Looking At 2 High-Yield Options: KIO And IVH

Summary

• These are two options in the high-yield sector that look at least semi attractive at these levels for various reasons.

• These funds are more hybrid funds like ARDC with some allocation to leveraged loans helping to diversify the portfolio.

• The high-yield space, as I've noted several times, is fully valued. But that doesn't mean you avoid it. It simply means you reduce some exposure and be selective.

• While the loan and convertible sectors may be more compelling, there aren't many other areas worth investing in right now. Additionally, HY NAVs are rising nicely.

• KIO is a very well-run fund and could easily be a buy and hold here. IVH is more of a medium-term (6-18 months) purchase with some upside optionality from potential proxy issues.

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High yield, to me, isn't all that attractive. I've been making that case for the last few weeks as credit spreads have come in significantly and now actually sit tighter than they were pre-COVID. A credit spread is a measure of risk as it details how much additional yield a credit bond earns above and beyond the same maturity Treasury rate.

When credit spreads blow out it can be a great buying opportunity. But when spreads are tight (anything less than 4%) then the risk is skewed to the downside. When spreads are less than 4% (currently 3.7%) then you are basically a coupon earner. That means you are unlikely to earn more in total return than the yield on the bond or bond fund (assuming it's a covered yield).

(Please, if you do not understand the above concept, let me know either privately or in the comment section below.)

(Source: FRED)

The problem for investors is that you just don't know when the spreads will blow out. They can stay tight for many years like we saw for a couple of years in 2017-2018. We saw spreads widen significantly in 2015-2016 blowing out to 10%. And then again in 2018 with spreads widening to 5.6%. And then again in March of 2020 with spreads reaching 11%. Those are golden opportunities to invest in high yield fixed-coupon bonds.

So right now I would keep the exposure limited to the best opportunities.

KKR Income Opportunities (KIO)

• Total Assets: $516M

• Leverage: 25.7%

• Management fee: 1.7%

• Daily Shares Traded: 128K

• Discount: -10.3%

• Distribution yield: 8.64%

KIO is a Core Portfolio fund that we added a few months ago as we re-positioned the strategy in only the best options. The fund is not a pure-play high-yield fund, which is one of the reasons we like it. That best comparison would be to Ares Dynamic Credit Allocation (ARDC) which allocates between fixed coupon bonds and leveraged loans.

The portfolio itself is a bit on the junkier end. But that's one of the reasons we like the fund. The higher quality non-investment grade space which is characterized by "fallen angels" (recently former investment grade bonds) and other BB-rated bonds. The BB bond space has been bid up significantly thanks to the Fed buying some of the bonds and ETFs that hold those bonds. There is little to no juice left there.

The CCC space, while getting tighter, is still a juicy overall yield around 7.5%. Given the recovery in the economy and the amount of liquidity sloshing around, plus the end of the lockdowns and restrictions in sight, the prospect for even the shakier companies out there is strong.

Portfolio Detail

The portfolio is currently over 50% loan and 45% fixed coupon high yield bonds.

(Source: KKR)

And by credit quality:

(Source: KKR)

The distribution was cut in November from $0.125 to $0.105 (-16%) and is now well covered. The earnings through 10/31 were very strong with EPS of $0.123. The most recent annual report shows $0.115 per month in earnings per share through 10/31 for the trailing year. Net investment income increased in the last six months though. Thus, we think the distribution is very safe for the next year.

The fund's NAV has been up strongly in the few months. It's the No. 3 fund on the basis of NAV total return. The two funds above it are not apt comparison with one being a convertible fund and the other a fund of funds. In the last year, the NAV is up 11.4% in total return. This handily bests the passive index and the CEF high yield category average.

The valuation is the last thing we need to come together. The discount is wide relative to the historical discount averages likely because of the cut they made in November. That's the opportunity, especially since the net investment income was increased in the last six months. This is a really great scenario. The fund trimmed its distribution but is actually earning more income. So from a total return perspective, the fund should do as well it has done, all else equal, and is trading cheaper.

(Source: CEFConnect)

Concluding Thoughts on KIO

While we're not buying this at a massive relative discount, every bp counts when spreads are tight. The risk on KIO is still skewed to the downside just like the rest of the high-yield CEF and mutual fund complex. But we think KIO is one of the better positioned and managed of the lot. We cannot predict when spreads will blow out and many investors cannot simply wait around cutting off their income supply waiting.

I'm purposely keeping my exposure toward high-yield loans lower given the spread data. Given we can't know when they'll blow out again, we don't want to be fully out of them. Mostly because there really aren't many places to venture at this point that offer any yield or any value. I would rather be in loans right now and even some convertibles but I do think KIO offers a relatively high value in the sector.

Ivy High Income Opportunities (IVH)

• Total Assets: $332M

• Leverage: 26.1%

• Management fee: 1.4%

• Daily Shares Traded: 68K

• Discount: -11.8%

• Distribution yield: 7.81%

IVH is an "orphan" high-yield CEF that we used to have in the Core but sold when the discount tightened a bit and we were de-risking. The fund looks attractive again for a few reasons including a wider discount, a higher relative yield, and strong NAV performance.

The upside optionality comes from Macquarie's Group pending acquisition of Waddell & Reed. Given that, shareholders need to approve their new investment advisory agreement with Macquarie. We have seen this a lot in the last year with Franklin-Templeton buying Legg Mason (Western Asset) (HIX)(EHI)(BWG)(HIO) as well as Morgan Stanley buying Eaton Vance (EVG)(EFT).

The problem is the lack of institutional or activist shareholders in the fund.

Saba appeared in the 9/30 report with 383K shares or just over a 2.3% position. It's not large but it wouldn't surprise me if they are actively buying more.

The Portfolio

Similar to KIO above, this fund is a blend of bonds and loans. The loans give some upside in case rates rise and are also a cheaper area of the non-investment grade market.

Like KIO above, this fund plays a lot in the junkier credits of triple-C land. 36% of the portfolio is in that space with another 3% unrated. 50% of the portfolio is B-rated and 10% BB.

The Distribution

As noted, the distribution was cut twice in the last year for a 15% drop in income. A lot of that had to do with some forced de-leveraging back in March that reduced the earnings power of the fund.

Earnings are now in line with the distribution so we do not expect another cut. In fact, with the strongly rising NAV they could keep the leverage percentage the same and produce more net investment income.

Valuation

The current discount is sitting on the one-year average mostly because of the second cut. Given that, it's one of the few funds with a negative one-year z-score in the high yield space. The NAV is now above the pre-COVID levels despite the de-leveraging.

Concluding Thoughts on IVH

IVH is a decent option in a space that is characterized by expensive funds and tight spreads (expensive bonds). But these two funds are blends of bonds and loans, with the latter being a much more compelling area of the bond market to invest in. The fund also has that upside optionality in the chance that the new investment advisory agreement is NOT enacted.

Takeaways and Conclusions

The high yield sector isn't my favorite. I've laid that out pretty clearly in this report and within morning notes the last couple of months. But to eliminate the asset class isn't a good move simply because there are really not many other places to go and many of you need the income. High-yield spreads can remain tight for years thus to shut off the income spigot entirely for an extended period is not feasible.

Instead, we want to position in the funds we think are best positioned to 1) close the discount creating alpha, 2) those funds that may have small tilts into areas we prefer (loans for example here) with the ability to make judgments to that tilt, and 3) funds that have strong NAV growth not just looking at the yield or discounts of the funds.

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