Yield to Worst

FINS: Why this premium 8% yield CEF is now a good choice

Darren415

This article was first published to Systematic Income subscribers and free trials on September 6.

The income market has been affected by two major trends this year: rising interest rates and widening credit spreads. These two the trends align very well with higher quality floating rate assets, which has led them to outperform this year. One of the few FECs that specializes in these assets is the term income trust Angel Oak Financial Strategies (New York stock market :New York stock market :FINS) which has outperformed almost all other credit CEFs this year.

The key takeaway is that the fund aligns very well with the two main market trends this year, which could easily continue beyond 2022 into next year. Additionally, the fund is trading at a double-digit discount and its recent distribution cut has both adjusted its distribution and moved its valuation to an attractive level. The decline also masks the fact that the fund’s net income profile has actually strengthened significantly this year and will continue to improve over the medium term due to a sharp rise in short-term rates.

A Look at FINS

FINS allocates mainly to floating rate bank debt.

The fund has a number of attractive characteristics in the current market environment. First of all, he mainly investment grade allocation profile.

angel oak

angel oak

Two, he mostly variable rate allocation profile. About 2/3 of the portfolio is made up of floating rate bonds – an extract is shown below.

Filing with the SEC

Filing with the SEC

Three is the responsibility profile is essentially fixed. Specifically, he has $54 million in repos and $85 million in fixed-rate bonds. More interestingly, the bonds are both relatively long (2026, 2028 maturities) and have very low interest rates. For example, the 5-year Treasury yield is currently 3.43%, while the weighted average interest rate on FINS bonds is only 2.6%. The fund masterfully timed the issuance of these bonds at historically low corporate bond yields.

angel oak

angel oak

Four, he held up very well this year with a total net asset value return of -5.9%. This comes against the backdrop of an investment-grade CEF sector total net asset value return of -13%. Its performance is better than nearly all credit CEFs due to the combination of a modest duration profile (due to floating rate holdings) and higher quality allocation.

Five, FINS has recently cut its distribution by 12%. This may not seem like a great outcome for some investors. However, its previous NAV distribution rate north of 9% was unsustainable and required resizing. After the cut, the cast is on a much stronger footing and removes the immediate need for new cuts.

Sixth, the fund has a the structure of the term, meaning it has an expected termination date which, in this case, is 2032 (which can be extended by 18 months). A termination date is not a guarantee that the fund will be terminated. That said, for funds trading at attractive discounts, it offers a positively asymmetric profile. Upon termination, its discount will drop to zero, creating a performance tailwind. And in case shareholders vote to overturn the termination, his discount shouldn’t be much larger. This is particularly the case for FINS as its discount is already 4% above the industry average while its 3-year total net asset value return is slightly above the industry average. If the fund is closed, it should enjoy a favorable return of 1% per year, as its discount decreases to zero over time. This pull-to-NAV yield, as we call it, is near its all-time high.

CEF Systematic Income Tool

CEF Systematic Income Tool

Seventh, most income investors focus on a given EFC’s current yield as well as its investment income to gauge how much they are earning. The problem is that in most cases, these two metrics are terrible approximations of the fund’s actual yield, which is the weighted average yield to maturity of the fund’s portfolio (or yield at redemption/worst for redeemable bonds).

This issue is much broader than just FINS and is present in all bond funds. Fortunately, some managers like State Street who manage the bond fund (JNK), which we use to illustrate the problem, makes it more obvious. The fund’s average yield at worst is 8.48% while its current yield (ie coupon/price) is only 6.46%. The difference has to do with the positive pull-to-par of the bonds in the portfolio given that the average price is only $87.82.

SSGA

SSGA

We can illustrate how the two yields compare for different bond price levels in the chart below. At a price of $100, the two are equal, however, they diverge as the price of the bond moves away from $100. Bond prices are, overall, below normal these days, meaning that the weighted average yields of the portfolio of bond funds at worst are higher than their current yields. The key point here is that, as bond prices are no longer above normal as they were in 2021, the the pull-to-par headwind turned into a tailwind and the portfolio’s yield at worst is actually higher than the fund’s net investment income would imply. This is a good result for a bond fund like FINS.

