DLY - DLY: Declining AUM And Some Risks But Strong Performance

2023-07-18 14:35:32 ET

Summary

• Investors today are in desperate need of income in order to maintain their standard of living in the face of the worst inflation that we have seen in decades.
• DoubleLine Yield Opportunities Fund invests in a portfolio of bonds and then applies a layer of leverage to give it a very high effective yield and provide income to its shareholders.
• The DLY closed-end fund is globally diversified, allowing it to take advantage of different monetary regimes around the world to make high profits.
• The fund's assets under management have been declining for the past eighteen months, which casts some doubt on its ability to sustain the current distribution.
• The fund is trading at a reasonably attractive discount to the net asset value.

There can be little doubt that one of the biggest problems affecting the average American today is the rapidly rising cost of living. Over the past two years, the prices of nearly everything have been rising at the fastest rate that we have seen in more than forty years. This is immediately apparent by looking at the consumer price index, which claims to measure the price of a basket of goods that is regularly purchased by the average consumer. As we can see here, this index has increased at a year-over-year pace that is much higher than the 2% that is considered healthy during every month of the past year:

We can see some improvements here in recent months, but that is somewhat misleading. As I explained in a recent article , these improvements were entirely due to the fact that energy prices are lower than they were at this time last year. When we look at the core consumer price index, which excludes volatile food and energy prices, the year-over-year inflation numbers look much worse:

The fact that this has been going on for about two years now makes the problem even worse because inflation compounds, just like investment returns. Thus, two years of high inflation represents a substantial increase in prices by the end of the second year compared to the starting point. This is the reason why real wage growth has been negative for 26 straight months. The rapid increase in prices has also forced consumers to resort to some unseemly things, such as dumpster diving or pawning their possessions just to obtain the money that is needed to cover their food and utility bills.

As investors, we are certainly not immune to this. After all, we need to eat and have bills to pay. We may also want to enjoy a few luxuries. All of these things cost money and obviously, everything is a lot more expensive than it was just a few short years ago. We have options available to us to get extra money that many people do not though. After all, we have the ability to put our money to work for us to earn an income. One of the best ways to do this is to purchase shares of a closed-end fund aka CEF that specializes in the generation of income. Unfortunately, these funds are not particularly well followed in the financial media and many investment advisors are unfamiliar with them so it can be difficult to obtain the information that we would really like to have to make an informed investment decision. This is a shame because these funds offer a number of advantages over familiar open-ended and exchange-traded funds. In particular, a closed-end fund has the ability to employ certain strategies that allow it to increase the effective yield of its portfolio to levels that are well beyond that of pretty much anything else in the market.

In this article, we will discuss the DoubleLine Yield Opportunities Fund ( DLY ), which is one closed-end fund option that investors can choose from when deciding how to best earn an income from their assets. This fund boasts an impressive 9.79% yield, so it certainly offers an attractive proposition to its investors. The fact that the fund currently trades for less than its intrinsic value helps as well. Let us investigate and see if this fund could be a good choice for your income portfolio today.

About The Fund

According to the fund's webpage , the DoubleLine Yield Opportunities Fund has the objective of providing its investors with a high level of total return. However, it aims to provide its total return primarily through distributions paid directly to the investors. This is not unusual for a closed-end fund. In fact, one of the characteristics of this asset class is that the members of it seek to maintain a relatively stable asset base and pay out all of their investment returns as distributions to the shareholders. This is one of the reasons why these funds have higher yields than most other things in the market.

The fund's objective also makes a lot of sense when we consider that this is a DoubleLine fund. This fund house is fairly well-known for its fixed-income funds. The DoubleLine Yield Opportunities Fund is no exception to this. As we can see here, 96.97% of the fund's portfolio consists of bonds or other debt securities:

As a rule, bonds provide all of their investment return in the form of direct payments to their investors. A bond investor purchases a newly-issued bond at face value, collects a regular coupon payment from the issuer that corresponds to interest on the loan, and then receives the face value back when the bond matures. There are no net capital gains over the life of the bond because bonds have no inherent link to the growth and prosperity of the issuing company. Thus, the bond's yield is the only source of net investment returns.

With that said, the price of bonds in the market does vary with interest rates. This makes it possible to generate some trading profits in addition to the bond's coupon yield by buying and selling bonds prior to maturity. The relationship between bond prices and interest rates is inverse, so when interest rates rise bond prices decline. The reverse is also true.

