NHS - NHS: Don't Ignore The Risk Of More Rate Hikes Best To DCA Purchases

2023-09-18 10:23:42 ET

Summary

• Neuberger Berman High Yield Strategies offers a remarkable 14.25% distribution yield but has underperformed over the past year due to rising interest rates.
• The fund primarily invests in junk bonds and aims to provide a high level of current income to investors.
• The fund employs leverage to boost its yield and total investment returns, but its use of leverage could increase volatility and risk.
• The fund is at risk of losses should interest rates rise further, which is possible. However, it should outperform in a flat to declining rate environment.
• The fund may not be able to sustain its distribution, as it has failed to cover it for eighteen months now.

The Neuberger Berman High Yield Strategies Fund ( NHS ) is a closed-end fund, or CEF, that aims to provide its investors with a very high level of income. It is currently doing a reasonably good job of accomplishing that task, as evidenced by its remarkable 14.25% distribution yield. Unfortunately, one of the only reasons that the fund has such a high yield is that its performance over the past year has been quite disappointing. As we can see here, the fund’s share price has declined by 7.90% over the past twelve months:

This is not particularly out of line with most other fixed-income funds, as just about anything that invests in bonds or other debt securities has been negatively impacted by the significant increase in interest rates that the American economy has experienced over the past eighteen months. In fact, this is not something that is not exclusive to the United States as nearly every developed nation has raised its benchmark interest rate over the past year. The United States has been one of the most prominent though, and its policies tend to have the most impact on dollar-denominated securities, so it is the one that we are most concerned about right now.

The reason why investors are interested in high-yielding securities right now is because the incredibly high inflation rate in the economy has been greatly reducing the number of goods and services that can be purchased with a given level of income. The easiest way to maintain a desired standard of living in such an environment is to increase the amount of money coming in the door. As just mentioned, the 14.25% distribution yield of the Neuberger Berman High Yield Strategies Fund seems like a good way to do that. Unfortunately, as I have pointed out in numerous previous articles, any time a fund acquires such a high yield, it is a sign that the market expects the fund to have to cut its distribution in the near future. As such, we want to pay special attention to the fund’s finances as we analyze it. Fortunately, the fund’s shares are currently trading at a price that is less than their intrinsic value, which is always appealing for potential buyers. Therefore, let us investigate and see if this fund could make sense to purchase today.

About The Fund

Interestingly, the fund’s webpage , says nothing about the primary objective of the Neuberger Berman High Yield Strategies Fund. The fund fact sheet likewise says nothing about the fund’s primary objective. This is very surprising, and admittedly this is one of the only funds that I have ever seen that lacks such a guiding statement. However, we can infer that the fund has the primary objective of providing its investors with a high level of current income based on the fund’s description of its business activities:

As we can see, the fund specifically states that 80% of its portfolio will be invested in below-investment-grade debt securities issued by both American and foreign securities. These are what are colloquially known as “junk bonds,” so this is a junk bond fund. The fund’s portfolio confirms that this is indeed what the fund is doing. As we can see here, the Neuberger Berman High Yield Securities Fund currently has 95.49% of its assets invested in bonds and other debt securities:

This fits well with the fund’s statement that “at least 80% of its assets will be invested in debt securities.” This is the reason why we can infer that the fund’s primary objective is to provide its investors with a high level of current income. As I have pointed out numerous times before, bonds are by their very nature current income investment vehicles. After all, a bond is purchased at its face value at issuance and pays its face value at maturity so there are no net capital gains over its lifetime. Its only investment return is the coupon payments that it makes to the bondholder. Thus, the provision of a high level of current income is the most reasonable objective for any debt fund.

Interest Rate Projections

As mentioned in the introduction, the Neuberger Berman High Yield Strategies Fund has been negatively impacted by the rising interest rates. This is mostly due to the inverse correlation between bond prices and interest rates. As everyone reading this is no doubt well aware, the Federal Reserve has been aggressively raising interest rates over the past twenty months or so as part of an effort to combat the incredibly high inflation that has been dominating the economy. As of the time of writing, the effective federal funds rate is at 5.33%, which is the highest level that it has been since early 2001:

For those that can actually remember it, early 2001 was the end stages of one of the strongest economies that the United States has seen in more than a century. The fact that the Federal Reserve has been forced to raise interest rates to such a level easily shows its determination to get the inflation rate down to its target 2% rate. Unfortunately, we are seeing signs that the central bank will have to go further. Over the past two months, the consumer price index has been trending up on a year-over-year basis, reversing a long period of consistent declines:

This is no surprise to regular readers, as I pointed out back in April that the series of improvements were destined to be temporary as they were driven by year-over-year declines in energy prices. Now that crude oil prices seem certain to increase over the next few months, we may continue to see headline consumer price index prints moving in the wrong direction.

