IHIT - IHIT: Disappointing Performance (Rating Downgrade)

2023-08-08 23:11:45 ET

Summary

• The Invesco High Income 2023 Target Term Fund is a closed-end fund that invests in commercial mortgage-backed securities.
• The CMBS market is facing a debt maturity wall, with the current interest rate environment making it difficult for borrowers to refinance.
• IHIT has a term structure that means it will have to liquidate its portfolio by December 2023, even if the underlying assets are underwater.
• The fund's management team has not de-risked the portfolio in response to the current market conditions, and we expect the collateral to continue its negative NAV performance.

Thesis

We wrote about the Invesco High Income 2023 Target Term Fund ( IHIT ) in January here, where we argued the fund had a chance to book a very nice 8% return for shareholders with minimal risk if it chose to unwind some of its portfolio and de-risk as much as possible. Our argument was that the CEF was trading at a discount to NAV, which coupled with its term structure and lack of collateral matching features would provide the ingredients for moving into less risky investments for the rest of the year.

We ended our piece with the following paragraph, prescient of the actions to come:

Unfortunately shareholder interests and management interests are not always aligned, and we believe the fund will continue to run its portfolio and clip its fees until the termination date, with dubitable results in terms of obtaining net total returns in excess of 8% for the remainder of the life of the fund. What is certain is that the volatility is going to be much higher.

And boy did we hit the nail on the head! The fund failed to de-risk, and despite the rally this year in the equity market, IHIT is down substantially since our article:

Not all markets are created equal, and while equities and corporate high yield have rallied, CMBS has not. Higher rates are not a fluke in the CMBS market, having a real impact on real estate values and refinancing rates. A building that derived certain economics with a 3% mortgage rate, will yield different results when the commercial loan required rate is 6%. In fact, even banks are pushing to clean their books of older vintage loans with little success:

Banks seeking to sell commercial-property loans are encountering a dried-up market with few options for an easy exit. Lenders including Goldman Sachs Group Inc. and JPMorgan Chase & Co. have been trying to sell debt backed by offices, hotels and even apartments in recent months, but many are finding that tidying up loan books is no easy feat when concerns about commercial real estate have surged. This year’s rise in borrowing costs has made commercial real estate one of the hardest-hit areas of the economy.

Bloomberg - August 7, 2023

We have seen a very bifurcated market this year, where themes like AI have driven up the price of certain segments on the back of future growth beliefs. The CMBS and CRE markets are the ones that drew the shortest straw here - they are hitting debt refinancing walls now, and the price adjustments for lower values are occurring as we speak.

IHIT Holdings

This CEF holds a portfolio of CMBS bonds:

CMBS stands for commercial mortgage backed securities, and they are a form of securitization that prepackages commercial loans into an SPV.

This portfolio contains a significant amount of Office and Retail exposure:

We can see from the above table that the 'Retail' sector is the largest concentration, followed by 'Office' and 'Lodging'.

As mentioned before, CMBS is a very particular asset class because it is hitting its debt maturity wall as we speak:

As we can see from the above CMBS Maturity Schedule, most of the debt in the space is coming due for refinancing in the next few years. This is the worst possible timing, with much higher rates and tighter lending standards in place at the moment.

IHIT Structure

IHIT is a term fund. That means the vehicle has a target liquidation date, when it is supposed to return capital to shareholders after liquidating its portfolio. That date is December 1, 2023.

Term funds can be higher risk investments when the underlying portfolio is underwater. The whole 'buy-and-hold' mantra is that good assets tend to recover price fluctuations when held for long periods of time. A term fund however establishes a limit on that holding period. In our case the IHIT fund maturity falls in a period of much higher interest rates and a very constrained mark to market on the underlying portfolio.

The fund does have a provision to account for stressed scenarios, with a one period extension possible for up to six months if the vote of the fund's Board of Trustees is agreeable. We believe the fund will choose to extend, and the market is telling us a similar story:

Instead of narrowing, the CEF's discount to NAV has actually widened since the start of the year. This is counterintuitive, since the discount to NAV goes to zero upon maturity date. The market is telling us two things: 1) the fund maturity date will be extended, 2) the market anticipates further NAV weakness.

How do we see the forward for this CEF?

The CMBS asset class is in the middle of the storm. This sector has not been spared the wrath of higher rates, with no P/E expansion here to compensate for the deteriorating fundamentals. As rates have moved up, the economics on loans coming due for maturity no longer make sense.

This set-up has resulted in numerous office buildings being sold below loan value, that CMBS sector being currently hit the hardest:

As seen in the debt maturity schedule above, more debt is set to mature in 2023/2024, with significant valuation implications. Debt that will not be refinanced will result in many properties being sold below loan values, which in turn will incur real losses in CMBS deals. While we do not expect AAA traches to be affected, sub, mezz and the most junior investment grade ones will.

IHIT invests mainly in junior investment grade slices and 'BB' tranches, which means it will be subject to real wipe-outs in some of its holdings as the year progresses.

Instead of de-risking in the beginning of the year to account for its lack of term maturity structure, the fund has kept to its detriment the entire capital stack in a worsening economic and fundamental environment.

We see more weakness to come for this CEF from a NAV perspective, despite the fact that we expect it to extend its termination date.

Conclusion

IHIT, we believe, is a classic story of shareholder interests and management interests not aligning. As shareholders, we want the highest possible return, with the least amount of risk. As portfolio managers, the team driving the IHIT fund seek to outperform a benchmark, even if that simply means recording a less negative total return than said benchmark.

The fund management team could have made a very simple de-risking decision at the start of the year, by liquidating most of the longer dated bonds and eliminating the leverage. The spare cash could have been put in treasuries or very short duration AAA CMBS bonds. Instead we have a case of a fund that has recorded a negative NAV performance since the start of the year and deteriorating fundamentals.

We expect more pain in the CMBS space as the debt maturity wall continues to challenge all market participants. Nobody seems to want to own CMBS risk in today's market, with banks tightening lending standards and trying to offload existing exposures.

We expect the Board of Trustees for the CEF to extend the termination date here, but that will not fix the underlying issues. We expect more NAV weakness here, and a negative NAV performance in the next 10 months. With treasuries yielding over 5% there is no reason to stay in this name. We are Strong Sellers of this CEF here.

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