HFRO - HFRO Update: Looks Attractive With A 37% Discount And An 11.6% Distribution Yield

2023-11-15 15:33:23 ET

Summary

• Highland Opportunities and Income Fund is a closed-end fund that invests in various asset classes, including real estate, CLOs, equity, and loans.
• HFRO pays an 11.59% distribution and trades at a 37% discount.
• HFRO often has large swings in its discount to NAV, and can be an excellent trading vehicle.
• HFRO is somewhat controversial because many of its underlying assets are not publicly traded.

(Data below is sourced from the Highland Opportunities and Income Fund website unless otherwise stated.)

Fund History

Highland Opportunities and Income Fund ( HFRO ) is an eclectic closed end fund that invests in a diverse set of asset classes: real estate, CLOs, equity, fixed and floating rate loans.

The fund is quite controversial. It was originally an open-end mutual fund that invested in floating rate loans. In 2017, when it appeared that the fund might win a large award from a Credit Suisse law suit, the fund attracted a lot of inflows and management got shareholder approval to convert the open-end mutual fund into a closed-end fund.

The fund now owns a more eclectic set of assets with a large allocation to real estate investments.

Investment Approach

• The primary objective has been to provide a high level of current income, consistent with preservation of capital. But this was changed to include capital growth.
• The fund uses effective leverage of about 15%, but that varies over time based on market conditions.
• Invests at least 25% in assets directly or indirectly secured by real estate.
• Focuses on real estate securities, floating rate securities, secured and unsecured fixed-rate loans and corporate bonds, mezzanine securities, structured products, convertible and preferred securities and equities (public and private)

The investment approach over the last few years has steadily moved away from being a floating-rate bond income fund to much more of a real estate fund. This occurred because management tried to convert HFRO from a closed-end fund format to a REIT format. But shareholders voted against the REIT conversion. In spite of this, the fund management has continued the emphasis on real estate investments, but they are maintaining the closed-end fund format.

The recent performance of HFRO has been mixed, partially because swings in the discount have had a larger effect than the actual NAV performance. But the Highland management has a reasonably good record with some other real estate funds that they run, and I would expect HFRO to perform in line with other real estate investments in similar sectors.

Some Recent Developments Since My Last HFRO Article

Here is a link to my last HFRO article published on May 30, 2023: Highland Income Fund (HFRO): Controversial CEF Has Become More Shareholder-Friendly .

I have been generally bullish on HFRO since the discount went north of 30% several years ago. The expense ratio has dropped considerably over the last three years which is a positive. But I also have learned to so some swing trading with HFRO in IRA retirement accounts. I often add to my position when the stock drops a lot on any given day and the discount increases below the recent average. I often trim some shares on big up days when the discount decreases below the 52 week average.

Some updates since then are listed below:

1) The Fund has continued paying out regular monthly distributions of $0.077, but they have not yet reported any share repurchases. I hope to see some repurchase activity when the next shareholder report comes out.

2) July 13, 2023- The Fund published an update on the Credit Suisse litigation. They reported the reduction in the judgment which actually occurred in February including the following assessment-

" On February 14, 2023, the Dallas Court of Appeals issued a ruling reducing the judgment to an amount that, including offsets for prior settlement proceeds received by the funds, may result in the two funds recovering zero net dollars on the outstanding judgment. The plaintiff will appeal this to the Texas Supreme Court for interpretation of its prior order. "

Source: NexPoint Highland Opportunity & Income Fund ((HFRO)) website

If there are any net proceeds, it would be allocated to two funds based on respective damages (approximately 82% to HFRO and 18% to ( NXDT ) ).

3) November 3, 2023- There was a large drop in the NAV of 5.7%, even though the overall stock market and REIT peers had a big up day. For example, VNQ was up 2.4%.

Most likely there was a downward NAV adjustment in one or more of the private holdings. These large NAV jumps sometimes occur with funds like HFRO because of the large allocation to private non-traded holdings. The estimated NAV for these private holdings may be updated infrequently (say monthly or quarterly), which can cause a big jump.

One Year Discount History for HFRO

Source: CEFConnect

Here is the asset allocation breakdown as of June 30, 2023:

Portfolio Allocation Breakdown

Source: HFRO Fund Fact Sheet Q2 2023

Real estate is the largest allocation category by far. A more detailed summary of the real estate holdings was presented in the second quarter presentation. The largest allocations are to Multifamily, Self Storage, Single family Rentals and Life Sciences with little or no allocation to the troubled retail and commercial office sectors.

Portfolio- Top 10 Exposures (as of June 30, 2023)

I believe that the NAV reported by HFRO management is reasonably accurate, although the valuation of private investments is always problematic and can add uncertainty to the NAV. Keep in mind that the NAV uncertainty can occur in both directions. The NAV could be overstated or understated.

