Recent volatility has created opportunities to invest in high yielding leveraged credit closed-end funds trading at a discount to net asset value.
2018 can be summed up in one word—volatility. To some, that word may have negative connotations. At BlackRock, we embrace volatility and look for opportunity. In our view, leveraged credit focused closed-end funds (“CEFs”) may present an opportunity for income investors seeking attractive yields.
Recent economic data confirms that the global growth is slowing, inflation remains moderate, and financial conditions have tightened. As a result, the Federal Reserve may be nearing its neutral policy rate. This Fed “pause” should benefit leveraged credit focused CEFs that have been adversely impacted by higher borrowing costs in addition to the confluence of geopolitical tensions, growth fears and overall negative market sentiment for risk assets.
Patience can pay with a long-term income strategy
In today’s fixed income landscape, we see opportunities to construct a much more efficient portfolio compared to a year ago to drive high income. Income can be an especially impactful force in some of these higher-risk asset classes, and price return appears considerably less important in today’s post-Quantitative Easing world (see Figure 1 below). Over a long enough time horizon, income can over-power the periodic draw-downs that credit markets may endure. When we look over a period of many years, we find that the vast majority of returns in major bond indices come from income, or coupon. Crucial to our philosophy in managing the portfolios is our prudent, disciplined, and steady approach to helping generate solid, reliable, and durable income over a longer-run investment window.
Investors with a greater risk tolerance may want to consider leveraged credit focused CEFs to achieve higher income with potential upside given attractive valuations. Within credit markets, we believe high yield fundamentals are improving with higher rated credits driving new issuance volume and interest coverage at post-crisis highs. Meanwhile, technical factors remain supportive as the high yield market has shrunk and valuations are looking more attractive following recent outflows. Similarly, emerging market debt valuations are starting to look attractive following significant underperformance in 2018 and the technical backdrop has become more supportive.
High income opportunities at a discount
Leveraged credit focused CEFs such as high yield and multi-sector strategies have experienced significant discount widening amid heavy tax loss selling at the end of 2018 (see figure 2 below). Current discounts are at levels much wider than their long-term averages, further increasing already attractive yields. For example, as of 1/31/2019, leveraged High Yield CEFs were yielding 7.8% on a net asset value (“NAV”) basis. However, given the average discount to NAV of 8.4%, the average yield on market price is currently 8.5% based on the Lipper High Yield Funds (Leveraged) category. We believe the combination of high income and potential capital appreciation from rising bond valuations, in addition to narrowing discounts, presents an attractive entry point for long-term investors with a higher risk tolerance.
Not all discounts are equal–use z-scores to identify potential value traps
When evaluating a CEF’s discount, we believe investors should not only focus on the absolute level, but also where the CEF is trading relative to its history. Historical data has shown that while discounts fluctuate, they eventually trend back to their norm. A useful tool to identify relative value opportunities is the Z-Score, which is a statistical measure that calculates the distance (measured in standard deviations) of a CEF’s current discount from its average discount over a stated time period. For example, a 3 year Z-score of -2 means that the CEF’s current premium/discount is 2 standard deviations lower (wider discount) than the CEF’s average discount over the 3 year period. Below we provide Z-scores and yield for some of BlackRock’s credit focused CEFs:
Stephen Minar, is a Director on the Closed-End Funds team at BlackRock.
This material is for informational purposes only and is not intended to be relied upon as research or investment or tax advice, and is not a recommendation, offer or solicitation to purchase or sell any securities or to adopt any investment strategy, nor shall any securities be offered or sold to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction.
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Performance results reflect past performance and are no guarantee of future results. Current performance may be lower or higher than the performance data quoted. All returns assume reinvestment of all dividends and/or distributions at the price of the Fund on the ex-dividend date. The dividend yield, market value and net asset value of a Fund’s shares will fluctuate with market conditions. Closed-end funds may trade at a premium to NAV but often trade at a discount.
The amounts and sources of Fund distributions reported in any notices to shareholders are only estimates and are not being provided for tax reporting purposes. The actual amounts and sources of the amounts for tax reporting purposes will depend upon a Fund’s investment experience during the remainder of its fiscal year and may be subject to change based on tax regulations. A Fund will send a Form 1099-DIV for the calendar year that will tell shareholders how to report these distributions for federal income tax purposes. Some Funds make distributions of ordinary income and capital gains at calendar year end. Those distributions temporarily cause extraordinarily high yields. There is no assurance that a Fund will repeat that yield in the future. Subsequent monthly distributions that do not include ordinary income or capital gains in the form of dividends will likely be lower.
Some investors may be subject to the alternative minimum tax (AMT).
The Funds are actively managed and their characteristics will vary. Stock and bond values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves special risks including, but not limited to political risks, currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Principal of mortgage- or asset-backed securities normally may be prepaid at any time, reducing the yield and market value of those securities. Obligations of U.S. government agencies are supported by varying degrees of credit but generally are not backed by the full faith and credit of the US government. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher rated securities. Investments in emerging markets may be considered speculative and are more likely to experience hyperinflation and currency devaluations, which adversely affect returns. In addition, many emerging securities markets have lower trading volumes and less liquidity. A Fund may use derivatives to hedge its investments or to seek to enhance returns. Derivatives entail risks relating to liquidity, leverage and credit that may reduce returns and increase volatility. Refer to a Fund’s prospectus for more information.
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