HNW - HNW: How To Analyze And Why You Should Pass On This Fund

2023-05-09 13:55:53 ET

Summary

• The HNW fund aims to deliver high current income from a portfolio of junk bonds, bank loans, and catastrophe bonds.
• The fund yields 10.8% while only earning 3-5% p.a. over the long run.
• Unless we are playing for a credit recovery, I recommend investors avoid 'return of principal' funds like HNW.

Continuing my quest to educate fellow investors, I will use the Pioneer Diversified High Income Fund Inc. ( HNW ) as a template to show how one can quickly analyze and reject 'return of principal' funds like HNW.

1) Fund Overview

The first step in analyzing an investment fund is to read the fund's marketing literature, to get a sense of what the fund is trying to achieve and how it plans to achieve its goals.

In the case of the HNW fund, Amundi , the asset manager, does not have a website typical of the fund industry with common fund details listed out clearly. Instead, investors are directed to the fund's factsheet, annual report, and semi-annual report on a minimalist website.

From the fund's factsheet, we learn that the HNW fund's goal is to deliver high current income from a portfolio of global high yield ("junk") bonds, leveraged loans, and event-linked bonds ("cat bonds").

At this point, it is important to note any investments and asset classes one is not familiar with, in order to understand the fund's potential risks and returns. For HNW, the cat bonds asset class is something not normally found in retail investment products.

What Are Cat Bonds?

A catastrophe bond is a high yield instrument issued by insurance companies to transfer underwriting risk to investors like hedge funds and pension funds. In normal times, the issuer pays regular interest payments to the bond investors. However, a cat bond allows the issuer to receive a payout if a specific event such as an earthquake occurs.

For investors, cat bonds are attractive because they typically pay higher yields than most other fixed income securities. Furthermore, as natural disasters are uncorrelated with financial markets and economic conditions, cat bonds can help investors diversify their portfolio exposures.

Returning to the fund overview, investors should also be knowledgeable about the fund's capital structure, i.e., does the fund employ leverage, either via preferred shares or debt, to enhance returns. Leverage can be a double-edged sword. When times are good, leverage can often turbocharge fund returns, turning an asset class that earns 6-8% into a fund that earns 10-12%. However, in bad times, leverage can also magnify drawdowns.

For HNW, we see that the fund has $43 million in debt outstanding against $98 million in common assets for 30% effective leverage (Figure 1).

Investors should also make note of the total expense ratio of the fund allocated to common shareholders. While the manager may only charge 1-2% management fees, investment funds also incur a host of other fees like administration, audit, trading, and leverage expenses. High fees are obviously something investors want to avoid.

In extreme cases like Oxford Lane Capital ( OXLC ), it can appear like investors are working for the manager and not the other way around given how incredibly high total expenses are: OXLC pays 12.57% of common assets as total annual expense! For HNW, the fund has total expenses of 2.9% of common assets, which is moderate.

2) Portfolio Holdings

After getting an overview of the fund, it is now time to dig into the nitty-gritty details. First, investors should assess the fund's portfolio, to see if the fund is doing what they laid out in the marketing materials. Furthermore, this is a good time to see if there are any potential red flags in terms of holdings or exposures.

For HNW, Figure 2 shows the fund's sector allocation as of March 31, 2023. The fund has 29.8% allocation to U.S. junk bonds, 17.0% allocation to emerging market bonds, 14.3% allocation to cat bonds, 11.5% to international junk bonds, and 8.0% to CMBS securities.

We also learn that the HNW fund has 2.7 years effective duration, so this is a relatively low duration fund. Overall, I do not see anything out of the ordinary with HNW's portfolio holdings.

3) Fund Returns

The next step is to check out a fund's historical returns to judge how the fund has performed and how it may perform in the future. Figure 3 shows the HNW's annual and historical returns gathered from Morningstar .

Historically, the HNW fund has delivered modest returns, with 3/5/10/15Yr average annual returns of 7.1%/0.9%/3.1%/5.5% to April 30, 2023. In general, long-term investors should look at longer-term 5, 10, and 15Yr returns as that may be more representative of the fund's earnings potential over a full cycle.

For example, HNW's 3Yr return figure appears significantly higher than its 5 Yr and 10Yr figure. What could be the cause of this discrepancy?

If we think back to April 2020, the beginning period of the 3Yr return figure, we can see that it is near the lows of the COVID pandemic when all asset prices were depressed (Figure 4).

Therefore, most funds have strong 3Yr return figures, since the base is low.

It is also useful to compare historical returns of active funds against passive ETFs in similar asset classes, to see if the active strategy delivers alpha. For HNW, we can look at the historical returns of the iShares iBoxx $ High Yield Corp Bond ETF ( HYG ) shown in Figure 5.

Relative to the HYG ETF, we can see the HNW fund has delivered higher 3, 10, and 15Yr average annual returns. This suggests the HNW fund does deliver some alpha.

4) Distribution & Yield

However, the biggest knock against the HNW fund is its distribution, which is currently set at $0.09 / month or an annual 10.8% yield. On NAV, the HNW fund is yielding 9.2% (Figure 6).

While HNW's distribution yield is very attractive on first glance, I fear about its sustainability, since the fund clearly earns total returns less than its yield.

Funds that do not earn their distributions are called 'return of principal' funds (an economic concept that is subtly different from the accounting concept 'return of capital') and are characterized by amortizing NAVs over the long run. This could be because the funds must liquidate NAV and or reach for yield and incur high losses in order to pay out their distribution yields.

Figure 7 shows HNW's NAV and price profile.

Over the long run, since market prices tend to track NAV, investors could end up losing on their principal. Furthermore, as NAV declines, there are less income earning assets to fund future distributions, making distributions even less sustainable. Eventually, distributions end up being cut (Figure 8).

With respect to HNW, the fund exhibits both a long-term declining NAV and a shrinking distribution rate that are characteristics of 'return of principal' funds.

5) Conclusion

While the HNW fund generates modest but respectable total returns of 3.1% p.a. over 10 years, it perennially pays a too-generous distribution yield, currently set at 10.8%.

Common sense tells us that when a person spends more than she earns, eventually she will go bankrupt. The same principle applies to investment funds that pay more than they earn. Eventually, the NAV either depletes or the distribution has to be cut, or both like the HNW fund.

Unless we are playing for a short-term credit recovery trade (please see my recent article on the PIMCO Dynamic Income Fund ( PDI ) for more details), I would recommend investors avoid 'return of principal' funds.

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