THQ - THQ: Deep Discount Available On This Healthcare Fund

2023-06-20 12:37:15 ET

Summary

• Tekla Healthcare Opportunities Fund (THQ) is trading at a deep discount, making it an attractive option for investors seeking broad-based healthcare exposure.
• Despite the challenges posed by higher interest rates, the discount and reasonable distribution rate make THQ a worthwhile consideration for investors.
• The fund provides exposure to a basket of healthcare-related names that are often seen as defensive during economic slowdowns, potentially providing some recession resistance.

Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on June 6th, 2023.

Tekla Healthcare Opportunities Fund ( THQ ) had enjoyed flirting with trading at a premium above its net asset value per share through 2021. In our last update , we noted that a discount was starting to appear. Today, that discount has expanded substantially, as has basically been the case across the whole closed-end fund space. CEFs had gone from historically narrow discounts to now historically deep discounts.

While it would be easy to point out that leverage and the increasing costs that come with a rising interest rate environment are the cause, we noted previously that isn't necessarily the case. The reason is that while the majority of CEFs are leveraged, there are plenty of non-leveraged or lowly leveraged funds available. There was no material difference in the discounts of leveraged vs. these non-leveraged peers. Instead, what could be playing a larger role is that CEFs are primarily income vehicles. When risk-free rates are rising, income vehicles that carry risks generally have to carry a spread higher that compensates for said risks.

THQ's now double-digit discount is looking quite appetizing for gaining broad-based healthcare exposure. The fund is leveraged, and that should be considered for more risk-averse investors. They are fairly mildly leveraged, but tit increases risks nonetheless.

The Basics

• 1-Year Z-score: -1.05.
• Discount: -11.48%.
• Distribution Yield: 7.21%.
• Expense Ratio: 1.46%.
• Leverage: 20.45%.
• Managed Assets: $1.1 billion.
• Structure: Perpetual.

THQ " invests across all healthcare sub-sectors and a company's full capital structure." They mention full capital structure, but the majority of the portfolio is in equity securities. Equity positions came to around 83% of the fund. The overall strategy leaves them mostly free to invest how they see fit within healthcare. The fund will also utilize an options writing strategy while also employing leverage through borrowings.

When including the borrowings, the fund's expense ratio was 2.77% in the last semi-annual report . That's significantly higher than the 1.87% they had in the previous fiscal year-end period of September 30th, 2022. This large increase was driven by the floating rate nature of the borrowings that they employ.

Rates have even risen a bit further at this point, so the next total expense ratio that includes leverage expenses would be expected to be higher. Their borrowing costs are based on SOFR plus 0.95%. That's now pushing their borrowing costs to over 6% based on the latest SOFR rate .

To make a profit for common shareholders when such a large portion of any potential returns are being offset by borrowing costs and the operating expenses that come on top of that. Common shareholders don't stand to benefit from this leverage unless returns start to go over ~7.50%.

That isn't impossible, but it becomes tough to accomplish. At this point, carrying leverage is to participate more in a rebound should one potentially occur. And, of course, management still continues to benefit from the management fee, whether or not there is a rebound. That means there is little chance for management to reduce leverage unless forced too.

Performance - Attractive Discount

The fund is now trading below its longer-term discount level since the fund's inception. The anomaly really was the 2021 period, where investors bid the shares up substantially and pushed them to trade at a premium on a few occasions. The heavier borrowing cost burden probably makes the current discount about where it should be. This is why I believe the fund is now even more attractively valued than it was in our previous update.

In terms of the performance of the fund, they've delivered fairly strong results. Of course, leverage expenses were cheaper, so performance going forward is likely to be more muted until or if interest rates are cut. That's expected to take place at some point in 2024.

To compare THQ to another healthcare fund in the last year whose portfolio is fairly similar, we can look at BlackRock Health Sciences Trust ( BME ). However, a big difference in BME is that it isn't leveraged at all and instead is only employing an options writing strategy.

In the last year, that clearly helped BME, but in a rebound, it is THQ that could see better results. That's why I wouldn't favor one over the other. They are complementary, but a more risk-averse investor would probably favor BME. Along with THQ and BME, I've also included the Healthcare Select Sector SPDR ( XLV ) for some further context. For the most part, THQ has been competitive in the last year as healthcare sort of remains flattish.

