Yield Hunting Power Rankings Report - January 2019

For those that are familiar with the ESPN NFL Power Rankings which rank the teams from 1-32 based on the opinions of several staff members, then this analysis will be familiar to you. Here we are ranking the entire CEF universe (~580 funds) using several factors and then applying a scoring methodology to it in order to rank the funds.

We will be doing this each month in order to provide a starting point for analysis and due diligence.

What are we looking for here and how are we ranking?

Coverage: > 99%UNII: > 0Yield: Higher is betterDiscount: Lower is betterZ-Score: < -1 (lower is cheaper)

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In aggregate, we had 48 funds meet the screen.

10 Largest Discounts

But where the coverage is above 99%, the shares trade at a discount, and UNII is positive. Sorted by discount ascending.

10 Highest Yields

But where the coverage is above 99%, the shares trade at a discount, and UNII is positive. Sorted by descending yield.

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10 Lowest Z-Scores

But where the coverage is above 99%, the shares trade at a discount, and UNII is positive. Sorted by ascending z-score.

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10 Highest Overall Score

But where the coverage is above 99%, the shares trade at a discount, and UNII is positive. Sorted by descending overall score.

Looking Deeper Into Ares Dynamic Credit

Let's look deeper into the Ares Dynamic Credit Allocation (ARDC). The fund is managed by Ares Management, one of the newest and leading alternative investment managers. ARDC is a product of the merging of two prior funds, ARDC and ARMFT (in 2015).

The fund currently trades at a 14.5% discount after trading over 20% below par not two weeks ago.

The fund pays 9.17% in yield which is well covered by net investment income. ARDC recently filed its latest N-CSR (annual report) which showed continued strong portfolio management and earnings. The objective of the fund is to adjust during differing periods of the interest rate and credit cycles by shifting the allocation across three broad categories: high yield bonds, leveraged loans, and collateralized loan obligations (CLOs).

Currently, the fund is split between bonds and loans and recently increased its allocation to CLOs. This is not materially different than at the end of April. Since then, CLO debt increased from 19.5% to 21.2% with CLO equity rising from 6.72% to 9.84%. Loans declined from ~25% to ~20%.

It's not surprising the reduction in loans as the leveraged loan index climbed for most of the first three quarters of the year amid significant retail demand. ARDC took advantage by reducing its allocation and pressing more into CLOs and bonds.

Essentially, the fund operates by employing a value-based methodology amidst the junk-credit sector. The duration is very low, so interest rate risks are not an issue for it.

In terms of the fundamentals, net investment income (NII) was virtually unchanged in the latest fiscal year compared to the year prior. However, that is where the similarities between the funds end. Realized gains on investments and currencies were $+4M compared to $+1.6M the year before. However, unrealized gains/losses were down $16.8M in 2018 versus a $+18M gain in 2017. So while net assets rose $22M in 2017, it lost $11M in 2018.

NII per share has been very stable and unrealized losses have increased this year, not surprisingly, as spreads have blown out.

Distribution coverage increased to 104.4%, so no distribution cut is likely in the near term. UNII is $0.12, which is highly supportive of the distribution as well.

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Concluding Thoughts

The most recent annual report should satisfy investors in terms of worries about the distribution. The fund made the right moves in the second half of the year by reducing loans. The NAV was still down but ~5% during the fourth quarter, including distributions, but that is not nearly as bad as it could have been.

We believe a bottom is likely in for this fund as it capitulated to over a 20% discount in a relatively short amount of time. Despite the rebound, the current discount is relatively attractive at 14.5% compared to the one-year average of 10.7%. The fund got as tight as 7% this year.

We think the shares are likely to get back to at least 11-12% discount and experience a rising NAV should the leveraged loan space see reduced fund outflows. Floaters rebounded smartly in the last week as they were substantially oversold and LIBOR continues to rise.

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