WDI - DLY: WDI Is A Potentially Better Alternative

2023-10-26 08:01:26 ET

Summary

• DoubleLine Yield Opportunities Fund has had a solid year in terms of total return performance as it rebounded from last year.
• That said, the Western Asset Diversified Income Fund is a potential alternative with a deeper discount and strong distribution coverage.
• At the same time, DLY isn't extremely overvalued, and in recent weeks, the fund's discount has actually widened back out from the ~3% discount the fund was sporting.

Written by Nick Ackerman, co-produced by Stanford Chemist.

DoubleLine Yield Opportunities Fund ( DLY ) has been having quite a solid year in terms of total return performance. Even the fund's total NAV return performance has been fairly solid after rebounding some from last year. That said, the problem is the valuation here leaves it less appealing, and it could be time to go on the hunt for some alternatives to invest in on the back of this discount narrowing. In particular, the Western Asset Diversified Income Fund ( WDI ) is another multi-sector bond fund - quite a different approach- but provides a deeper discount and covers its distribution.

The Basics

• 1-Year Z-score: 0.54
• Discount: -5.70%
• Distribution Yield: 10.08%
• Expense Ratio: 3.38% (including interest expense)
• Leverage: 19.55%
• Managed Assets: $907 million
• Structure: Term (anticipated liquidation date February 25th, 2032)

DLY's investment objective is quite simple: "seek a high level of total return, with an emphasis on current income." To achieve this, the fund will "invest 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 or other income-producing investments of issuers anywhere in the world, including in emerging markets, and may invest in investments of any credit quality."

DLY is a multi-sector fixed-income fund with the flexibility to really invest in just about anything and anywhere and at any time. That flexibility leaves the portfolio managers to invest where they feel capital might be best put to work. While the fund carries a diverse basket of exposure to a wide mixture of assets, they have tended to tilt more into mortgage-backed security exposure in both residential and commercial.

Leverage and Distribution Coverage

The fund is relatively mildly leveraged, and that has come on the back of portfolio deleveraging as they've taken down their borrowings. At the end of the last fiscal year, total outstanding borrowings stood at nearly $226 million. This had dropped down to $185 million at the end of their last semi-annual report, and today, it's around $170 million.

That being said, leverage increases volatility nonetheless and increases the risk of investing in DLY.

Funds have also had to deal with rising interest rates, which have an immediate impact on the costs of borrowing. DLY pays at a rate of "one-month two-day lag secured overnight financing rate ("SOFR") plus 0.10% plus 1.10%."

In the case of DLY, it had taken its expense ratio with the inclusion of interest expenses from 2.60% last fiscal year to 3.38%. The last semi-annual report showed that average interest rates for the borrowings came to 5.43%. At this time, with rates going higher, the borrowing costs have been pushed to over 6%.

Fortunately, they have floating rate exposure and that higher income generation has been able to offset the higher expenses to keep

The downside to this is that DLY was lacking coverage in the form of net investment income coverage previously. Given that NII has been basically flat - while better than what we've seen from some other fixed-income funds - it is still coming in at NII coverage of around 90%. This would be based on the ~$1.40 annualized distribution and the assumed annualized $0.63 figure.

Given the coverage has been pretty flat, I don't suspect the fund would cut the distribution at this time, but it, of course, can never be ruled out.

They've maintained the same $0.1167 monthly distribution since coming to market in 2020. That works out to a distribution rate of 9.66% and around 9.39% on a NAV basis.

Potential Alternative

What makes DLY look less appealing now than when we last covered the fund is the fact that its discount has narrowed. DLY has performed fairly well since I've turned bullish on it. In hindsight, mid-2022 was a bit early, and the later part of 2022 would prove to be the most ideal time to add the fund when looking back.

Still, since our last report in May of this year, the fund has been able to put up some solid total returns. More recently, in the last couple of weeks, the fund has been under heavier pressure, just as all fixed-income investments have been.

Through this time, the fund's discount has narrowed. Just a couple of weeks ago, the discount was cut in half from where it was earlier this year. The fund's discount has been fairly volatile this year overall.

On a YTD basis, we can see what is mostly driving this discount narrowing as well - it comes from the fund's share price rocketing higher while its NAV is performing more modestly. More recently, as rates surged, DLY's NAV did take more of a hit.

With that being said, DLY is looking more pricey these days, even after the recent drop, and that's why an alternative could be a bit more attractive to consider. Though admittedly, the fund hasn't run up to a significant premium or anything, so at the same time, holding isn't the worst idea either.

One alternative that could be worth considering would be WDI, as we noted at the start of the article. This is another multi-sector bond investment closed-end fund and, while not exactly the same, share that characteristic with each other.

Here's a breakdown of how each portfolio is positioned. DLY has a weighting more toward MBS exposure, and WDI slants toward high-yield bonds, but both also incorporate a fairly meaningful weight to both bank loans and collateralized loan obligations.

Bank loans and CLOs, which are pooled bank loans then sold into various tranches with varying degrees of risk, are important considerations because that's where a lot of the floating rate exposure will come from. That's what can drive the underlying income generation in the current rising rate environment.

However, with being at or near peak rates, it is something to consider going forward that if rates are cut, then both funds could see a negative impact. That being said, rates are expected to stay "higher for longer," so that's probably not something to be overly worried about for a year or so. When that happens, underlying fixed-income prices can actually rise anyway to offset that headwind in terms of potentially reduced income generation.

For some context of how sensitive each fund is to interest rate changes, DLY's portfolio duration currently comes in at 3.78 years. Duration for WDI is a bit higher at 5.06 years. This means that for every 1% interest rate change, these funds should experience a 3.78% and 5.06% change in portfolio value, respectively.

Both funds are most heavily invested in junk-rated debt, but DLY does have a slight tilt in more investment-grade quality at around 20% split between investment-grade corporates and agency and government debt. For WDI, they are under an 8% weighting in BBB and above debt.

With that being said and some of the differences being noted, I believe that WDI is a worthwhile alternative due to the strong distribution coverage. The last semi-annual report put NII at $0.86, on pace to grow by over 8% from the prior year. That puts the fund's NII coverage at 102.4% based on the $0.14 monthly distribution. The growing NII WDI has been able to experience relative to DLY has meant the fund has seen several distribution increases as well.

Additionally, the discount for WDI remains deep and had also saw a widening more recently as rates turned higher.

Neither fund has a really long history, but DLY is a bit older than WDI. The funds, being fixed-income, haven't produced remarkable returns either.

However, that was more a function of the overall fixed-income space due to rapidly rising interest rates. Here are the total return performances from when WDI launched, which was arguably at one of the worst times ever.

Investment grade bonds are actually setting up for their third negative year of performance in a row. High yield has performed better as it is generally less interest rate sensitive due to lower maturity and higher yields.

Conclusion

DLY has seen its discount narrow, primarily from the fund's share price performing exceptionally well this year. However, some NAV declines more recently saw the discount narrow further. It isn't at any sort of extreme overvaluation, but considering an alternative could be appropriate. I believe that WDI represents one alternative that is attractive to consider. This would be due to the fund's valuation remaining attractive and distribution coverage remains strong.

Since WDI's launch, the funds have performed similarly on a total NAV return basis, and that is to say, challenged in the current interest rate environment - as we highlight across the whole corporate bond space. On the other hand, it also highlights why they could be a fair swap pair as they correlate closely despite tilting towards various different areas as multi-sector bond funds with plenty of flexibility.

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