The reason that the above discussion is relevant to our discussion of the Neuberger Berman High Yield Securities Fund is because of the impact that rising inflation will have on the Federal Reserve’s future decisions with respect to interest rates. If the central bank sees that inflation numbers are trending in the wrong direction, it could raise interest rates further as some analysts have predicted . Meanwhile, other analysts do not believe that will happen. Personally, I would not be surprised to see a further rate hike this year as the ‘Core Services CPI ex-Shelter,’ which is one of the Federal Reserve’s most-watched indicators, recently reversed a series of declines:

If the central bank does indeed raise interest rates further, it will probably push down bond prices and by extension the shares of this fund. After all, the Neuberger Berman High Yield Strategies Fund has a 52.00% annual turnover, so it is definitely not holding all of the bonds in its portfolio to maturity. At any rate, the price of the fund’s shares will normally correlate to the current price of the bonds in the fund’s portfolio and not to whether or not it will hold them to maturity. As holding a bond to maturity is the only real way to guarantee that an investor will not lose money on the fund (unless the issuing company defaults), the fund could very easily take some realized losses if it chooses to sell or has to sell some of the bonds in its portfolio in the near future.

Performance Of The Fund

As mentioned earlier, the Neuberger Berman High Yield Strategies Fund invests primarily in junk bonds. One of the defining characteristics of these securities is that they have substantially higher yields than investment-grade bonds, which is intended to compensate for the fact that the risk of default is much higher for these securities. In fact, high-yield bonds have had a much higher yield than just about anything else in the market for a long time. As of the time of writing, the Markit iBoxx USD Liquid High Yield Index ( HYG ) has a 5.76% yield. That is obviously quite a bit higher than the yield of the S&P 500 Index (SP500). In fact, it is higher than any common stock index except for the Alerian MLP Index ( AMLP ). The fact that these bonds have such a high yield means that the direct payments that they make directly to the shareholders can be sufficient to offset any price declines.

This has certainly been the case with this fund over the past year. Despite the fund’s share price declining 7.90% over the past twelve months, the fund actually managed to deliver a positive total return to its shareholders:

As we can see here, the Neuberger Berman High Yield Strategies Fund managed to deliver a 5.11% total return over the past twelve months. This is unfortunately not quite as good as the junk bond index that was just referenced:

Investors in both the Neuberger Berman Fund and the index managed to make money over the period, but investors in the index did a bit better. However, we can see that there were times in which the closed-end fund was significantly outperforming the index. Indeed, the fund was generally far more volatile than the index over the period. This is probably because this fund employs leverage, which we will discuss in just a bit.

Fortunately, the underperformance does not persist over a long period of time. Over the past ten years, the Neuberger Berman High Yield Strategies Fund significantly outperformed the index on a total return basis:

We see the same thing over the past five years, but the Neuberger Berman Fund did underperform over the three-year period. The common point here would appear to be that this fund will outperform the index during extended bond bull markets, such as when interest rates are decreased. However, it will underperform the index during periods of rising rates. This is actually what we would expect from a levered bond fund. As already discussed, the Federal Reserve seems exceedingly unlikely to cut rates in the near-term, which could make for a challenging environment. However, if the central bank holds rates steady as opposed to raising them then it is almost certain that the worst is behind us. A case could therefore be made for dollar cost averaging into the fund right now, but there could still be some near-term weakness.

Leverage

As just mentioned, the Neuberger Berman High Yield Strategies Fund employs leverage as a way to boost its yield and total investment returns. I explained how this works in various previous articles, such as this one :

In short, the fund borrows money and then uses that borrowed money to purchase junk bonds or other income-producing assets. As long as the purchased assets have a higher yield than the interest rate 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. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, that will usually be the case.

However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not using too much leverage since that would expose us to too much risk. I do not generally like to see a fund’s leverage exceed a third as a percentage of its assets for this reason.