As everyone reading this is no doubt well aware, the Federal Reserve has been aggressively raising interest rates over the past year in an attempt to reduce the incredibly high inflation in the economy. This is evidenced by looking at the federal funds rate, which is the rate at which the nation's commercial banks lend money to one another on an overnight basis. As we can clearly see here, the effective federal funds rate is at the highest level that we have seen since 2007:

The central bank's rate-hiking regime was very rapid as it took the effective federal funds rate from 0.08% in February 2022 to 5.08% today. That is a 500 basis point increase in sixteen months, which must be one of the most rapid increases in history. Due to the relationship between bond prices and interest rates, this rapid interest rate increase sent bond prices tumbling. We can see this quite clearly by looking at the share price of this fund over the past few years:

As we can see, the price of this fund had been relatively stable from mid-2020 until 2022, when it began to plummet in the first half of the year. This is a direct result of the interest rate hikes that caused the price of the bonds that are held in the fund's portfolio to fall. Fortunately, more recent interest rate increases such as the ones this year have not had a significant effect because the market was expecting them. In fact, the fund is actually up slightly over the past twelve months:

This tells us that the most important thing for the fund's future performance is going to be how close the market's expectations for interest rates match what the Federal Reserve actually does. Currently, the market expects that the Federal Reserve will raise rates at least once and possibly twice more this year. That will almost certainly happen, so the remainder of the year at least will probably not shock the bond market or this fund.

Unfortunately, the market is expecting that the central bank will cut rates next year and there is a very real possibility that this will not happen. As mentioned earlier, the inflation rate outside of energy is still incredibly high. As such, any increase to energy prices will reignite the headline inflation rate numbers and cause the Federal Bank to resume its aggressive rate hikes. There are reasons to believe that this will be the case, including the fact that OPEC+ is showing a willingness to cut production and cause an oil supply shortage globally. Russia's export volume also went down recently, further tightening global supply. As an increase in energy prices will go against the market's expectations for interest rates, that could have a devastating impact on this fund's performance next year and hand some losses to investors buying today.

With that said, the DoubleLine Yield Opportunities Fund is not exclusively limited to investing in American markets. The fund's webpage describes its strategy as follows:

The fund will seek to achieve its investment objective by investing in a portfolio of investments selected for its potential to provide a high level of total return, with an emphasis on current income. The fund may invest in debt securities and other income-producing investments of issuers anywhere in the world, including in emerging markets, and may invest in investments of any credit quality.

The fact that the fund can invest in foreign bonds reduces its exposure to the policies of the Federal Reserve somewhat as most other markets around the world have been less aggressive than the United States in terms of interest rate increases over the past year. It does appear that the fund is taking advantage of this ability somewhat as only 67.77% of its assets are in American fixed-income securities:

This is very nice because of the protection that it provides us against regime risk. Regime risk is the risk that some government or other authority will take an action that has an adverse impact on a company that we are invested in. One example of this is interest rate policy, as the United States has been much more aggressive about raising interest rates than Europe over the past year. The Bank of Japan has yet to raise its benchmark interest rate. Thus, bonds from different nations will deliver different performances. As a case in point, the iShares Core Japan Government Bond ETF is actually up slightly over the past year:

That ETF is not traded on any American exchange, so unfortunately I cannot link to a quote page for it. Here is a link to the web page for that index fund, though. For our purposes here, the takeaway is that the bonds of different countries will perform differently based on the central bank policy of a given country. The fact that the DoubleLine Yield Opportunities Fund has the ability to invest abroad allows it to provide exposure to these different regimes and thus possibly deliver higher performance than a bond fund that is invested solely in American bonds.

For its part, the DoubleLine Yield Opportunities Fund has managed to deliver better performance than the American bond index. We can see that here:

As we can clearly see, the fund managed to substantially outperform the Bloomberg U.S. Aggregate Bond Index over any period that we care to mention. As just discussed though, this is not a perfect comparison since the Bloomberg U.S. Aggregate Bond Index only invests in American bonds while the DoubleLine Yield Opportunities Fund has the ability to invest abroad. It is important to keep in mind that the fund's past performance is no guarantee of future results but the fund's history of outperformance does give us confidence in management's ability to navigate various market environments and deliver superior returns.

Leverage

In the introduction to this article, I stated that closed-end funds such as the DoubleLine Yield Opportunities Fund have the ability to employ certain strategies that can boost the effective yield of the portfolio beyond that of the underlying assets or indeed just about anything else in the market. One of these strategies is the use of leverage. In short, the fund borrows money and then uses that borrowed money to purchase bonds or other income-producing assets. As long as the purchased assets have a higher yield than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, this will usually be the case. However, it is important to note that leverage is much less effective at boosting the fund's effective portfolio yield today with interest rates at 5% than it was two years ago when interest rates were at 0%.

Unfortunately, the use of debt in this fashion is a double-edged sword because leverage boosts both gains and losses. As such, we want to ensure that the fund is not employing too much leverage since that would expose us to too much risk. I generally like a fund's leverage to be less than a third as a percentage of its assets for this reason. Fortunately, the DoubleLine Yield Opportunities Fund appears to be fulfilling this requirement as its levered assets comprise 20.24% of the portfolio as of the time of writing. Thus, it appears that this fund is striking a reasonable balance between risk and return.

