High-yield bonds are one of the worst performing bond sectors so far in 2014. But with so many closed-end funds (CEFs) relying on them to lever up cash flows from borrowed capital, what should investors expect between now and year end?
Late 2013 and early 2014 saw resurgence in the demand for high income assets following the massive rise in interest rates. Yet, with rates now back near 2% and the Federal Reserve’s bond buying program completely runoff, current high-yield bond prices present chances for renewed investor demand in the CEF space.
The credit markets have been traveling down a rocky road during the second half of the year, especially in light of the recent equity market volatility. Moreover, a stronger U.S. dollar has also put downward pressure on higher-yielding opportunities in developed markets abroad. The one silver lining for multi-sector strategies has been the continued outperformance of dollar-denominated preferred stocks and emerging market corporate or sovereign debt, even in spite of ongoing geopolitical turmoil. Yet, it’s largely been a mixed market with issues on the low end significantly underperforming the higher-rated triple or double B categories.
Not surprisingly, as I scan the investable universe of credit heavy fixed income CEF’s I’m not impressed with recent performance. Although there are some pockets where managers have been able to muster alpha from the herd through the use of interest rate or credit default swaps, generally speaking CEF market prices have largely moved sideways.
Examining a five-year chart of credit spreads between high-yield and investment-grade debt, high-yield rates have clearly widened in October, even hitting the psychologically important 5% threshold. While it would be most advantageous to make long term investments in high yield in the 6% – 7% spread range, today’s prices do exhibit a much better relative entry point than the June – July timeframe when levels approached pre-crisis lows.
Examining a chart of effective yields on the lower quality CCC or below debt that is contained within many CEFs, prices have and yields have become much more attractive in recent months. Even more attractive relative to the broad index of credit spreads.
If an investor believes we are likely to experience low Treasury rates on the intermediate to long end of the curve for an extended period, and that the economy will remain on solid footing. Taking a chance on stagnant CEF prices at current levels makes a lot of sense from both an income and capital appreciation perspective. If highly leveraged companies have a supportive economic environment, we are likely to see a resurgence of broad-based spread compression.
My favorite opportunities to take advantage of attractively priced high-yield assets both here and abroad are through the Avenue Income Credit Strategies Fund (ACP), the Legg Mason BW Global Income Opportunities Fund (BWG) and the Western Asset High Income Opportunity Fund (HIO). All three provide a unique management perspective, attractive relative discounts, and sound distribution policies relative to underlying portfolio cash flows.
From a strategy perspective, for clients in our Dynamic CEF Income portfolio, we are beginning with small allocations in select names, typically with just 5% of the total portfolio. I would like to see trends begin to re-emerge before adding to existing themes given the risk of Fed policy or additional equity market volatility. However, I believe we are likely to see much higher prices on all three funds between now and year end.