BGH - A Fund That Checks All Our Boxes
Summary
We continue to discuss funds that are showing strong NAV momentum and trade at a wider than the sector discounts plus have higher yields.
Barings Short Duration High Yield (BGH) is just one of those funds. The NAV momentum is fantastic. The yield is still much better than the HY sector avg.
The yield is safe given the strong coverage ratio and large UNII balance.
But beware, the portfolio is junky with a large amount of CCC rated debt. I call CCC "equity-lite" because it moves a lot with stocks.
(This report was issued to members of Yield Hunting on May 11. All data herein is from that date. Since this report, the discount has closed by 0.5% and the price is relatively flat.)
We continue to discuss funds that are showing strong NAV momentum and trade at a wider than the sector discounts while also having a higher-than average yield. Barings Short Duration High Yield (BGH) is just one of those funds. The NAV momentum is fantastic. The yield is still much better than the average taxable bond CEF at 7.7% and the discount is still relative wide compared to the taxable space as a whole at -6.7%.
The distribution has not changed in more than a year paying $0.1056. For those looking for a place to allocate capital, this is one we would have no hesitation to buy today. But there are caveats. Read on!
The Fund's Investment Strategy
The investment mandate of the fund focuses on purchasing North American and Western European non-investment grade company credits. The fund has the flexibility to shift the geographic weighting better opportunities.
The prospectus and annual report lays out the investment parameters:
The Fund seeks to take advantage of inefficiencies between geographies, primarily the North American and Western European high yield bond and loan markets and within capital structures between bonds and loans. Under normal market conditions, the Fund will invest at least 80% of its Managed Assets in bonds, loans and other income-producing instruments that are, at the time of purchase, rated below investment grade (below Baa3 by Moody’s Investors Service, Inc. (“Moody’s”) or below BBB- by either Standard & Poor’s Global Ratings, a division of the McGraw-Hill Company, Inc. (“S&P”) or Fitch Ratings, Inc. (Fitch), or unrated but judged by the Adviser or Sub-Adviser to be of comparable quality).
The Fund will seek to maintain a weighted average portfolio duration of 3 years or less and the Fund may invest up to 50% of its Managed Assets in bonds and loans issued by foreign companies.
Characteristics:
Total assets: $531mm
Leverage: 29.5%
Avg Daily Volume: 70K shares
Avg Daily $ Volume: $975k
Distribution Payment per share: $0.1056
Distribution yield: 7.7%
Duration: 2.2 years
Number of holdings: 159
The Portfolio
This is a junky portfolio. Let me say that again: This is a junky portfolio.
Just over half of the portfolio is in senior UNSECURED bonds with 24% in senior secured bonds and the rest of the portfolio from loans and even some equity holdings. But more importantly, the credit quality should be framed. The portfolio continues nearly 40% what is CCC (equivalent) debt with another 40% in single B. Just 20% is in the highest rated non-investment grade category, BB.
(Source: Barings)
See what I mean by junky?
CCC is very speculative debt. In the Financial Crisis, almost half of all CCC rated debt defaulted, the worst in history. Now that was an anomaly and we can see that in later events, the spread or implied default rates were much lower. In the Covid Crisis, the implied default reached over 40% but the current implied default rate is now less than 8% while actual default rates are less than half of that. This implies some potential upside if those defaults do not come to fruition. This is also why prices of lower rated debt continue to rise- the market is banking that the likelihood of default is declining.
(Source: S&P)
Here is some commentary from Pinebridge that I think is helpful to framing the risks in lower rated bonds.
Lower-rated bonds have also tended to suffer much more in slow-growth and recessionary economic environments, as well as during periods of elevated market volatility. For example, in the aftermath of the 2008 financial crisis, the trailing-12-month default rates for CCCs peaked at 51.9%, versus 15.6% for B rated credits and just 3.7% for BB rated credits.2 A similar trend is found in previous economic downturns. And today, as the economy continues to grapple with the ramifications of the Covid-19 crisis, the trailing-12-month default rate for CCCs has reached 42.9%, while B and BB rated credits have maintained defaults at 1.65% and 0.14%, respectively, as of 30 September 2020.3
The other key to their portfolio is the overweight to energy and commodity credits- especially to oil and gas names. That sector accounts for over 15% of the portfolio. Other commodity names account for another 11%.
(Source: Barings)
The fund also has the ability to be tactical in regards to geographic concentration. Right now, just under 80% of the portfolio is invested in the US with another 3% in Canada for total North American exposure of 83%. The rest is a combination of Western Europe and some names in Africa (mostly related to mining companies).
The Distribution and NAV
The yield looks fairly secure but the fund is a semi-annual reporter. The last report was from the end of 2020 where they reported 127% coverage and UNII of 30 cents per share. The question for us is not the distribution, that looks solid, but the NAV.
Remember, the NAV encompasses all the information about the value of the underlying assets. The price was down almost 50% in March 2020. But the NAV was also down in line with the S&P 500 at 35%. That makes sense since the fund holds so much in the portfolio of CCC rated debt. I like to call CCC "equity lite" and similar to a lower beta equity fund. But when you add in ~30% leverage the beta closes in on one (meaning it moves in line with stocks).
Today, the NAV is on the move higher and the price is trying to keep up. A lot of the NAV movement lately has been due to rising oil and other energy prices boosting the underlying energy related bond holdings.
Valuation
While the discount is not massively cheap at -6.2%, it is at a massive discount to the sector valuation. The high yield bond CEF sector is now at juts a -1.5% average discount. So a -6.2% discount looks very compelling. Especially when you consider that this distribution is actually covered and not fictional like so many of the funds in the sector.
If we calculate NII yields and discounts into our model, BGH is, by far, the best option in the entire space. In fact, it is the best option across the high yield sector, the loan sector, the limited duration sector, multisector, and mortgages.
We think it could get close to par meaning you could capture as many as 5 or 6 points of discount closure. In the meantime, we are collecting a strong yield plus the uptrending NAV momentum. It's a very compelling opportunity.
Concluding Thoughts
This is one of the best options we have today. I wish I could say it was a low or no-risk option but it is not. Should volatility rise back up, and spreads widen back out, this one is going to see the NAV decline. It will also likely see more sellers rush for the exits meaning that the price would fall faster than the NAV.
Still, for a small allocation, we think BGH should be a part of the portfolio given the cyclical trade exposure you get via mostly energy but also consumer discretionary sectors.
Be careful and be choosy. Don't get over your skis. Allocate some of your risk budget (speculative capital) to it and I think we will be okay. My position size right now is just 1.7% but it has slowly been moving higher.