WDI - HIX: High Income Fund But Not Quite Appealing

2023-11-17 14:18:46 ET

Summary

• Western Asset High Income Fund II offers exposure to a globally diversified portfolio focused on high-yield fixed income.
• The HIX closed-end fund currently trades at a small discount, and that is part of what makes it unappealing at this time even despite trading closer to its longer-term average level.
• There are alternative funds within the Western Asset family, such as HYI and WDI, that may be more attractive options due to their better valuations.

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

Western Asset High Income Fund II ( HIX ) provides investors with exposure to a globally diversified portfolio focused on fixed income. That fixed-income exposure is primarily high yield in nature, with the majority of the portfolio firmly in non-investment-grade territory. The fund also employs leverage, which leads to additional volatility, as well as being a closed-end fund ("CEF") that sees sizeable fluctuations with discounts and premiums.

Currently, the fund offers a small discount after regularly flirting with a premium for the last several years. However, the discount isn't that deep, and there have been several times when the fund's discount has been wider. In fact, the whole closed-end fund space has been trading at some of the deepest discounts seen in years.

So, despite the fund's discount and being relatively cheaper relative to the last several years, HIX doesn't represent the most attractive opportunity at this time. I would view it as a hold/neutral at this time. Some alternatives could be appropriate that have more appeal at this time.

The Basics

• 1-Year Z-score: -1.24
• Discount: -2.22%
• Distribution Yield: 13.33%
• Expense Ratio: 1.4%
• Leverage: 28.53%
• Managed Assets: $433.6 million
• Structure: Perpetual.

HIX's investment objective is "high current income with capital appreciation as a secondary objective." The fund will attempt to achieve this by offering "a leveraged portfolio of high-yield corporate debt securities from both the U.S. and non-U.S. corporations, with strategic allocations to emerging markets and derivatives."

The fund employs leverage in the form of borrowings and reverse repurchase agreements. As rates have been rising, this has impacted the fund by increasing the fund's total expense ratio to 3.26%. Their reverse repurchase agreements show that during their last annual report , they were paying around 5.5% for these borrowings. These are short-term instruments that have already matured in May. Given that rates have increased since then, it is highly likely that their borrowing costs on these have risen, too.

For their borrowings, they pay a rate of SOFR plus a spread. They don't list it specifically, but the average interest rate in that report came to 3.81%. That was for the period ending April 30, 2023. We know rates have climbed since then, as SOFR has hit 5.33% . Most leveraged funds that borrow through a credit agreement pay anywhere from 0.5 to 1% in spreads above SOFR. That would put HIX's borrowings right around the 6% rate right now, which is where we see most other CEFs.

Why HIX Looks Like A Neutral To Me

There are several choices when it comes to a high-yield, fixed-income approach in the CEF space. Therefore, we can often find some opportunities at least somewhere in the space, and paying up for a fund that flirts near a premium isn't generally necessary. Still, HIX has been doing just that. A premium isn't new to this fund, and the current discount may appear attractive relative to its long-term history.

Sometimes, this can be justified if the fund regularly outperforms or offers some unique exposure. In terms of performance, the fund doesn't appear to offer any sort of advantage on a regular basis. In fact, most standard annualized performance periods measured show that HIX is near the bottom end of the performance range.

In my opinion, HIX's portfolio isn't necessarily the most unique portfolio either. They invest in high-yield bonds, and that includes global exposure. Flexibility can be great, and going global certainly adds more flexibility.

History may not repeat, but without the most solid track record and trading only at a mediocre valuation of a slight discount - on an absolute and even relative to its history - there would seem to be other options we could find in the fixed-income high-yield space.

In fact, I think we can look toward some of its sister funds if you want to keep it in the Western Asset family.

Potential Alternatives

HYI

The first fund I think could be a potential alternative is the Western Asset High Yield Defined Opportunities Fund ( HYI ). This is quite a similar fund in terms of how it is invested. It takes a global approach to investing in high-yield debt instruments and even incorporates emerging market debt.

