“It Was the Best of Times, It Was the Worst of Times”[i]

A Tale of Two Cities offers a good description of 2016’s capital markets.  Stocks began January by recording their worst start of any year in history.  By February 11th the Dow and S&P 500 had fallen over 11% while the Nasdaq and Russell were each down over 16%.
From those dark times, stocks have rebounded.  In fact, the major averages have surged around 10% from the February lows and have recorded three consecutive weekly gains. Indeed, in 2016’s nine weeks, Wall Street has experienced both the ‘worst of times’ as well as some care free trading.
Now, investors are facing the debate of whether the February bottom is the end of the selling versus the view that the rally will fade and markets will retreat again.  Bulls point to continued strong employment data (last week’s report estimated that 242,000 jobs were added in February well above the 192,000 forecast).  This helped calm fears over the U.S. economy slipping into a recession which was one of the main worries in January.
The bears contend that the three-week bounce is just a counter-trend move and that prices will ultimately drop to fresh lows.  They maintain that central bank policy (negative interest rates, QE, etc.), China’s economy, and the collapse of commodities (especially crude oil) will have negative economic influences which will eventually result in lower equity prices.
After this year’s selling and then buying, here is where the averages closed last week.
2016YTD                                        
Dow Jones Industrial Average  -2.4%
S&P 500                                    -2.2%
Nasdaq Composite                    -5.8%
Russell 2000                              -4.7%
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
“It Was the Age of Wisdom, It Was the Age of Foolishness”[i]
This market environment is making both investors and traders feel frustrated and foolish.  One month Armageddon is at hand while the next month markets believe that central banks will cure all of mankind’s problems.  Indeed, no matter your time frame or investment mentality, it’s hard to find suitable investments ideas.
With the belief that markets trade to extreme levels (both higher and lower), one strategy is to look among oversold and beat up areas of the market.  After the start to 2016, this shopping list is long.  One option worth considering is the high-yield sector of the bond market.  This portion of fixed income was especially hurt in 2015 because of the worries surrounding energy company bonds.  Further, other non-energy issues within high-yield were sold over recession concerns.  Maybe this is a case of the baby being thrown out with the bath water and the selling was overdone.
First, some review is in order.  High-yield bonds are debt securities issued by companies with credit ratings of BB and lower.  In general, these securities offer higher returns in the form of interest payments.  However, the issuing companies’ financial condition is below that of a blue chip organization.
Now let’s turn to some ways of investing in high yield bonds.  Many readers might not be familiar with closed end funds but they offer a structure that would help in gaining exposure to high-yield bonds.  Closed end funds offer some advantages (and disadvantages) over the more familiar conventional mutual funds.
A closed end fund is an investment security that invests in a variety of other things such as stocks and bonds.  In this way, a closed end fund is like a mutual fund – it is a portfolio of stocks, bonds, commodities, currencies, or a mix of the above.  Like the more popular mutual fund (open ended), a closed end fund calculates the NAV or net asset valued.  The difference is that an open ended mutual fund trades at that NAV which is computed after the market close.  A closed end fund trades throughout the day during market hours and often trades at values that greatly differ with the NAV.
A closed end fund sells shares at an IPO and uses that capital to invest. On the other hand, a mutual fund buys and sell shares daily based on investor demand and the share count is continually increasing and decreasing but always at the NAV.
Another important difference is that closed end funds typically use leverage.  This is something that traditional mutual funds don’t do.  The leverage that closed end funds apply is often in the form of preferred shares or repurchase agreements. This additional capital is used to buy more assets in the fund’s strategy.   The intention is to create a positive difference between the fund’s longer term return and the cost of the leverage.  The result is that closed end funds have a higher cost structure but can provide enhanced returns when the strategy is executed properly.
Closed end funds, like mutual funds, can focus on a market sector, industry, geographic region, and various asset classes.  For example, there are closed end funds that cover technology, banking or energy.  Municipal bonds are a popular area for closed end funds and there are several choices from individual states to nation-wide funds.  Staying within fixed income, different approaches include Treasury, corporate (investment grade as well as high-yield), and international sovereign (developed together with emerging market).
Within the equity universe, closed end funds have similar broad ranging options.  From domestic large-cap to international small-cap and everything in between, there is a large assortment of approaches.  There are generic growth and income as well as a variety of value styles.  You can even choose country specific funds such as China, Japan, Germany, India, China, Korea, Taiwan, Turkey, or even Mexico.
Also, it is important to recognize that some well know investment companies offer closed end products.  Nuveen, Blackrock, Eaton Vance, John Hancock, Morgan Stanley, JP Morgan, to name a few of the fund sponsors.