As of the time of writing, the Neuberger Berman High Yield Strategies Fund has leveraged assets comprising 37.23% of its portfolio. This is a bit higher than we want to see, and it could certainly explain some of the fund’s volatility compared to the index. In past articles, I have stated that fixed-income funds can generally sustain a bit higher level of leverage than common equity funds due to the relative safety of their assets. While that is true, the fact that this fund invests mostly in junk bonds partially offsets the safety that it would otherwise enjoy with a fixed-income portfolio. As such, there might still be some reasons for concern here, but fortunately its leverage is not too far above that one-third level.

Distribution Analysis

While the Neuberger Berman High Yield Strategies Fund does not explicitly state an investment objective, it is a fair assumption that the provision of a high level of current income is a very important objective for it. In order to achieve this objective, the fund invests in a portfolio of junk bonds that provide the majority of their investment return in the form of direct payments to the shareholders. The bonds in the fund also tend to have a fairly high yield, and this fund effectively boosts that yield through its use of leverage. As such, we can assume that the fund itself has a very high yield. This is indeed the case as this fund currently pays a monthly distribution of $0.0905 per share ($1.086 per share annually), which gives it a 14.25% yield at the current price. Unfortunately, the fund has not been very consistent with its distribution over the years. As we can see here, it has varied quite a bit over time:

With that said, the fund has been remarkably consistent with its payout since June 2019, as the distribution has remained flat since that time. This makes the Neuberger Berman High Yield Strategies Fund one of the only fixed-income funds that has not altered its distribution in response to the shift in Federal Reserve policy from quantitative easing to monetary tightening. This is something that could appeal to any investor that is seeking to earn a safe and secure income from the assets in their portfolio. However, as I pointed out in the introduction, any time a fund’s distribution gets into the double-digits, it is a sign that the market expects that the fund will have to cut its payout in the near future. As such, we should investigate its finances in order to determine the actual risk of such an event.

Fortunately, we have a very recent document that we can consult for the purpose of our analysis. As of the time of writing, the fund’s most recent financial report corresponds to the six-month period that ended on April 30, 2023. As such, it should give us a good idea of how well the fund handled the first few months of this year, which was surprisingly strong for the bond market due to optimism that the central bank would cut rates in the near future. The report should also give us some insight into the fund’s ability to weather challenging market conditions such as the one that lasted over most of 2022.

During the six-month period, the Neuberger Berman High Yield Strategies Fund received $10,566,897 in interest from the assets in its portfolio. It received no dividends or other income, but it did have to pay foreign withholding taxes out of this amount. That left the fund with a total investment income of $10,566,863 during the period. The fund paid its expenses out of this amount, which left it with $5,399,261 available for shareholders. As might be expected, this was nowhere close to enough to cover the $10,553,716 that the fund paid out in distributions over the period. This is something that could be quite concerning as we usually like fixed-income funds to completely cover their distributions out of net investment income.

With that said, there are other ways through which the fund may have been able to obtain income. For example, it might have had some capital gains that could be paid out. The fund had mixed success at this during the period. It reported net realized losses of $10,569,197 but these were partially offset by net unrealized gains of $13,577,214. Overall, the fund’s assets declined by $2,101,340 during the period after accounting for all inflows and outflows. Thus, it did not fully cover the distribution, but admittedly it did get closer than I would have expected. With that said though, the fund’s net assets declined by $12,813,238 during the preceding full-year period. It failed to cover its distribution during that period as well. This certainly explains the market’s apparent concerns about the distribution as it does appear that this fund may need to cut the payout.

Valuation

As of September 14, 2023 (the most recent date for which data is available as of the time of writing), the Neuberger Berman High Yield Strategies Fund has a net asset value of $7.95 per share but the fund’s shares currently trade at $7.62 each. This gives the fund’s shares a 4.15% discount on net asset value at the current price. This is quite a bit better than the 3.11% discount that the fund’s shares have had on average over the past month. As such, the price certainly appears to be quite reasonable right now.

Conclusion

In conclusion, the Neuberger Berman High Yield Strategies Fund is a very reasonable way to earn an income today. There is certainly a risk that the fund will have to cut its distribution in the near future, though, as it failed to cover it over the trailing eighteen months and any further rate hikes could cause more unrealized or realized losses. The fund should do well, though, if interest rates remain stable or even decline from their current levels. Thus, it may make sense to dollar cost average in to limit exposure at any given time.

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