However, two distinct differences of the fund are that it is a term fund and it is non-leveraged. In my opinion, these are two positives for the fund. No leverage means they don't have to deal with the rising costs of interest rates, which should mean relatively less volatility.

While that could mean giving up some upside in a rebound, one will have to weigh that against the potential for further losses. From HYI's inception to today, the performance on a total NAV return basis has been quite close. However, we see through the periods of a rising market, HIX does start to move higher.

That's where the term structure could come in to favor HYI going forward. If each of these funds carries on with the same or nearly identical performance, HYI could have the upside. This is because the fund is anticipated to be liquidated on or around September 30, 2025. That gives the fund around two years left of existence, and when the fund is liquidated, that means that the current discount will be realized.

Right now, HYI's discount is more appealing at this time with this catalyst on the horizon.

Though it should be noted that the Board does have the ability to propose an amendment to extend the length of the term, in the case of HYI, it would require shareholder approval. Either way, you are gaining similar exposure to a portfolio of what HIX is already carrying at a slightly better price with no leverage. That seems like a fair trade.

In terms of each fund's distribution, HIX's payout is higher currently. However, the last annual report shows that HIX earned $0.50 net investment income for the six-month period and paid out $0.59. That puts coverage at less than 85% for the period ending April 30, 2023.

HIX's last quarterly financial report didn't necessarily show a significant improvement when they earned $0.12 NII against the $0.147 paid out per quarter, or what works out to around 81.6% coverage. That showed a decline year-over-year of $0.01 in NII.

For HYI, the last semi-annual report shows that the fund earned $0.52 and paid $0.57 for coverage of around 91%. So, on that basis, too, despite the higher distribution rate of 13.33% for HIX, HYI's more modest 10.10% has a bit better coverage for the period ending May 31, 2023.

HYI bumped up their monthly distribution slightly for the final quarter of 2023. This could have been because their last quarterly financial report for the period ending August 31, 2023, saw NII increase by $0.01. That isn't a massive increase, but higher is always better than lower. It also meant that based on the last quarter of $0.27 earned and $0.285 paid out on a current quarterly basis after the raise, distribution coverage could come to nearly 95%.

WDI

Finally, I also wanted to take the opportunity to highlight the Western Asset Diversified Income Fund ( WDI ). For an investor wanting to get a bit more creative with this multi-sector fixed-income fund, WDI could be it. WDI has a short history, and it is also leveraged like HIX is. During the fund's short history, on a total NAV return basis, WDI has performed quite a bit better.

The added flexibility for the fund to incorporate more floating rate exposure during this rising rate environment seemed to be helpful.

Yet, the total share price returns were much closer. In this case, it was because WDI has gone to a significant discount, with its share price trading well below its NAV per share.

WDI is also a term fund like HYI is; though, that term date isn't anticipated until around June 24, 2033. So that shouldn't necessarily be weighed in on the decision yet, as we have nearly a decade left until that comes into play.

If the better relative value doesn't get you, then surely the 13.03% distribution rate that WDI pays that is fully covered definitely should. Once again, the floating rate exposure that WDI carries has helped the fund on this front, as the fund's NII has been rising.

In the last semi-annual report for WDI, they earned $0.86 per share and paid out $0.78. Based on the last monthly distribution, since they've been increasing it, they'd be paying at a rate of $0.84 every six months - which still means it's being covered based on their last known NII with coverage at 102.38%. That's for the six months ended June 30, 2023. We should be getting a new quarterly financial report from WDI before this month is over, but I'm expecting it to once again show a rise year-over-year due to rates being higher now than a year ago.

Conclusion

HIX isn't a terrible closed-end fund. They are a fairly basic leveraged high-yield bond fund with global exposure. With that said, given the shallow discount and trading only near its long-term average discount, Western Asset High Income Fund II isn't exactly the most appealing fund to consider at this time. The non-leveraged sister fund HYI takes a similar approach might be more tempting for investors at this time. Alternatively, if an investor wants to get a bit more spicy with a multi-sector bond fund, their cousin WDI might be an even more alluring target, given the meaningful discount and strong distribution coverage.

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