It Was the Epoch of Belief, It Was the Epoch of Incredulity”[ii]
Returning to our high-yield theme, we think the closed end funds offer some attractive ways to invest in this part of the bond market.  Before getting into some specifics, let’s review these bonds’ recent performance.
As mentioned above, the high-yield market has been declining since the spring of 2015.  High-yield energy has been the leader in this retreat.  Many exploration and production companies used debt to finance the sizable growth in the drilling industry.  The price declines in crude oil and natural gas are headwinds to these bond issuers’ abilities to service their debt.  Consequently the markets have priced in this additional risk by lowering the bond prices.
In addition, to the energy sector, recession worries also played a role in weakness of high- yield bonds.  As we know, bond prices decline when interest rates move higher.  While this does influence high-yield fixed income, these bonds often trade in the same direction of the stock market.  This is primarily a function of the belief that high-yield bond issuers have an easier time of servicing the debt in a good economy.  Recessions, which are often accompanied by lower stocks prices, make it more challenging for some companies to make interest payments.  Below is a 15-year chart of the Barclay’s U.S. Corporate High- Yield Index and the S&P 500.  While they don’t always move in lockstep there are clear signs of correlation.

This chart clearly shows a divergence since the beginning of 2014.  We would expect this to be resolved – either the S&P 500 declines towards the Barclay’s Index or the high-yield index climbs back to the S&P 500’s level.  Of course, there is the possibility that the correlation has been broken and the divergence widens but 15 years of data would favor convergence.
Below is a table with some specific closed end bond funds.  It gives an overview on four high-yield funds.  Also there is a fifth fund (AllianceBerstein Income Fund) that focuses on Treasuries.  It is included because of some unique recent developments.  Specifically, the closed-end fund (symbol ACG) is being acquired by the AB Income Fund (an AllianceBerstein mutual fund).  This has forced a narrowing of the gap between ACG’s price and its NAV (recently below 2%).  But a 4.9% dividend is available until the deal is closed later this year.
Similarly, The Deutsche High Income Trust recently announced that they are terminating the fund and liquidating the assets.  Upon shareholder approval, it is expected to be completed by November 30, 2016.  This decision was driven by an activist shareholder – Saba Capital Management LP. While the spread between price and net-asset-value has narrowed, it remains approximately 7%.  We would expect this to gradually shrink as the fund begins returning capital to shareholders.  Add this to the 7% dividend yield and you get a pretty compelling total return.
The two Blackstone sponsored funds have a different type of catalyst – since their inception they have a scheduled liquidation.  The Floating Rate Fund (symbol BSL) has to be liquidated and the funds returned to shareholders by 2020.  The Strategic Credit Fund’s has a longer stretch before its liquidation date – 2027.  Notwithstanding other bond market problems, these funds should see their discounts to its net-asset-value contract.

[i] Ibid
[ii] Ibid

[i] “A Tale of Two Cities”, Charles Dickens
“We Were All Going Direct to Heaven, We Were All Going Direct The Other Way”[i]
Charles Dickens’ words seem applicable to our stock market, but provide little help in predicting its future directions.  Investor sentiment has improved from the pessimism of the start of the year.  Some of the worries over systemic issues have been reduced.  Also, U.S. economic growth seems be continuing although at lower levels than previous expansions.
Nevertheless, the challenges facing global economies and markets are not insignificant and its far from clear that the emerging markets contractions and developed countries negative interest rate policies won’t negatively impact our economy.  The bottom line is that there is still a great deal of risk and uncertainty.
In an effort to provide stability and return, closed end funds focusing on the high-yield bond market, might part of the solution.  As explained above, both these bonds and these closed end funds have unique risks that must be considered.  However, recent declines in the price of the bonds as well as the discounts to net-asset-value within the closed end funds offer a margin of safety.  Please contact us with any questions.

[i] “A Tale of Two Cities”, Charles Dickens
Mr. Kerr is an Investment Advisor Representative of advisory services offered through Kildare Asset Management, a Registered Investment Advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks.  The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index.  Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional.
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