Investment grade corporate bonds look attractive here as spreads are reversing their widening trend.
PAI has gone from a large premium (unwarranted) to a moderate discount.
We lay out the case for both investment grade bonds and PAI as a means to gain exposure to them.
For several weeks prior, we had been informing our readers that there was an opportunity brewing in a high-quality investment grade closed-end fund. For those investors who have a lot of volatility in their portfolio, maybe from individual REITs or MLPs, adding some moderate-yielding base positions that have extremely low volatility may be of value.
The Western Asset Investment Grade (PAI) is a smaller $141 million, unlevered fund. Liquidity is a bit lower with just 20K shares, on average, traded daily. We added it to our Peripheral Portfolio over a month ago.
The investment strategy from the prospectus:
The Fund’s investment policies provide that its portfolio be invested as follows: at least 75% in debt securities rated within the four highest grades, and in government securities, bank debt, commercial paper, cash or cash equivalents; up to 25% in other fixed-income securities, convertible bonds, convertible preferred and preferred stock; and not more than 25% in securities restricted as to resale. Trust preferred interests and capital securities are considered debt securities and not preferred stock for purposes of the foregoing guidelines.
The fund is comprised of 73.5% investment grade corporate, with just over 10% in high yield and another 10% in emerging market debt. Again, the fund does not contain any leverage and carries an average coupon of 6.04%. We have been looking at funds that have no leverage more closely as the flattening yield curve is likely to cause significant distribution cuts to most CEFs.
The fund has a distribution yield of 4.95% after recently hitting our target of 5%. Expenses amount to 1.8% of shares, lowering the Net investment income yield ("NII yield") to 4.73% (as of December 31). The variance between NII and the distribution would indicate a chance for a cut to the distribution. Without any leverage, there is no way to toggle up leverage in order to support the distribution.
However, the fund does have a sizeable UNII bucket with over 12 cents - enough for the difference between NII production and the distribution for 44 months. Of course, a fund does not have to wait until the UNII gets to zero to cut the distribution.
If we smooth the NII earnings over the last twelve months, the fund has been able to produce $0.567 per share of earnings per month, very close to the distribution payout. Given the back-up in yields for investment grade over the last few weeks, they could conceivably be closing that gap between NII and the distribution.
The one thing investors should notice is the duration of the fund at 7.22 years. This is clearly an interest rate sensitive fund but you are trading that sensitivity for the safety of investment grade credit quality. As we noted in our Core Portfolio update, investors must attempt to balance interest rate risk with credit risks in order to have proper diversification.
Right now, we are overweight credit as the economy is not showing signs of a recession. But when the next downturn comes, the interest rate sensitive funds and securities will provide the downside cushion necessary to reduce the draw-down. Those include municipal bonds, treasuries, agency MBS, and investment grade corporates.
(Source: Western Asset)
At the end of the year, the fund was trading at a 2.4% premium to NAV, which we think is ridiculous. Last year, the fund returned 15.31% on price and 10.27% on NAV, a significant performance given the risk and lack of leverage. However, when we recommended to members, the discount had widened to over 7%, a significant move in a short amount of time, given there has been no distribution cut. Today the shares are around 4.8% below NAV.
The chart below shows the price and NAV over the past three years. The fund has mostly traded at a discount - as it should given the lack of leverage and the capitalization of the expense ratio. Last year, the fund reached a high premium of nearly 12% - a ridiculous level.
The NAV has been a little weak (from the wider spreads and the move higher in interest rates). We think that will stabilize and likely pull up the price as spreads eventually compress for investment grade bonds.
The Case for Investment Grade
Over the last several weeks, investment grade spreads have widened materially for the first time in over 2 years during the oil swoon. You can see the medium-term lower trend of spreads (corporate bond yields compared to treasuries). The spread bottomed in early February at 91 bps when volatility increased and the recent correction began.
(Source: FRED Database)
We have been watching the spreads for some time, waiting for a "bottom" in investment grade corporates for an opportunity to enter. A couple of months ago, it appears that bottom was made at 117 bps. It has since started to come back down, although we are definitely in the early innings. The current spread is back to 115 bps. It does appear a double-top may be forming. If we can get a new downtrend established, the spread should head back down to 90-95 bps over the course of 2-4 months and boost the NAV.
The fund was trading at a nice discount to NAV after trading at a large premium last year. We told our members that we think there is a possibility that the discount can close by 100-300 bps providing a tailwind to the nearly 5% yield. That occurred over the subsequent one month with the discount going from 7.7% to the current 4.8%. That 5% yield is also relatively safe given the lack of leverage and credit quality amidst more volatility in the markets today.
The investment grade sector should see improved supply and demand dynamics that help drive those spreads lower. Investment grade issuance was low at year end and in January which fell by 31% yoy. Issuance then ramped significantly in the February and March in order to take advantage of the lower spreads. In February, issuance rose 17%. In March, we had the CVS bond deal, one of the year's largest, which was sized at $40 billion, used to finance the acquisition of Aetna.
As supply continued to increase and volatility in the equity market rose, investor enthusiasm for new issuance weakened and yields rose. Issuance may fall again as corporations finish up positioning their balance sheets post-tax reform. As such, we think we are at a point where we should buy the dip in investment grade and the PAI is a great vehicle to do so.
We also think the long-end of the curve may have made most of the move it is going to make this cycle. Our apex target for it over the next 12 months is 3.25% to 3.50%. Even PIMCO noted at a recent luncheon we attended that at 3.50%, the 10-year would be a "screaming buy" and that they would be "big buyers" at that level.
A chart that we follow closely is the ratio of copper-to-gold verses the 10-year yield. The two metrics have diverged recently which may mean the 10-year falls back to the 2.80% area.
High yield has outperformed investment grade, but we think the risks are rising to these issuers. Balance sheets are more levered today than they were in 2007, prior to the election. Relative to high yield, investment grade has been underperforming.
(Source: The Daily Shot)
Bond investors must weigh to primary risks: interest rate risk and credit risk (we are ignoring reinvestment risks and others). The former is influenced by rising rates reducing the value of existing, lower yielding bonds. The latter is the risk that the company issuing the debt goes bankrupt and you do not receive 100% of your principal back.
Right now, investors are shunning interest rate risks for fear of much higher rates. But it is those positions that have interest rate sensitivity that provide downside protection for when the markets decline. We believe most investors today are far too overweight credit at the expense of duration (interest rate sensitive holding).
The Bottom Line
As we noted above, we think the long-end of the curve has made as much as 75% of the move higher since the post-Brexit lows. In addition, spreads are starting to look attractive here as well. This is a relatively safe closed-end fund with a 5% yield. While the discount has already closed a few hundred bps, we still think the fund is compelling.
For those investors who want to buy individual corporate bonds, this may be a better option giving you professional management and the potential for capital gains on top.
Our members did well on this opportunity in a very short amount of time. While we are not traders, opportunistically adding solid funds with a good macro thesis can add significant value to the portfolio. If you want to be a part of this vibrant, and we believe, most intelligent investing community, consider joining this unique marketplace service.
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