2023-06-02 12:16:31 ET
Summary
- Term and target term funds, such as Miller/Howard High Income Equity Fund and Invesco High Income 2024 Target Term Fund, offer opportunities for investors to realize a fund's discount as they approach their termination dates.
- Both HIE and IHTA are set to liquidate in 2024, but investors should be aware of potential extensions and the possibility of funds going perpetual through tender offers.
- While not risk-free, these funds can provide alpha when investors realize the discount, but their performance may be affected by market conditions such as a deep recession.
Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on May 18th, 2023.
A feature that closed-end funds have been implementing since around 2018 has been a term structure. This means that investors are able to realize the discount on a CEF, whereas perpetual funds could potentially trade at discounts into perpetuity.
The Miller/Howard High Income Equity Fund ( HIE ) is a term fund, while Invesco High Income 2024 Target Term Fund ( IHTA ) is, as its name would suggest, also a target term fund. We've explored these differences before. The material point is that a target term fund attempts to return the original NAV back to investors. It does not guarantee it will happen, but it is their intention.
Both funds are fairly unique since they launched before term funds became common. Both of these funds are also looking set to liquidate later in 2024, so their termination dates are coming up and will be something to watch closely and potentially exploit.
The Miller/Howard High Income Equity Fund
- 1-Year Z-score: 0.45
- Discount: 7.02%
- Distribution Yield: 6.18%
- Expense Ratio: 1.92%
- Leverage: 11.05%
- Managed Assets: $201.191 million
- Structure: Term (expected November 24th, 2024)
HIE is classified as a "diversified, closed-end management investment company whose primary objective is to seek a high level of current income with capital appreciation as a secondary objective."
They intend to invest "at least 80% of its total assets in dividend or distribution paying equity securities of US companies and non-US companies traded on US exchanges. The Fund will seek to invest in securities that the Investment Advisor considers to be financially strong with reliable earnings, high dividend or distribution yields, and rising dividend growth. The Fund may invest up to 25% in Master Limited Partnerships ("MLPs"), generally in the energy sector. The Fund intends to engage in an options writing strategy consisting of writing put options on securities already held in its portfolio or securities that are candidates for inclusion in its portfolio. It may also engage in covered call writing strategies, and it may buy put and call options. The Fund may write covered put and call options up to a notional amount of 20% of the Fund's total assets."
HIE is a fund I've regularly followed since the big crash after Covid. The fund performed terribly due to heavy energy exposure and elevated leverage levels. Today, the fund is less leveraged, and that can be a good thing to reduce volatility in the final portion of its life. In fact, the fund has reduced its leverage since our last update .
To reiterate, this fund is not a target-term fund. Generally speaking, target-term funds want to reduce their volatility heading into the final stretch. Another benefit of reducing leverage is reducing expenses as interest rates have risen. Including leverage expenses, their last report showed a total expense ratio of 2.34%.
HIE is a fund that came before term funds were commonplace. Any fund after roughly 2018 is now mostly term structure. This does make HIE a bit more unique in that language for liquidating has become more standardized. For HIE, the fund is a bit more ambiguous in terms of being able to go perpetual.
A couple of funds have done this in the past to get out of liquidating as they were supposed to. That being said, Nuveen allowed for 100% tender offers for shareholders. That's essentially allowing the same thing and is now one of the standards for switching a term fund to a perpetual structure.
The Nuveen Mortgage and Income Fund ( JLS ) and Nuveen Mortgage Opportunity Term Fund 2 ( JMT ) were those funds. JMT no longer exists because investors tendered more than the limit they provided. Therefore, they ended up liquidating the fund as intended. After that happened, Nuveen expedited the liquidation for JMT a couple of months earlier .
In the case of HIE, though, the prospectus is quite clear. It states that:
The Fund will terminate on November 24th, 2024, absent shareholder approval to extend such term. If the Fund's Board of Trustees believes that under then current market conditions, it is in the best interest of the Fund to do so, the Fund may extend the termination date for one year, to November 24th, 2025, without a shareholder vote..."
This tells us that they will need shareholder approval if they want to go perpetual. At the same time, they also allow for an extension without shareholder approval. For term funds, this is standard. The extensions are generally anywhere from six months to two years.
