HYB: Retain high yield CEF for DRIP (downgrade)

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We recently covered the New America High Income Fund (New York Stock Exchange: HYB), a CEF that we have been holding in our portfolio for about six months. In our last article, we wrote about the very significant net discount that CEF offers Asset value and attractive entry point offered. CEF has risen since our rating:

As high risk-free rates continue and high yield spreads are compressed, we will revisit HYB and highlight why CEF no longer offers an attractive entry point. Furthermore, we will explain why this name is considered a “contract” and the profits are deposited in the fund.

The discount has narrowed

One structural feature that was mispriced the last time we covered this name was the discount to net asset value. behind In December 2023, we wrote:

We can see from the chart above from YCharts that CEF typically sees its discount in the range of -10% to -12% in a normal price environment, with fluctuations as prices move up or down. In the 2020/2021 zero interest rate environment, the fund even traded at a premium to NAV (it was overpriced at that level). Currently, it is below the discount rate from an NAV perspective.

The discount has now narrowed to its historical range and is currently -10%:

We do not expect further tightening here until the Fed actually starts cutting interest rates. The reason behind this statement is that the Fund’s leverage is at a variable interest rate, thus hampering the performance of the Central Monetary Fund in a high interest rate environment.

The high cost of leverage reduced profits

When an investor buys a CEF, he is buying a leveraged structure that should yield more than non-leveraged funds. However, HYB was severely hampered by its financing with a variable interest rate:

As the fund rotated new holdings and the cost of funds based on the higher rates came into full effect, we saw a significant deterioration in its dividend yields. Currently, CEF has roughly the same price as the SPDR Bloomberg High Yield Bond ETF (JNK) at 6.7%. This is too low for a leverage structure in our opinion. While we are happy to stay here, we will not buy any more at today’s levels.

As a reminder, the Fund has bank facilities at SOFR + 100 basis points:

Until the SOFR declines significantly, the fund will have difficulty achieving a significant net interest margin given its conservative portfolio construction.

What is the downside of this CEF?

We initially liked HYB because the fund has been in the market for a long time and has a conservative credit risk structure. Let’s take a look at how the name will fare from a draw perspective in 2022/2023:

During 2022, when interest rates and credit spreads rose, CEF had a drawdown of -30% from a price perspective, versus just -13% for unleveraged JNK. It is interesting to note CEF’s performance during the October/November 2023 market risk avoidance event:

Because interest rates were already high, the fund suffered not only from widening credit spreads, but had a drawdown similar to unleveraged JNK, all while KIO had a much larger drawdown. We plan for a -10% drawdown on CEF during the next extreme risk off event, based on its historical performance in a rising interest rate environment. The fund’s risk metrics also support this view, with the 3-year standard deviation at 12.5%.

The portfolio is still conservative

The fund has a high proportion of “BB/Ba” names:

“BB” names (or “Ba” names in Moody’s nomenclature) are better rated for high-yield credits and represent a lower probability of default. The fund has a 32% portfolio of BB names, and it also contains some investment-grade bonds.

From a sector perspective, the CEF focuses on a sector whose leverage has shrunk significantly in the past three years, and is now seeing debt/EBITDA metrics at 1.5 times on average:

We are talking here about energy, which makes up 13.3% of this fund. We like ‘Energy’ as a sector for debt holders, as the majority of companies in this space recognize the importance of having a healthy balance sheet.

What you should expect from HYB moving forward

CEF will not be able to get an exciting dividend yield until risk-free rates fall, so we expect an approximate dividend yield of 7% here. Moreover, the “soft” narrowing of the discount to NAV has already occurred, with the CEF now in the middle of its historical range. The discount will only narrow when prices are lower. We saw this clearly in 2020/2021 when CEF traded flat versus NAV in a low interest rate environment.

From a risk/drawdown perspective, the fund will only experience a widening of credit spreads in the future (a macro view on peak rates on our part). Given the conservative construction of the portfolio, we expect an approximate drawdown of -10% here in a risk-free environment.

So HYB is an unexciting CEF going forward, and will only become attractive when the Fed starts cutting interest rates or the discount to NAV widens again to no avail.

Conclusion

HYB is a closed-end fixed income fund. The vehicle has been in the market for a long time and runs a conservative portfolio with a leverage ratio of 30% at the top. The Central Monetary Fund faced difficulties due to high risk-free rates, as it obtained leverage through bank facilities priced on a SOFR basis. In our last article, we admired the fund’s entry point based on a very large discount to NAV, a discount that has now narrowed to its historical range. As long-term interest rates rise, CEF has seen its net interest margin narrow, with its dividend yield now standing at just 6.7%. We no longer find current rates attractive and believe the Fund will not make any significant progress until the Fed begins lowering interest rates. We own the name and hold it at current price levels.