Distribution - Rising Yield

Since our last update, the fund's share price has decreased. The benefit of that is the distribution yield rises in that case. That goes back to the rising risk-free yield and other income vehicles being driven down to increase their yields to compensate for the risks. Otherwise, the fund has held firm on the $0.1125 distribution paid every month.

With the latest price meaning investors now see a distribution rate above 7%. At the same time, the fund's NAV distribution rate remains a reasonable 6.38%.

Inevitably, investors will wonder about the sister Tekla fund, Tekla World Healthcare Fund ( THW ). The distribution rate on that fund comes to an appealing 9.89%. However, since the fund, as of writing, is currently trading over an 11.5% premium, the actual portfolio has to generate 11.04% returns to cover its current distribution.

If one is looking for more sustainability with potentially less downside, I believe it is THQ. That's why I have and will continue to favor THQ over THW. For me to get interested in owning THW - as I've done in the past - I'd want to see a deep discount similar to THQ.

Going back to THQ, though, the distribution coverage is going to rely on capital gains to fund the distribution generally. This is usual for most CEFs that focus heavily on equities. However, the latest report shows that net investment income, or NII, has turned negative.

They previously had only a fairly slim NII, as measured by the $0.01 NII per share. However, it is now negative at $0.02 per share. This is a direct result of the higher borrowing costs that we discussed above. As interest rates have only further increased, the expectation would be that NII goes even more negative. So at this point, capital gains need to cover the distribution but also the expenses of the fund.

This isn't that unusual or unexpected, as healthcare stocks don't pay substantial yields, for the most part. Instead, most of the holdings are more dividend growth plays.

Helping to offset all of the NII losses due to higher expenses was the fund's options writing strategy. The six-month report showed they generated $4.168 million for the fund. While option premium really isn't 'income,' it is something that can be fairly recurring, no matter the market environment.

THQ's Portfolio

The fund is fairly active in managing the portfolio through buying and selling. The fund's portfolio turnover rate reflects that; the last report shows a turnover rate of 17.96%. In the last five years, it has bounced around anywhere from 39.59% and up to 59.42%.

At the same time, the overall construction of the fund isn't necessarily showing dramatic shifts.

Pharma positions make up the majority of the fund, and that was fairly similar to the 27.4% of the allocation it was a year ago when we last touched on the fund. That's followed up by healthcare providers & services, which came in at 22.5% last year - similarly, not a dramatic shift there either. Then we have the sub-sector "Health Care Equipment & Supplies _x000D_" which was a year ago at 15.8%. That's a comparable weighting to what we see with the latest data, as is the same typo/error present a year ago on their website.

We also see familiar names in the top ten holdings. Not only because these are most of the same names, we saw last year, but these are just large-cap healthcare names that are well recognized.

The top ten actually comprise a considerable weighting of the fund's assets at 49.7%. That's despite CEFConnect putting the number of holdings at 129. That's also above the top ten weighting from last year, which came in at 41.4%. At the same time, the fund's largest holding, UnitedHealth Group ( UNH ), saw its allocation come down from the 9.1% level while positions such as Johnson & Johnson ( JNJ ), AbbVie ( ABBV ), Pfizer ( PFE ) and Eli Lilly ( LLY ) all saw a boost in their weightings.

Overall, the top allocations became closer to being more balanced than it previously was. At the same time, it saw the reduction of more diversification elsewhere - positions that aren't allocated to the top ten.

Conclusion

THQ is trading at a deep discount, that's presenting a fairly attractive time to consider this fund. Higher interest rates are dragging on the fund's potential while rates remain where they are. However, I believe the discount and reasonably attractive distribution rate offset those negatives while we wait. They may stay higher for longer, but the expectation isn't for rates to rise substantially from current levels. Rates are expected to stabilize around current levels, and that should mean the increasingly negative impact should at least lessen.

If/when interest rates are cut, it could reduce some of the pressure of these high borrowing costs. Additionally, the idea would be that rates being reduced would probably come during a recession. That's where a healthcare-oriented fund also has its own benefits, as the healthcare space is generally seen as a defensive area of the market.

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