FSD - ACP: Strong Sell Despite 17% Distribution Rate

2024-01-03 07:42:35 ET

Summary

• The abrdn Income Credit Strategies Fund has a high distribution rate of over 17%, but it is not fully covered by income generated from the fund.
• ACP charges a high management fee and has a history of risk-adjusted underperformance.
• The fund's current 3.3% discount to NAV is not attractive relative to historical norms and other CEF discounts.
• ACP's pending acquisition of the First Trust High Inc Long/Short Fund represents another negative catalyst.
• I am initiating ACP with a strong sell and believe investors should favor other lower fee global high-yield products.

The abrdn Income Credit Strategies Fund (ACP) has an eye-popping distribution rate of over 17%. However, despite providing a high level of current income, I believe this closed-end fund ("CEF") is a strong sell.

ACP charges an extremely high management fee and has a long history of risk-adjusted underperformance, which I expect to continue going forward. Moreover, despite the fact that most CEFs are trading at historically wide discounts to NAV ACP is trading at a very small discount to NAV.

ACP's pending acquisition of the First Trust High Inc Long/Short Fund (FSD) represents another near-term negative catalyst.

For these reasons, I am initiating ACP with a strong sell and believe investors will do better in other high-yield product offerings.

Understanding The 17% Distribution Rate

ACP's 17% distribution rate does not appear to be fully covered by income generated from the fund. Rather, a significant part of ACP's distribution is funded through a return of capital.

For the fiscal year ended October 31, 2023, ACP paid out total distributions of $51.6 million or $1.20 per share. $0.48 of the $1.20 per share was a return on capital, while the remaining $0.72 was net investment income. Thus, the distribution rate based on net investment income only is ~10.6% which is still fairly high.

A comparable passive ETF such as the iShares US & Intl High Yield Corp Bond ETF (GHYG) has an average yield to maturity of 7.1%.

Another way in which ACP is able to boost its distribution relative to funds such as GHYG is through the use of leverage. Currently, ACP has a leverage ratio of ~43%.

High Expense Ratio Is a Negative

ACP charges a management fee of 1.89% and has other expenses of 0.50%. Prior to the fee waiver, which is currently 0.15%, ACP has a total expense ratio excluding the cost of leverage of 2.39%. After the fee waiver, ACP has a total expense ratio excluding the cost of leverage of 2.24%.

Simply put, this is a very high total expense ratio. For context, the average expense ratio for bond mutual funds is 0.37%. Given the fact that ACP invests in both US and International high yield bonds, the iShares US & Intl High Yield Corp Bond ETF is a reasonable comparison. This fund charges a total expense ratio of 0.40%.

Expense ratios are particularly important in the high-yield space. According to data compiled by Morningstar, just 28.3% of high-yield funds have outperformed their benchmark over the past 10 years, just 6.5% of the high-yield funds in the highest fee quintile have done so. Comparably, 46.4% of high-yield funds in the lowest fee quintile have outperformed their benchmark. Thus, I believe the level of fee is particularly important in the high-yield space.

For this reason, I view ACP 2.24% total expense ratio as a significant negative.

Weak Historical Risk-Adjusted Performance

As shown by the chart below, despite the significant use of leverage, ACP has failed to outperform its passive peer GHYG over the past 10 years. ACP has delivered a total return of 32.4% over the past 10 years, while GHYG has delivered a total return of 34% over the same time period.

In addition to delivering lower returns than GHYG, ACP has also experienced significantly more volatility. As shown by the chart below, over the past 10 years, ACP has experienced an average 30-day volatility of 15.7%. Comparably, GHYG has experienced an average 30-day volatility of 7.3%. In terms of Sharpe ratios, over the past 10 years, ACP has posted an average 3-year Sharpe ratio of 0.36 while GHYG has posted an average Sharpe of 0.41 over the same time period.

I believe the biggest drivers of weak risk-adjusted performance have been ACP's elevated expense ratio, as well as volatility related to the discount/premium to NAV.

I do not expect these to change going forward, and thus I expect ACP to experience worse risk adjusted performance relative to GHYG going forward.

Discount To NAV Is Not Attractive

Currently, ACP is trading at a 3.3% discount to its NAV. Comparably, ACP's average historical discount to NAV over the past 10 years has been 5.4%. Moreover, other CEFs are currently trading at historic discounts to NAV.

The average CEF discount is currently ~9.2% which is estimated to represent a 93rd percentile cheapness relative to historical norms.

I do not view ACP's 3.3% discount to NAV as attractive in this context.

FSD Acquisition Is A Potential Negative

On October 23, ACP announced that its board had approved a proposed acquisition of the First Trust High Income Long/Short Fund (FSD). Under the terms of the proposed merger, each FSD shareholder will receive ACP shares with a NAV equal to the NAV of FSD.

FSD shareholders must still approve the deal at a meeting targeted for February 2024 while ACP shareholders must approve the issuance of new shares at a meeting set for January 19, 2024.

I believe the deal is a negative for ACP shareholders as historically FSD tended to trade at a much wider discount to NAV than ACP. Currently, FSD has managed assets of $560 million, while ACP has managed assets of $497 million. Thus, FSD is actually the larger of the two funds. For this reason, I would not be surprised to see ACP trade at a discount more in-line with FSD's historical norm. Moreover, I believe a significant portion of current FSD shareholders may decide to sell their stake upon completion of the transaction, as FSD is a fairly different product than ACP.

FSD is a U.S.-focused fund with 85% exposure to U.S. securities, while ACP has just 35% invested in U.S. securities. ACP is a long only strategy, while FSD employs a long/short strategy. FSD also focused on higher quality credits, with 67% of the fund invested in securities rated BB or better. Comparably, just 20% is invested in securities rated BB or better. Finally, ACP's expense ratio of 2.24% is well above FSD's expense ratio of 1.16%.

For these reasons, I suspect ACP may experience significant selling pressure upon the completion of the proposed transaction.

What Would Make Me Less Bearish

One thing that would make me less bearish on ACP is if the discount to NAV were to widen considerably from current levels. A larger discount would allow investors to potentially offset some negatives due to the high expense ratio. Moreover, a large discount has the potential to attract CEF activists, who may push the fund to take action to close such a discount. I would view a discount of 10% as a level at which I would consider upgrading my rating on ACP to sell from strong sell.

Another thing that would make me more bullish is if ACP were to substantially lower its expense ratio. A total expense ratio more in line with GHYG's 0.40% total expense ratio would strike me as much more reasonable than the current 2.24%.

Conclusion

At first glance, ACP may seem like an attractive investment opportunity based on its massive 17% distribution yield. However, a deep dive into the fund suggests that much of this distribution is funded by a return of capital and the use of leverage.

Historically, ACP has performed poorly on a risk-adjusted basis vs. comparably lower fee products.

ACP's very high expense ratio of 2.24% is a significant negative as investors have many lower fee alternatives to choose from. The level of fees appears to be particularly important in the high-yield market segment, given the fact that low-fee active high-yield products have experienced a better chance of outperforming their benchmarks than high fee active high yield products.

ACP's 3.3% discount to NAV is not attractive relative to its own historical norm or CEFs more broadly.

The proposed transaction for ACP to acquire FSD has the potential to lead to significant selling pressure, which may result in a widening discount to NAV compared to current levels.

For these reasons, I rate ACP a strong sell and believe investors should consider other products to get exposure to global high-yield bonds.

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