It wouldn't be unheard of if HIE tried to go perpetual through a similar manner that Nuveen had done with their funds. As long as it's a tender offer for 100% of shares at 100% of NAV, investors receive the same benefit in the end - that would be cashing out at the fund's full NAV per share at the time.
At one point, pre-Covid, HIE traded at a premium quite regularly. However, after getting a whacking during that period, the fund dropped to a deep discount. At a discount of 7.02%, that allows some fairly attractive upside when it comes to termination.
Of course, the caveat is that anything can happen in the market between now and termination. With a recession expected, depending on the depth, that could cause quite the volatility heading into the final period for the fund. It could drop the fund enough to want to utilize the 1-year extension.
One reason to remain optimistic that the fund will do the right thing is because of significant activist ownership. Saba Capital owns nearly 15.5% of the fund. They also have Atlas Wealth and SIT Investment Associates with sizeable positions as well.
Invesco High Income 2024 Target Term Fund
- 1-Year Z-score: -2.14
- Discount: 10.42%
- Distribution Yield: 5.69%
- Expense Ratio: 1.28%
- Leverage: 28%
- Managed Assets: $95.27 million
- Structure: Target Term (expected liquidation is December 1st, 2024)
IHTA's investment objective is "to provide a high level of current income and to return $9.835 per share." To achieve this objective, the fund seeks to invest "in securities collateralized by loans secured by real properties and other real estate related debt securities."
Right off the bat, I'd note that the fund's current NAV is $7.77. They are unlikely to meet their target NAV as they intended. That would imply a nearly 27% return between now and the anticipated liquidation date. In my opinion, that would certainly be a lofty return to achieve. Holding some debt securities to maturity could help, but they have some maturities on the other side of their liquidation date.
On a positive note, this is somewhat limited because they also included that "with respect to 70% of the Fund's Managed Assets, limiting the longest expected maturity of any holding to no later than June 1st, 2025."
Interestingly, the average maturity isn't one of the stats they provide in their fact sheets . They provide that the effective duration is 1.97 years as of March 2023. Their portfolio isn't particularly large, so glancing through their last report shows that the longest maturity on the debt securities is in 2027. The majority of the previous positions mature in 2024 and 2025.
This isn't a fund I've covered before, but now that the discount is over 10% with roughly a year and a half left, it is quite interesting. The fund's discount has actually expanded quite drastically more recently. In fact, they were actually flirting with a premium toward the end of 2022.
One of the reasons for this dramatic sell-off could be that the fund is heavily invested in commercial MBS. Anything touching commercial right now is viewed as highly risky.
At the same time, the fund's portfolio - despite the "high income" in the name - is carrying mostly investment-grade debt. Albeit, it's on the lowest rung of the credit quality ladder.
As a small fund, they probably aren't too enthusiastic about doing anything cute regarding the termination date. However, they allow the Board to extend the fund's termination date by "one period of up to six months by a vote of the Board of Trustees." Any extension further than six months and that will require a shareholder vote to amend.
One other note about target term funds is that when they look like they will miss their target, they will gradually cut down their distribution. This allows the fund to retain more of the cash flow to prop up the NAV.
We've already seen several cuts for IHTA, and I would expect more as time goes on. This is especially true if the fund starts deleveraging as it should as it enters the winding-down period. They are also still fairly highly leveraged at this time, so that will be something to watch going forward.
Conclusion
Term and target term funds are closed-end funds that we can use to exploit opportunities to provide alpha through realizing a fund's discount. However, there are some quirks that investors should know, such as ways to extend the term. That includes with or without shareholder approval in some cases. Additionally, funds can also attempt to go perpetual through a tender offer. As long as the tender offer is for 100% of outstanding shares at 100% NAV, an investor is still getting the same choice.
HIE and IHTA are two funds worth watching as we enter the final durations of their existence. While these are certainly not risk-free investment choices, it's one way to guarantee alpha. That is to say, if you had two identical funds that exactly mirrored these two, HIE and IHTA would outperform when investors realize the discount. Note that this does not mean there are guaranteed returns. A deep recession could limit the performance of these funds heading into the final years.
For further details see:
HIE And IHTA: 2 CEFs Set To Liquidate In 2024