FTHY - FTHY: 2027 High Yield Term Trust At Big Discount

2023-11-02 12:52:45 ET

Summary

• This Fund primarily holds a portfolio of high yield corporate securities.
• Its yield on price, as well as on NAV are in double digits.
• The fund is set to terminate in 2027 and we review its prospects in light of that.

One can infer the primary characteristic of a typical FIRST TRUST HY OPPORTUNITIES 2027 TERM ( FTHY ) holding, just based on its name. Yes, this closed-end fund holds a portfolio of high yield securities of the corporate kind. It holds both general debt and senior, secured floating rate loans, with a preponderance of the former as of the date of the most recent data published on the fund website.

This fund began operations in June 2020 with the aim to fulfill the current income needs of its investors. When conditions are typical, FTHY invests at least 80% of its assets in securities rated below investment grade (a.k.a., high yield securities). The portfolio also has room for securities that are unrated at the time of purchase, provided that the advisor deems them to be of quality comparable to high yield issuances. As of September 30, FTHY's portfolio was in line with this strategy, with over 90% invested in high yielders.

The fund held close to 215 securities as of the above-noted date, with over 50% of them originating from the media, technology, insurance, and healthcare sectors. On a more granular level, close to 30% of the securities were issued by 10 companies.

FTHY does not necessarily stick to its home country for its portfolio incumbents. CEF Connect was kind enough to provide a geographical breakdown of its corporate bond holdings (81.97%) as of September 30.

With regards to the raison d'etre, FTHY distributes 13 cents on a monthly basis. At the current price of $12.77, this is a mouthwatering 12.21% yield for its unitholders. Since it trades at a discount to its NAV of $14.85, the yield on the NAV is lower at 10.50%, but it is the 12.21% number which will get the salivary glands of the income investor going. The fund distributed more than 14 cents for a few months back in 2021-2022, and while the payout has declined since then, it has solidly held over the 12 cent mark.

Can It Fund This?

The collective yield to maturity and yield to worst of the underlying portfolio are almost identical and very close to what the fund distributes on NAV.

But the fund has expenses (more on that later in this piece), and net of expenses, FTHY actually overdistributes. The effective duration of the portfolio is not exorbitant and is reflective of how much the portfolio value will decline (3.86%) with every 100 basis points rise in interest rates, and vice versa. At this stage of the cycle, we don't really anticipate a whole percentage point increase remaining for interest rates, so the fund investors are exposed to a very modest duration risk.

FTHY started with an end date in mind, and that too is reflected in its name. The intention is to liquidate and distribute the net assets to its unitholders " on or about " August 1, 2027. When around six months are left until the termination date, FTHY has the option to move to cash or short-term high quality investments like U.S. Treasuries. Unlike a couple of ETFs we have covered in the past, iShares iBonds 2024 Term High Yield and Income ETF ( IBHD ) and Invesco BulletShares 2025 High Yield Corporate Bond ETF ( BSJP ), this closed-end fund does not limit itself to securities maturing in the year of termination. The list of current holdings on FTHY's website shows that it holds securities maturing even in 2038. The data on CEF Connect is slightly more dated and is as of September 30, but it gives a fair idea of how the maturities are spread out.

So unlike the two aforementioned ETFs, this one is not a good candidate for inclusion in a bond ladder.

Performance

The fund came into being during the thick of the ZIRP (Zero Interest Rate Policy) days. Borrowing costs were low and the investment returns outshone by a margin. Not to be left behind, FTHY hopped on the leverage party bus and remained blissfully inebriated until 2022.

While overall this investment has been under water since inception, its hefty distribution has kept its unitholders relatively shielded. They, however, would have been better served by holding SPDR Bloomberg High Yield Bond ETF ( JNK ), SPDR Bloomberg Short Term High Yield Bond ETF ( SJNK ) or Invesco Senior Loan ETF ( BKLN ).

Coming back to the expenses of this fund, at last count, FTHY charged 3.05% annually to bring the world of high yield to the doorstep of its investors.

In contrast, JNK and SJNK cost 0.40%, and BKLN costs 0.65%, but being ETFs, they do enjoy economies of scale. In FTHY's case, we can see above that the expense would have been 1.86% (not uncommon for actively managed funds), if not for the year-over-year rising interest expense. The weighted average interest rate for the year ending May 31, 2023, was 4.42%, while the weighted average interest rate at that date was 167 basis points higher at 6.09%. So as of today, this interest expense per dollar of borrowing , is likely to be higher.

Another visual worth noting from the annual report excerpt above, is that the fund has reduced its borrowings considerably (over 43% of net assets in 2022 to 21% in 2023). As CEF Connect shows it below, it is 18.38% of total assets.

The net portfolio has declined since between the May 31 and the end of last month, but the point is that the borrowings are declining and this gets a thumbs up from us. Until June 7, FTHY had access to a $315 million credit facility with interest rate based on SOFR plus 0.80%, and 0.10% in credit spread adjustment. It also paid a 0.30% per annum commitment fee if it drew less than 90% of the amount available. Effective June 7, the facility was reduced to $280 million, but now has a higher interest (SOFR plus 105 basis points) and commitment fee (0.35%). Even if we kept the interest rate at 6.09%, the number it was at on May 31 of this year, the interest expense on the $123 million loan will surpass last year's number of $7 million. We have not even considered the 0.35% in commitment fees for FTHY being below the required level of borrowing (90% of $280 million).

Verdict

FTHY started with a NAV of $20 and it now stands at $14.85. Barring its inception fiscal period, it has been distributing more than it makes and that is glaringly obvious below.

Over a third of the 2023 fiscal year distributions were funded by returning some of the investors' own capital back to them, and the story remains unchanged for the current fiscal year so far.

Now the question here is, where do you see the interest rates closer to 2027, when the fund intends to terminate? Investors betting on lower rates by then, will see reversal of some of the unrealized losses, leading to a rise in the fund NAV. In its commentary , FTHY shows a comparison of the number of its holdings that have defaulted versus the JP Morgan High-Yield Bond Universe since June 2020.

That the high yield market's current default rate remains below the long-term (from March 1999) average default rate of 3.02% is also noted. Of course default is not the only criteria here. It is obvious that the fund has not even kept up with its benchmarks. But we also have far lower leverage today and a discount to NAV that should add some alpha here as it closes over the next four years.

We think all things considered this could do a bit better than JNK but the default cycle in high yield bonds still lies ahead of us. So we continue to emphasize quality over high yields. The expense ratio differential versus ETFs also robs the fund of its NAV discount closing advantage. We rate this a hold and might be interested in it if the discount blows up wider alongside high spreads widening as well.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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