Systematic income

Systematic income

Finally, bank loans are the most common bank loans for income investors looking for floating rate assets. However, while rising short-term rates lead to higher loan distributions, they also put significant additional pressure on borrowers in the form of increased interest charges. This is particularly difficult for lower-rated borrowers who make up the bulk of the lending industry. The advantage of a fund like FINS is that because most borrowers are of higher quality (about two full rating levels above the typical loan borrower) rising interest expense is much less of a concern for FINS portfolio borrowers. Obviously, this higher quality profile comes at the expense of yield, but once we adjust for the different levels of expected losses between bank loans and investment grade bonds, the yield differential is not as large as it seems.

Assess the fund’s income profile

Let’s take a look at what the income picture looks like.

Unfortunately, as with most other CEFs, it is not easy to determine what the true underlying performance of the fund is.

Normally, investors use the fund’s distribution as a proxy for its underlying return; however, this is generally a very bad idea.

Other investors do something better, which is to go towards the fund’s income as published in the semi-annual shareholder reports. However, this is a problem for a fund like FINS for two reasons. First, as discussed above, as a bond fund, its investment income will misrepresent its portfolio performance at worst because it ignores pull-to-par. And two, because he mostly holds floating rate bonds, the shareholder reports are hopelessly outdated given how fast short-term rates have moved, i.e. they will underestimate the actual performance of the fund’s portfolio.

To assess the fund’s actual performance, we need to understand the fund’s holdings – in particular, we need to look at its coupon structure and weighted average price. We can get these numbers from the fund’s April holdings report. What we get is that its weighted average coupon is around SOFR/Libor + 3.8% and its weighted average own price is around $98.70, which we conservatively round to $100 for this exercise . Not all holdings are variable rate, but those that are not have relatively high yields, which is a compensating factor.

To assess the performance of the fund’s price portfolio, we show two numbers. The chart on the left shows the fund’s portfolio return on price of 7.33% when the SOFR rises to 3%, which is expected to happen around the time of the Fed hike in September. The chart on the right shows that the fund’s portfolio return on price will increase to around 8.5% when the SOFR is at 4%, which is around where it should peak.

CEF Systematic Income Tool

CEF Systematic Income Tool

These are clearly very attractive levels for most investment grade risk. By contrast, BBB-rated investment grade bonds are now trading at a yield of 5.25%. Higher quality preferred banks are trading around 5-6% yield. This acceleration in performance is a function of the fund’s leverage, its high discount and its relatively low cost of leverage.

The fund’s discount now trades relatively wide relative to its sector, creating an attractive entry point.

CEF Systematic Income Tool

CEF Systematic Income Tool

Take away food

As highlighted above, a fund like FINS now offers a compelling proposition as a top-quality holding in a diversified income portfolio.

However, it comes with some risks, but not of the usual kind. The main risk is missing out in case corporate bond yields fall. In this scenario, longer duration and lower quality assets, such as CEFs of high yield corporate bonds, would outperform FINS.

In our opinion, it is not necessary to consider income distribution as a choice. An income portfolio can happily accommodate high yield corporate bonds as well as high quality floating rate bank debt in which FINS specializes.

The second risk for the fund is that the Fed’s key rate starts falling again after peaking. As the chart below shows, the Fed’s key rate does not tend to stay at its peak for long.

Bloomberg

Bloomberg

The Fed’s Mester, however, recently said, “My current view is that it will be necessary to move the fed funds rate to just above 4% early next year and keep it there. at this level. I don’t expect the Fed to cut fed funds. rate target next year.” This view is most likely widely shared within the Board given the high level and relative stickiness of inflation. It would also be odd if the Fed started cutting rates then even as it continues to reduce its portfolio via its quantitative tightening operations. Overall, we do not expect short-term rates to fall significantly next year, but even if that happens, the decline will likely be much more gradual than the rise.