Description

We believe certain closed-end funds currently offer a large, temporary double discount to their intrinsic values thanks to a combination of technical issues in the credit markets and year-end tax-loss selling.  With high yield bonds pricing in a substantially higher default rate over the next couple years and a number of closed-end funds trading at double-digit discounts to their NAVs, it is possible to invest in well-diversified portfolios of already highly discounted securities at 85 to 90 cents on the dollar.  The investor can collect monthly payouts at annual yields of 10-12% while waiting for a recovery in the underlying assets and a collapse in the NAV discount.  Total returns north of 20% will likely to be realized over a one-year holding period, with a very comfortable margin of safety given the market prices as of Friday’s (12/28/07) close.

While this writeup proposes investment in the Western Asset High Income Opportunity Fund (ticker HIO), there are actually a number of corporate high-yield closed-end funds that are trading at significant discounts to their NAV.  We will focus on five that fit our criteria of:

1) Offering at least a discount to NAV;

2) Managing at least $500mm in assets; and,

3) Being managed by an advisor with a strong reputation in fixed-income.

Important characteristics such as portfolio composition, yield, leverage, management fees and expenses, NAV performance history, market discount/premium history, and the likelihood of a dividend cut will be discussed so that VIC members can evaluate which fund or funds may be most appropriate for their portfolios.

The Case For High Yield

Of course, investment in any of these funds only makes sense if one believes that the high-yield asset class is not about to plunge into the abyss.  Many economists have notched their recession probabilities up to 50% for 2008.  However, in terms of performance for the asset class, the question remains, how much of this prospective slowdown/recession is currently priced in?

While GDP growth over the next few years is anyone’s guess, we know for certain that a lot more bad news is priced into high-yield than what is visible based on trailing information.  When December’s numbers come in, 2007’s high-yield default rate will likely register below 0.50% (fifty basis points), the lowest since consistent data have been tracked beginning in 1980.  Meanwhile, the average spread on the high-yield market has increased from 257 bps at the end of 2006 to 581 bps at December 28, 2007.  There are only two periods since 1987 that high-yield spreads have exceeded current levels for longer than a few months:

The above table shows that spreads 60% higher than current levels corresponded to average trailing default rates 18 to 20 times current levels.

Buy and hold returns over a given period can be measured by subtracting the product of the default rate and the loss given default from the spread offered by the asset class.  Assuming an average 35% recovery on defaulted corporate issues, losses on the average default would equal 65%.  An index portfolio purchased at an 870 bps average spread and held from July 1989 to August 1991 would have returned about 660 bps less than each year’s coupon, due to the product of the 10.2% default rate and the 65% loss given default assumption.  Thus, excluding mark-to-market considerations, the portfolio would have netted 210 basis points over comparable treasuries annually during that period (the 870 bps initial spread less 660 bps in losses due to defaults).  Similarly, subtracting the 600 bps of annual losses due to defaults during the February 2000 through February 2003 period from the 920 bps average spread at the time would have given a holder annual returns of 320 bps over treasuries.  Note that this net return over treasuries significantly exceeds the maximum possible spread that could have been achieved on an index portfolio purchased at the prevailing 257 bps spread at the end of 2006. 

The point here is that at the right price, acceptable returns can be garnered through periods of increasing defaults—even if defaults hit extraordinarily high levels.  At the current 581 bps spread, the default rate would have to skyrocket 1,800% to 9 percent annually for high-yield to underperform treasuries on a buy and hold basis.  History shows nothing remotely like this happening before.  The largest percentage jump to levels above 4% occurred when defaults rose 135% from 1.7% to 4.0% between 1998 and 1999.

Despite the somewhat bubbly nature of the high-yield market during 2006 and into 2007, with spreads grinding ever tighter and covenants registering ever lighter, the quality of new issues, the raw material for future defaults, has held materially higher in recent history than during the years leading into 1999.  Senior notes represented only 68.0% of high yield issuance between 1993 and 1998, as compared with over 83.4% of new issues between 2003 and 2007.  Similarly, deferred interest and PIK-notes represented 12.3% of the high-yield market between 1993 and 1998, as compared to only 2.7% of the market between 2003 and 2005.  In 2006, toggle notes, a cash-pay/PIK hybrid, were introduced and thus notes with interest payments that are potentially deferrable (though still arguably higher quality than PIKs and zeroes) rose to 7.8% of the new issue market.  Toggle note issuance continued to rise in 2007 until they represented almost 10% of new deals prior to the market shutting down in July.

It seems that stupidity in lending found a home on the consumer side during the period after the 2000-2002 debacle in corporate lending.  After 5 years, things were starting to get dumb again on the corporate side but, before it could really step up, the festering consumer issues came to roost and the market went into balance sheet protection mode.  Thus the poison was effectively cut off from the high-yield folks before it got the chance to do much damage to the average quality of paper outstanding. 

Finally, there appears to be a lot more opportunistic capital ready to step into distressed situations than there was in the aftermath of Long-Term Capital and the unwinding of the technology bubble.  It is less likely now than in 2002 that the relatively few issuers that will face liquidity shortfalls over the next couple years will find bankruptcy as their only option.  The structural soundness of the high-yield market coupled with the relative abundance of opportunistic external capital suggests to us that it is really too early to expect a rise in default rates dramatic enough to justify spreads widening much beyond current levels.

Comparison of Closed-End Funds

The following funds were selected based on the discount, size, and reputational criteria mentioned above:

If a manager operated more than one similar fund at a similar discount, we went with its largest fund.

1. Porfolio Composition

Insight into each fund’s portfolio composition can be elicited by looking at their top three issuer concentrations:

PHK stands out as being the most aggressive in concentrating its credit risk, whereas HYT seems to be the most diversified.  We’d give HIO top ranking here taking both credit quality and diversification into consideration.

2.  Leverage