1.00%
Cayman Islands  1.00%
Other Countries  1.00%

Ratings Buckets:

BBB 13%
BB 60%
B 26%
CCC 1%

Top 10 Holdings:

Dish Dbs 5.125% 5.13 01 May 2020 -- 2.24%
First Data Corp. 1.00 24 Mar 2021 -- 1.82%
Telesat Cda / Telesat 144A 6% 6.00 15 May 2017 -- 1.43%
Jabil Circuit 5.625% 5.63 15 Dec 2020 -- 1.35%
Csc Holdings, Inc. 1.00 17 Apr 2020 -- 1.23%
Calpine Corp. 1.00 27 May 2022 -- 1.15%
Novelis 8.75% 8.75 15 Dec 2020 -- 1.07%
Cco Hldgs Llc / Cco Hldgs Cap 144A 5.5% 5.50 01 May 2026 -- 1.06%
Teck Resources 2.5% 2.50 01 Feb 2018 -- 1.01%
Cco Hldgs Llc / Cco Hldgs Cap 6.5% -- 0.92%
United Rentals North Amer 7.375% -- 0.83%

----------------------------

They're scheduled to liquidate on 3/30/2018, a scant 1.75 years from now; this could happen sooner, but that seems unlikely. Holding everything constant, the expected return is 10.7%/year, consisting of 6.13% from NII + 4.6% from the discount going away on the liquidation date. That level of asbolute return can be nothing but yawn-inducing to an equity investor, but when viewed through the lens of FIXED INCOME ALPHA, it's astounding.

And that's really pretty much it. I'm going to beat the FIXED INCOME ALPHA drum a bit more at the end of this write-up, but, since I know I have to pad this out to some decent length, let me first

(a) briefly compare DHG to some ETF alternatives, and

(b) address the question, "Is now a dumb time to invest in high yield?"

Comps, can I get Comps?

Let's look at DHG vs. JNK and HYG, the two best-known (to me, anyway!) high yield ETFs. Courtesy of Yahoo! Finance, here's a graph of the last 5 years of NAV-only performance:

Blue is DHG, green is HYG, red is JNK. DHG wins! Things aren't as great over the last one and two years, where DHG places between the ETF alternatives, outperforming JNK but losing to HYG. Honestly, I think this pretty impressive, because DHG is a leveraged junk bond during a challenging period for high-yield, the managers must have doing something right.

Here's what I get for 5-year total returns:

DHG wins again! and by a significant margin! I'm not trying to claim these guys are any good, but evidence of incompetence is not found in the historical record.

Going forward, who knows what will happen? But just using credit ratings as a proxy, I see DHG with a Moody's WARF score of 25 vs. 38 for HYG and 44 for JNK. That's something like BB+ for DHG vs. BB- for the ETFs. Adjusting for DHG's leverage, I don't see a reason to expect underperformance.

What Are You, Crazy?

So is now a dumb time to invest in high yield? Maybe, but here's some historical perspective:

This closed at 6.16 on Jul 5. Working backwards, let's see when spreads have been materially higher over the last 20 years:

1. February's melt-down.
2. Greek/Eurozone/Financial-crisis-aftershocks crisis.
3. Financial crisis.
4. Telecom/Worldcom implosion.
5. Recession and terrorism.

I have no idea where spreads should be, but here's where they've been:

Maybe things are worse now than the run of the last 20 years, I could be convinced. On the other hand, I can see sense in the argument that absolutely low rates rationally require some degree of spread compression. This is of course very superficial; it'd require a lot deeper analysis than I'm capable of delivering to show that investing in HY is now dumber relative to its own history or current alternatives.

Wrap-Up

There's tons of different ways of looking at the alpha opportunity here, but the simplest is to note that, thanks to 4.6% annualized discount narrowing and 40bps of coupon pick-up, an investment in DHG at these prices will outperform DHG-at-NAV by 5% year. You can whack away at that number, and I have. But I haven't been able to see how one would expect (actual results could of course differ) DHG to do worse than outperform the HY markets by 2%/year. With that kind of alpha, if this were a scalable and repeatable strategy -- it's neither -- I would have billions in AUM instead of typing this write-up into a $300 Windows laptop sitting on top of a broken garden table I found on the street in a dingy Brooklyn apartment where the floors are so slanted that, if I let go of an egg on side of the room, it'll crack when it hits other wall.

Here's some scenario analysis to help out with risk-return eyeballing:

1. It's possible one could close this out in the next couple of months for small absolute returns but a phenomenal IRR.
2. One-year 15% returns are very conceivable: 6% coupon, 4% rates/spreads, 5% from discount narrowing.
3. Base case is hold to liquidation for 10%-11%.
4. This pretty simplistic, but at 20% expected returns, you've got about 500 bps of unfavorable rate/spread developments priced in. The way you lose money on this either: Financial Crisis Part II, or a combination of rising rates/spreads. Like, if 18 months from now the 10 year is at 3.5% and there's a pretty nasty panic, you'll be down. Tail risk, basically; anything can happen.

A Few Closing Notes

1: Looking back further than five years is pointless due to manager/strategy change.

2: It's possible that Deutsche could try to wriggle out of the liquidation. I'm not worried about it.

3: Distributions have been on a downward path due to falling rates and DHG moving up the quality ladder.

4: Fees are on the high end, but I don't think that's an issue due to: (a) the short time frame and, (b) too lazy to step through the math right now, but I don't think they're onerous by more than 40bps or so.

5: Numbers are a bit stale but not materially so.

Yours,

Bowd

Catalyst

Time.