In my estimation, a 20% discount is enough to account for the additional NAV uncertainty. The current 40% discount along with the attractive distribution yield seems more than adequate to account for the added uncertainty.

Trading Opportunities in HFRO

I have owned a core position in HFRO for several years. But because of big swings in its discount to NAV, there are often very good trading opportunities to add shares on a sharp downward move in the price, or to trim shares when the stock bounces up rapidly. Consider this table of price/discounts for the recent period starting from October 12, 2023:

Note that HFRO reached a discount level of 45.45% on October 18, and the discount expanded even further to over 48% on October 26. If you bought HFRO anywhere in this time period, you would be able to trim some shares now at the 37% discount level.

On May 16, 2023 HFRO announced a large $100 million share repurchase program where the Fund can repurchase its stock in open-market transactions over a two year period. This will be highly accretive to NAV if/when the repurchases are actually executed.

There were no share repurchases in the second quarter of 2023. I contacted Investor Relations, and asked them if they would consider providing more frequent updates of their share repurchase activities. This is done by several other closed-end funds. For example, SPE provides monthly updates of their share buyback activity.

They told me that for now, they only plan to provide updates in the annual and semi-annual shareholder reports. Perhaps if other shareholders request more frequent share buyback updates, the Fund's Board will reconsider this policy.

Fund Performance

The NAV performance of HFRO has been good since 2018 on a relative basis compared to its Morningstar Bank Loan fund peers, but it has been lagging somewhat in 2023 on a year-to-date basis. Now that HFRO has morphed into more of a real estate fund, Morningstar should consider a change to the HFRO peer group.

Here is the year-by-year total return performance record since 2018 when the fund converted to the closed-end fund format:

Source: Morningstar

Three Year Annualized Fund Performance

Source: Morningstar as of November 12, 2023

Alpha is Generated by High Discount + High Distributions

When you invest in HFRO, there is potential to capture "alpha" from the high discount and distribution yield.

The distribution rate of 11.59% along with the 37.3% discount allows investors to capture some alpha by recovering a portion of the NAV whenever a distribution is paid out.

When you recover NAV from a fund selling at a 37.3% discount, the percentage gain is 1.00/ 0.627 or about 59.5%. So the alpha generated by the 11.59% distribution is computed as:

(0.1159)*(0.595)=0.0690 or about 6.90% a year in discount alpha.

Note that this is way more than the 1.45% baseline expense ratio, so you essentially have a negative expense ratio of about 5% a year when you own this fund.

Future Potential For Activist Activity

Institutions hold about 36% of the shares.

Here are some opportunistic investors that owned shares in HFRO as of September 30, 2023:

Activist #shares

Thomas J. Herzfeld 2,922,007

Atlas Wealth LLC 879,966

Bulldog Investors, LLP 351,923

Matisse Capital 170,000

Source: nasdaq.com

It is worth noting that Saba Capital is not currently a shareholder in HFRO. When Boaz Weinstein was asked if he would consider an activist play on HFRO on his Twitter/X feed, he replied " Don't mess with Texas ".

Bulldog Investors is a well-known closed-end fund activist firm run by Phil Goldstein. Thomas J. Herzfeld, Atlas Wealth and Matisse Capital are all well know opportunistic closed-end fund investors that almost always support activist investor activities.

To my knowledge, there is no current activist activity occurring with HFRO. But activist owners still provide a nice benefit. There is always the possibility that one or more of the activist owners will start an activist campaign in the future. I am sure the fund managers are aware of the activist ownership, and this "keeps them on their toes", and could prevent future actions that are negative to shareholders.

Highland Income Fund ((HFRO))

• Total investment exposure: $1,026 Million
• Total Common assets: $867 Million
• Annual Distribution (Market) Yield= 11.59%
• Last Regular Quarterly Distribution= $0.077 (Annual= $0.924)
• Fund Baseline Expense ratio: 1.45%
• Discount to NAV= -37.29%
• Effective Leverage: 15.5%
• Average Daily Volume (shares)= 234,259 (Source: Yahoo Finance)
• Average Daily Dollar Trading Volume = $1,850,000

HFRO is a fairly liquid stock and usually trades with a bid-asked spread of one or two cents. But when the market gets slow, the spread can widen to five cents or higher. There is often limited size available on both the bid and asked of only 100 or 200 shares. Because of this, I would recommend using multiple small size orders to accumulate a position. I generally use limit orders, but when you use a small market order, you will usually get some price improvement and receive a price somewhere between the bid and the asked price.

I believe that HFRO is at a decent level for a starting purchase now at a 37% discount. I would get more aggressive if/when the discount gets back above 40%.

For further details see: