HYT - HYT: Wait For Price To Drop Before Buying In Due To Risks

2023-06-28 19:40:37 ET

Summary

• Investors are in desperate need of additional sources of income to cover the rapidly-rising cost of living.
• BlackRock Corporate High Yield Fund, Inc invests in a portfolio of corporate junk bonds with the goal of providing its investors a high level of income, so it is understandably appealing.
• The market appears overly optimistic about interest rates, and the Federal Reserve could torpedo the fund by failing to cut near term.
• The fund's 10.65% yield is very attractive, but it may not be able to maintain it.
• The HYT closed-end fund is trading at a lower discount than normal, so it might make sense to wait for a correction to improve the margin of safety.

It is unlikely to be a big surprise to anyone that one of the biggest problems facing the average American today is the incredibly high rate of inflation. We can see this evidenced in the consumer price index, which claims to measure the cost of a basket of goods that is regularly purchased by the average American. As we can see here, the index has increased at a year-over-year rate that well exceeds the 2% that is considered healthy during each of the past twelve months:

This chart shows the headline consumer price index, which has been steadily declining over most of the past several months. This is somewhat misleading, however, since it was mostly driven by energy prices, which are broadly cheaper than they were during the same quarter of last year. I discussed this in a blog post from not too long ago. Once we remove the impact of energy prices, we can see a very different story. The core consumer price index, which excludes volatile food and energy prices, shows this quite clearly:

While this measure of inflation has been declining since February, we can clearly see that it remains at far higher levels than the headline consumer price index. This is the reason why it seems as if everything keeps getting much more expensive despite the reported improvements in the official inflation data. These rapid increases in the cost of living have caused real wage gains to be negative for 26 straight months:

As a result, there are now many people that are seeking out second jobs or entering the gig economy just to obtain the extra money that they need to cover their bills and maintain their lifestyles.

As investors, we are certainly not immune from this. After all, we all have bills to pay, require food for sustenance, and want to have a certain amount of enjoyment in life. All of these things are considerably more expensive than they were at this time last year. Fortunately, we do not have to take on additional work in order to obtain the extra income that we need to continue to purchase the things that make us comfortable. We have the ability to put our money to work earning an income.

One of the best ways to accomplish this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income. These funds are unfortunately not very well followed by the investment media and many investors are unfamiliar with them. As such, it can be difficult to obtain the information that we would like to have to make an investment decision. This is a shame because these funds have a number of advantages over ordinary exchange-traded or open-ended funds. In particular, a closed-end fund has the ability to employ certain strategies that allow them to boost its yields far beyond that of any of the underlying assets.

In this article, we will discuss the BlackRock Corporate High Yield Fund, Inc ( HYT ), which boasts an impressive 10.65% yield at the current price. Few people will argue that this is one of the highest yields available in the market and one that is easily large enough to get the attention of any income-focused investor. I have discussed this fund before, but a few months have passed since that time so naturally some things have changed. This article will focus specifically on these changes as well as provide an updated analysis of the fund's finances. Let us proceed and see if this fund could be a good addition to your portfolio today.

About The Fund

According to the fund's webpage , the BlackRock Corporate High Yield Fund has the stated objective of providing its investors with a high level of current income. This is hardly surprising considering that the fund's name implies that it invests in high-yield bonds and similar securities that are issued by private businesses. This is indeed the case, as 96.03% of the fund's portfolio is invested in bonds alongside a very small allocation to other fixed-income securities:

Bonds are by their very nature an income vehicle. An investor will purchase a bond at face value at issuance, receive a steady stream of interest payments over the life of the bond, then receive the face value of the bond back at maturity. Thus, the only investment returns that will ever be earned over the life of the bond are the coupon payments. The same is generally true for preferred stock, although there is no maturity date. However, in some cases, the company will have the ability to buy back the preferred shares at par value, which is also the same price that was originally paid for the preferred stock. Thus, these assets likewise derive all of their investment returns from the direct payments that are made by the company to its investors. The reason for this is that fixed-income securities have no inherent link to the growth and prosperity of the issuing company so they do not derive any capital gains from this.

With that said, the price of bonds and preferred stocks varies from day to day based on market sentiment and interest rates. Thus, it is possible for a fund to earn some capital gains by buying and selling these assets prior to maturity. It is an inverse relationship, so when interest rates go up, bond prices go down and vice versa. As everyone reading this is no doubt well aware, the Federal Reserve has been very aggressively raising interest rates over the past sixteen months in an attempt to combat the very high inflation that is ravaging the economy. As of the time of writing, the effective federal funds rate is 5.06% compared to 0.08% back in February of 2022:

This is the highest interest rate that we have seen since 2007 and as such, we literally have an entire generation of traders and market participants that cannot remember a time in which there was a cost to obtaining money. More importantly, this rapid increase in interest rates has ended the bull market that has dominated the bond market since the 1980s. We can see this quite simply in the fact that the iShares Core U.S. Aggregate Bond ETF ( AGG ) was down just over 13% last year:

Curiously, it has since recovered significantly and is actually up year-to-date despite the fact that interest rates have been rising all year. This is due to the market's almost certainly misguided belief that the Federal Reserve will panic at the first sign of a recession and cut rates. Indeed, the market is currently priced as though interest rates will be lower by the end of 2024 than they are today. The Federal Reserve has already stated that it expects two more rate hikes this year and no cuts at all for an "extended period of time."

The BlackRock Corporate High Yield Fund was certainly not spared from the carnage that afflicted the bond market. It handed investors a 22.62% loss in 2022, although the fund's portfolio actually did quite a bit better:

This is something that we have seen a lot of with fixed-income funds. During the 2021 bull market, income-focused investors aggressively bought up closed-end funds for their high yields and little regard for price. The 0% interest rates that year made pretty much anything with a reasonable yield look attractive. Once the Federal Reserve started raising rates, money market funds and similar assets became more appealing and there was a flight out of risk for safety, as safe assets actually paid something. The fund's performance year-to-date is much more appealing as the BlackRock Corporate High Yield Fund is actually up 2.02% year-to-date:

However, the same comments I made about the bond market as a whole apply here. The market seems overly optimistic that the Federal Reserve will cut rates. If the central bank does show some integrity and stands firm in the face of a weakening economy, we could very easily see this fund decline rapidly once investors realize that their expectations were wrong.

As I noted in my last article on the BlackRock Corporate High Yield Fund, its holdings are somewhat different than those of a broad-market index fund like the iShares Core U.S. Aggregate Bond ETF. The closed-end fund invests primarily in high-yield bonds, which are commonly called "junk bonds." We can see this easily by looking at the credit ratings that have been assigned to the securities in the fund's portfolio:

An investment-grade bond is anything that is rated BBB or higher. As we can clearly see, that is only 6.41% of the fund's total assets. The remainder of the portfolio is invested in speculative-grade securities. Curiously, that is a much more aggressive portfolio than the last time that we discussed this fund as it had a 9.07% investment-grade weighting back in April.

This is something that may concern investors that are concerned about the preservation of principal, which is a group that would likely include most retirees. After all, we have all heard that high-yield bonds tend to have a fairly high default risk. However, we can clearly see that 79.13% of the fund's portfolio is invested in bonds that carry either a BB or a B rating. These are the two highest possible ratings for speculative-grade securities. According to the official bond ratings scale , a bond that carries one of these ratings is issued by a company that has the sufficient financial strength to carry its current debt obligations and weather a short-term economic shock without a need to default.

Thus, the overwhelming majority of this fund's portfolio should be reasonably safe from defaults. In addition, the fund has 1,369 unique positions so any individual company accounts for essentially a negligible portion of the bond's portfolio. The only real risk here is if a prolonged economic downturn causes widespread defaults. That would be something that resembles the Great Depression, so we probably have bigger problems than just some investment losses if that were to occur.

Leverage

In the introduction to this article, I stated that closed-end funds have the ability to employ certain strategies that have the effect of boosting their yields beyond that of any of the underlying assets in their portfolios. One of the strategies that is employed by this fund is leverage. In short, the fund borrows money and then uses that borrowed money to purchase high-yield bonds. As long as the purchased assets have a higher yield than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates. As such, this will normally be the case. However, it is worth noting that the rising interest rate environment has made this strategy less attractive than it was a few years ago, when leverage was basically free.