Distribution Analysis

As mentioned earlier in this article, the DoubleLine Yield Opportunities Fund has the stated objective of providing its investors with a high level of total return. However, the fund prioritizes delivering this total return in the form of direct payments to the investors. In order to achieve this objective, the fund purchases bonds and other fixed-income assets that primarily deliver their returns in the form of high yields paid directly to the shareholders. The fund also applies a layer of leverage to artificially boost the yield of its portfolio beyond that of any of the underlying assets. As such, we might assume that the fund would have a very high distribution yield itself.

This is certainly the case, as the DoubleLine Yield Opportunities Fund pays a monthly distribution of $0.1167 per share ($1.4004 per share annually), which gives it a 9.79% yield at the current price. The fund admittedly does not have nearly as long of a history as many other fixed-income closed-end funds, but it has been remarkably consistent with its distribution for as long as it has existed:

There are very few fixed-income funds that boast such consistency with respect to their distributions due to the fact that market interest rates play a significant role in bond returns. For the most part, interest rates are entirely out of the control of any individual fund or manager. The fact that this fund has managed to deliver a remarkably stable distribution over time though is certain to appeal to any investor that is seeking a stable and secure source of income to use to pay their bills or finance their lifestyles.

As is always the case though, it is important that we ensure that the fund can actually afford the distribution that it pays out. After all, we do not want to be the victims of a distribution cut since that would both reduce our incomes and almost certainly cause the fund's share price to collapse. These are things that anyone seeking a high level of income from their portfolio obviously does not want. Thus, we should investigate the fund's finances and determine how well it is covering its distributions.

Fortunately, we have a fairly recent document that we can consult for the purposes of our analysis. The fund's most recent financial report corresponds to the six-month period that ended on March 23, 2023. This is one of the most recent reports currently available for any closed-end fund, which is quite nice to see. This report should give us a good idea of how well the fund handled the challenging market conditions that existed last year as well as the strength in the bond market during the early months of this year. During the six-month period, the DoubleLine Yield Opportunities Fund received $41,561,081 in interest along with $806,636 in dividends from the assets in its portfolio. Overall, this fund reported a total investment income of $42,367,717 during the six-month period. It paid its expenses out of this amount, which left it with $30,075,994 available for the shareholders.

Unfortunately, this was not enough to cover the $33,571,635 that the fund actually paid out in distributions, but it did get fairly close. At first glance, the situation is still concerning, though, as we normally like fixed-income funds to pay all of their distributions out of net investment income.

However, a fund like this does have other methods through which it can obtain the money that is needed to cover the distributions. For example, it might be able to earn capital gains by trading bonds that could be paid out. The fund, unfortunately, failed at this task during the period. It reported net realized losses of $14,741,558 but this was partially offset by net unrealized gains of $11,510,376 during the period. Overall, the fund's assets went down by $6,726,823 after accounting for all inflows and outflows, which comes on the heels of a $239,560,596 asset decline during the full-year period that ended on September 30, 2022. This fund thus has suffered at least eighteen months of steadily declining net asset value. That is not a sustainable situation for the fund and we certainly have some reasons to be concerned here.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. In the case of a closed-end fund like the DoubleLine Yield Opportunities Fund, the usual way to value it is by looking at the fund's net asset value. The net asset value of a fund is the total current market value of all the fund's assets minus any outstanding debt. This is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can acquire them at a price that is less than the net asset value. This is because such a scenario implies that we are obtaining the fund's assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of July 17, 2023 (the most recent date for which data is available as of the time of writing), the DoubleLine Yield Opportunities Fund had a net asset value of $15.21 per share but the shares only traded for $14.29 each. This gives the fund's shares a 6.05% discount to the net asset value at the current price. That is quite a bit better than the 3.97% discount that the shares have traded at on average over the past month. Thus, the price today certainly seems to be reasonable.

Conclusion

In conclusion, investors today are just as desperate for income as everyone else as we all want to maintain our standard of living in the face of the worst inflation that the United States has seen in more than four decades. The DoubleLine Yield Opportunities Fund appears to offer a fairly good way to do that as it boasts a high yield and has consistently beaten the domestic bond index. The foreign exposure here is quite nice too as it allows the fund to take advantage of stronger bond markets abroad.

The biggest concern here is that the DoubleLine Yield Opportunities Fund's asset base has declined for eighteen straight months and there are a lot of doubts that it can maintain its yield. This is almost certain to be true if the Federal Reserve fails to cut rates next year. Thus, it is probably a good idea to be cautious, but someone that is willing to dollar cost average into the fund over the next several months may be reasonably pleased here.

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