DHY - CIK And DHY: Why These Corporate Bond CEFs Belong In Most Income Portfolios

2023-06-28 11:30:33 ET

Summary

• We highlight our strategy of allocating to a pair of sister High Yield corporate bond CEFs Credit Suisse Asset Management Income Fund, Inc and Credit Suisse High Yield Bond across our portfolios.
• Specifically, allocating to this pair of funds and doing an occasional rotation between them can deliver double-barreled performance via two independent sources of alpha.
• Our lazy-man approach to rotating across these funds has, in effect, more than doubled the yield on offer across these funds.
• The funds themselves continue to perform very well and stand out for their strong absolute and risk-adjusted returns.

This article was first released to Systematic Income subscribers and free trials on June 19.

In this article, we highlight a closed-end fund, or CEF, investment strategy that we use across income portfolios. In short, it relies on holding one of two strong-performing similar funds and rotating between them as their relative valuation changes.

We discuss this strategy in the context of the CEF pair:

• Credit Suisse Asset Management Income Fund, Inc ( CIK )
• Credit Suisse High Yield Bond Fund ( DHY )

The key takeaway here is that a double-barreled strategy of focusing on a couple of very similar quality funds and occasionally rotating between them can generate very strong returns that can convincingly beat average sector exposure.

Quick Fund Snapshots

CIK and DHY are CEFs that allocate primarily to high-yield corporate bonds with a sweet spot rating being single-B. The funds also hold a minority of the portfolio in floating-rate loans and CLOs.

The advantage of this type of portfolio is that it roughly offsets the rise in leverage costs that we have seen since the start of 2022 with the rise in the income received from floating-rate positions. For instance, 2022 net income of CIK was flat to its 2021 level - a good result in a period of falling incomes across most credit CEFs.

CIK and DHY are funds that were originally set up by Credit Suisse Asset Management. As many investors know, Credit Suisse Group AG was taken over by UBS Group AG (UBS), with CS becoming an indirect wholly-owned subsidiary of UBS.

The funds' boards approved an interim advisory agreement which allows CS to continue to provide investment advisory services for up to 150 days until the funds obtain shareholder approval of a new investment advisory agreement. In a recent filing, UBS said that it does not anticipate changes to the funds' investment strategies or portfolio managers and it expects advisory services to be transferred to UBS subject to any approvals.

CIK and DHY have strong track records in the HY CEF sector, so there is some risk that this might change after a new advisory agreement. This is something that bears watching.

Strategy Overview

As highlighted above, there are two aspects to the strategy we discuss in this article. One is to allocate to a strong-performing pair of funds. This is because rotating between underperforming pairs of funds is less compelling since whatever additional return is produced by the rotation, i.e., alpha is likely to be given away by underperformance, i.e., beta. In the context of our strategy, even if there are no rotations to take advantage of, investors can be comfortable knowing they are allocated to a quality fund.

The second aspect of the strategy is the rotation. This part of the strategy is not essential as many investors would rather set a buy-and-hold position. However, as we discuss below, this strategy is also not one that requires a big commitment. For instance, in our portfolios we have only made 3-4 changes (depending on the portfolio) over 18 months. Even this small amount of active management allowed us to, in effect, double the yield over a buy-and-hold position.

Overall, this double-barreled aspect of strong performance and opportunistic rotation can significantly boost the return of either one of the funds. It can also significantly outperform the broader sector as we show below.

CIK/DHY Case Study

In this section, we highlight how we have made use of this pair of funds in our investment strategy.

First, the two funds are historic sector outperformers. Over the last 5 year, CIK is the top-performing fund in the High Yield Corporate Bond Sector and DHY is not far behind. The two funds also boast some of the best risk-adjusted returns as well as consistently strong returns.

Two, the funds are fairly similar to each other, though not as similar as many other sister funds. Their 3-month rolling total NAV return correlation typically stays above 60%.

And their total NAV returns have tracked each other well over the last 3 years. The reason CIK has slowly pulled ahead is due to its lower management fee.

Until about 2020, the discount differential traded typically between zero and -10%, i.e., DHY used to trade at a richer valuation. Since around 2020, CIK has moved out to a richer valuation. This makes a lot more sense in our view given its lower management fee, something we have highlighted over the years, so we expect this to continue going forward.

Strategy Results

We have used this strategy in our Core Income and High Income Portfolios.

In the Core Income Portfolio, we made two trades after the initial allocation to DHY, one to CIK in April of this year and another back to DHY in June (there is a small orange dot at the end of the line below indicating a rotation back to DHY).

This shows the same timeline but in terms of the discount differential. Specifically, we held DHY from 2022 to April 2023 when we rotated to CIK when the discount differential fell to less than 2.5% (i.e., CIK traded at a discount around 2.5% tighter than DHY). We then rotated back to DHY when CIK moved out to trade at a premium 16% higher than DHY.

The chart below shows the performance of CIK, DHY and the rotation strategy in blue with red vertical lines showing the rotations.

Here is another way to view the results - the rotation strategy outperforms the best performing fund, i.e., CIK by about 8% since the start of 2022. The absolute total return is not impressive, however, that's entirely due to what's happened to income assets since 2022.

This chart shows the total return since 2022 of all HY CEFs (blue lines) and the return of the strategy. It shows that this simple strategy has outperformed all HY CEFs since 2022.

We also pursue the same strategy in our High Income Portfolio. However, because that portfolio is more tactical we have done more trades on the pair. As it happens, the result in the High Income Portfolio was slightly worse than that of the Core Income Portfolio. This is because we rotated away from CIK earlier before its valuation increased even further relative to DHY. Overall, the strategy added over 2% over the return of CIK and 8% above the return of DHY in the High Income Portfolio.

Key Challenges

The strategy is not without challenges. One, investors need to be aware of which funds are sufficiently similar that it makes sense to rotate between them. It's certainly possible to rotate between dissimilar funds, however, in that case the strategy will have exposure to different levels and types of risk which will create more return noise.

Our favorite sector to use to illustrate CEF similarity is the preferreds sector, which boasts multiple funds from the same issuers, which happen to have very similar portfolios.

A quick way to gauge fund similarity is to look at the pairwise 1Y total NAV return correlation matrix shown below. Squares that are red show funds that are very similar, and vice-versa. If we read across the first row, for example, we see that DFP is highly related to (FFC), (FLC), (PFD), and (PFO) - no surprise, since all 5 funds are run by Flaherty.

Not all funds run by the same manager are this similar. For example, many PIMCO Multi-sector funds don't have the same strategy, i.e., (RCS) and (PGP) are very different in their portfolios from (PTY) and (PDI).

Another challenge is that tracking opportunities can be difficult as it requires gauging both the discount differential between two funds as well as knowing when it's out of line with the historic average. The chart below shows the discount differential between FFC and FLC, which mostly stays between 7.5% and -2.5% (i.e., FFC tends to trade at a higher valuation than FLC due to its lower management fee). The fact that the discount differential is mean-reverting can give investors confidence in the rotations.

Finally, there are operational challenges, such as executing the rotations which can take some time and may be tricky for less liquid funds. There are also potential capital gains consequences in taxable accounts.

Takeaways

Our key takeaway here is that a strategy of focusing on a pair of quality funds and doing an occasional rotation can provide double-barreled performance for income investors, generating returns well in excess of the best funds in the sector. And although there are some challenges executing this strategy, they are not insuperable for most investors. For this reason, we consider the pair of CIK and DHY as strong contenders in all but the most defensive income portfolios.

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