The real downside to leverage comes from the fact that it boosts both gains and losses. As such, we want to ensure that the fund does not have too much leverage, because that would expose us to too much risk. I do not typically like to see a fund's leverage exceed a third as a percentage of its assets for this reason. Fortunately, the BlackRock Corporate High Yield Fund satisfies this requirement, as its levered assets comprise 28.48% of the total portfolio. Thus, this fund appears to be striking a reasonable balance between risk and reward today.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the BlackRock Corporate High Yield Fund is to provide its investors with a high level of current income. In order to accomplish this objective, the fund purchases high-yield bonds, which tend to have pretty respectable yields. It then applies a layer of leverage to boost the yield above that of any of the securities in the portfolio. As such, we can probably assume that this fund will have a respectable yield itself. This is certainly the case, as the BlackRock Corporate High Yield Fund pays a monthly distribution of $0.0779 per share ($0.9348 per share annually), which gives it a 10.65% yield at the current price. Unfortunately, the fund's distribution has varied quite a lot over the years, as we can clearly see here:

This sort of variation is not unusual for a fixed-income fund. The fortunes of these funds are highly dependent on interest rates due to the link between bond prices and interest rates that we discussed earlier in this article. In addition, the yield offered on securities that the fund purchases are impacted by interest rates, so the fund's income will also vary somewhat with interest rates. This all affects the distribution since a fund cannot pay out more money than it makes from its portfolio over time. This may not mean much to an investor that wants a stable and secure source of income to use to pay their bills, however.

With that said, anyone buying the fund today will receive the current distribution at the current yield and does not have to be particularly concerned with the fund's past. This is because anyone buying the fund's shares today will receive the current distribution at the current yield and will not be affected by its past actions. As such, the most important thing for anyone buying today is the fund's ability to sustain its distribution at the current level. Let us investigate this.

Fortunately, we do have a recent document that we can consult for this purpose. As of the time of writing, the fund's most recent financial report corresponds to the full-year period that ended on December 31, 2022. This fund will unfortunately not provide any information about the fund's performance for most of this year, but the majority of the troubles that afflicted the bond market recently occurred during 2022 so this report will still give us a very good idea of how well this fund managed to handle that challenging environment. We can probably assume that its year-to-date portfolio performance has been much better than what is reflected in this document.

During the full-year period that ended on December 31, 2022, the BlackRock Corporate High Yield Fund received $1,081,187 in dividends and $108,273,649 in dividends from the assets in its portfolio. When we combine this with a small amount of income from other sources, the fund had a total income of $109,642,819 during the period. It paid its expenses out of this amount, which left it with $85,310,028 available for the shareholders. Unfortunately, this was not nearly enough to cover the $107,967,726 that the fund paid out to its shareholders during the period. This is concerning as we generally like to see fixed-income funds paying their distributions entirely out of net investment income.

With that said, this fund does have other methods through which it can obtain the money that it needs to finance its distributions. For example, it might be able to achieve some capital gains that can be paid out to the shareholders. This is what the fund did in 2021 as its net investment income during that year was also not enough to completely cover its distributions. Unfortunately, the fund failed miserably at this task in 2022, which is unsurprising considering the challenges that the bond market faced during that year. It reported net realized losses of $48,802,949 and had another $243,082,240 net unrealized losses during the period. Overall, the fund's assets declined by $145,727,235 after accounting for all inflows and outflows during the year. These inflows included a $167,749,786 rights offering that was still not enough to offset the fund's losses in 2022.

The fund clearly failed to cover its distribution during the period. While it seems likely that it delivered a better performance so far in 2023, we will want to pay close attention to the fund's finances when it releases its semi-annual report in a few months. It is quite possible that its distribution is not sustainable and will need to be cut.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. In the case of a closed-end fund like the BlackRock Corporate High Yield Fund, the usual way to value it is by looking at the fund's net asset value. The net asset value of a fund is the total current market value of all of the fund's assets minus any outstanding debt. It is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can obtain them at a price that is less than the net asset value. This is because such a scenario implies that we are purchasing a fund's assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of June 27, 2023 (the most recent date for which data is currently available), the BlackRock Corporate High Yield Fund has a net asset value of $9.31 per share but the shares currently trade for $8.84 per share. This gives the fund a 5.04% discount on the net asset value at the current price. This is a reasonable discount, but it is nowhere near as good as the 7.46% discount that the shares traded at on average over the past month. As such, it may make some sense to wait and see if the shares drop a bit before buying in.

Conclusion

In conclusion, the BlackRock Corporate High Yield Fund certainly looks like an appealing way to earn a high level of income. While the fund is invested mostly in junk bonds, it has sufficient diversification to protect investors against default risk. The biggest concern here is that the market is far too optimistic about interest rates, and if the Federal Reserve does not cut in the near future then it will torpedo this fund. The central bank has implied that such a cut is highly unlikely so that is a very real risk. In addition, the fund's ability to sustain its distribution appears somewhat questionable. It may make the most sense to wait until the BlackRock Corporate High Yield Fund, Inc valuation drops so that there is a greater margin of safety.

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