BGH CEF: 8.3% low duration CEF efficiency with a margin of safety
This article was first published to Systematic Income Subscribers and Free Trials on March 23
The recent period of strong increases in Treasury yields has clearly delineated the funds most resistant to rising rates of those who are most vulnerable. In this article, we highlight the Barings Global Short Duration High Yield Fund (NYSE: BGH) which trades at a current yield of 8.3% and a discount of 10.2%. The fund has a very low duration profile and has held up well year to date, outperforming most fixed income funds.
BGH is a fund that we’ve highlighted a few times as part of our focus on what we call cross-credit CEFs or funds that have relatively broad mandates to spread between loans, corporate bonds, CLOs and other types of credit securities. As we will see below, the fund has a number of margin of safety characteristics that make it attractive. At the same time, its more cyclical/lower quality profile poses some risks, especially for investors worried about a near-term recession. While not our base case, recent geopolitical tensions, rising energy prices and a flattening yield curve have increased its likelihood.
A quick overview of the fund
BGH is part of the broader Barings umbrella which manages nearly $400 billion in assets and is a subsidiary of MassMutual.
The fund’s asset allocation is split between bonds (secured and unsecured) as well as floating rate instruments such as loans and CLOs.
The fund’s quality allocation is rather low, with three-quarters of the portfolio being allocated to securities rated B and below.
The fund has an unusual sector orientation with a quarter of its holdings in energy and mining.
The duration of the fund is 2.2, which is rather low in the credit universe and is a function of three elements: a significant allocation to floating rate securities, a tilt towards shorter-dated bonds as well as a tilt towards higher coupon bonds (why coupon/yield level affects duration can be visualized here).
One thing we like to do is also calculate a fund’s empirical duration, which measures the true sensitivity of the fund’s net asset value to interest rates over the past year. As many investors know, two funds with the same official duration can behave very differently in times of rising interest rates. This is due to the simple fact that 1) credit securities do not always move 1:1 with their duration and 2) there are other drivers of security performance than interest rate sensitivity. Specifically, high yield securities often exhibit more moderate interest rate sensitivity than their profile indicates. On this metric, BGH reports as having a very low empirical duration, in fact, slightly negative, meaning that its net asset value has tended to recover on average when interest rates rise.
The fund has outperformed the CEF time-limited sector across different time horizons in terms of total net asset value. It also outperformed the CEF loan sector and performed on par with the high yield bond sector despite the sector’s longer duration profile.
To get an idea of the fund’s income profile, let’s look at the following chart which shows both the monthly NII per share (blue bars) as well as the fund’s distributions (orange bars).
The chart shows some interesting things.
First, the fund’s most recent payout coverage (as of Dec. 21 report) is comically high at 144%. For credit funds (i.e. covering sectors such as high yield, loans and limited duration), coverage tends to be closer to 80-90%. The fund’s net investment income or NII yield is 10.73% and 12% on price – both exceptionally high in the industry. Recall that although there are funds with double-digit distribution rates, their NII yields are generally significantly lower.
Second, the fund’s income profile fell from a high of $0.163 (per month per share) in June 2018 to a low of $0.132 two years later and recovered mostly to $0.153 as of December 21.
Third, the fund’s distribution was sharply reduced by 30% in 2020 and has remained at the same level since then.
Let’s take a closer look at the fund’s internals to see what drove these numbers.
The fund’s unusually high NII level of return is a function of two key factors. The first is the fund’s lower quality allocation (judging by credit ratings), as highlighted above, which allows the fund to hold holdings with higher yields relative to other funds. And second, the fund tends to favor high coupon bonds. For example, the fund holds $2 million of a 9.63% Ford 2030 bond. the bind was trading at a price of around $140 at the end of the year when the fund’s last shareholder report was filed, which translates to a yield to maturity of around 3.5% (a figure which includes the pull-to-par or capital loss of -$40 over 8 years); however, the yield on the bond as it appears in the fund’s income statement is 6.9% (which is simply 9.63% / 140%).
This dynamic is one we’ve been discussing to the hilt, which is why we like to distinguish between CEF payout rates, NII returns, and portfolio returns. Unfortunately, achieving portfolio returns is notoriously difficult and requires a few tricks; however, it provides a much clearer representation of a fund’s sustainable ability to generate value. Many investors who rely solely on payout rates or who think they are going “beyond” by considering NII returns as well are surprised when total credit fund returns do not measure up to these numbers.
This does not mean that funds with high NII returns and a negative pull-to-par cannot be invested. It just means that investors should be aware that a fund like BGH with a NAV NII yield of 10.7% generates sustainable value closer to a 7-8% figure.
Let’s move on to the decline in the fund’s NII in 2020. The explanation for this is the fact that the fund deleveraged, reducing its borrowing by 40%. Since then, it has reduced its borrowing by 45% although it remains somewhat below the pre-COVID level. The fund reduced its borrowing in the second half of 2021 by around 12% (dropping its leverage from 30 to 27.5%), which in retrospect was a good move. Credit valuations were obviously expensive, so a reduction in exposure is a sign of decent discipline from fund managers and helped preserve net asset value during the recent rally in yields.
An important question is how the recent hike in short-term rates and an expected Fed hike path will affect fund earnings. The short answer here is that it won’t matter much. Indeed, the fund retains approximately the same number of floating rate securities as floating rate liabilities.
The fund continues to trade at a deeper discount to the time-limited sector – the current differential of around 2.5% is close to a 5-year high, i.e. the fund remains inexpensive compared to its sector.
We get a similar picture if we compare the fund to the high yield loan and bond sectors with a discount differential of around 5%, i.e. BGH is trading 5% cheaper per relative to these sectors despite similar historical total net asset value returns.
Take away food
BGH has a number of obvious risks that are important to keep in mind. Firstly, its lower quality/more cyclical allocation makes it more vulnerable in a “typical” recession where one would expect a sharp rise in the number of corporate defaults. A stagflationary environment could suit the fund given its focus on energy and materials, particularly if these sectors continue to benefit from rising prices as they have over the past year.
Second, even in the absence of a recession, the fund’s lower quality profile could lead to further deleveraging in times of excessive volatility. It should be noted, however, that deleveraging is not something that can be avoided, even by funds with higher quality holdings (like Nuveen’s preferred funds that hold securities issued by higher quality entities) or those who are perceived as the “best-in”. -class” such as PIMCO funds. A recent discretionary decline in fund borrowing, relatively modest leverage and outperformance this year show that fund managers are not rushing for closes and are aware of the high level of risk of the fund.
At the same time, BGH offers a number of attractive features for investors. Its lower quality allocation may be an asset in a barbell portfolio where a smaller portion of an income portfolio should be dedicated to higher risk assets and a larger portfolio may be dedicated to higher quality or risky assets. dry powder.
Separately, the fund’s low duration and broad ability to generate alpha are attractive, as are its high level of distribution coverage and large haircut, providing a double margin of safety for investors.