2023-10-18 12:42:55 ET
Summary
- Western Asset Premier Bond Fund's discount has widened amid rising risk-free Treasury rates, presenting an attractive entry point for investors.
- The fund is split between investment-grade and below-investment-grade bonds, making it quite sensitive to interest rate changes.
- The fund's higher quality tilt could make this a more conservative fund relative to its pure-junk counterparts when the economy slows.
Written by Nick Ackerman, co-produced by Stanford Chemist.
Western Asset Premier Bond Fund (WEA) has recently seen its discount open up materially. This has come about as risk-free Treasury rates have surged to their highest levels since 2017. This fund is split between investment-grade and below-investment-grade, which leaves it fairly interest rate sensitive as the larger sleeve is investment-grade rated bond holdings. This could be setting up an attractive entry point for investors looking to put capital to work.
The Basics
- 1-Year Z-score: -1.00
- Discount: -8.87%
- Distribution Yield: 8.07%
- Expense Ratio: 1.07%
- Leverage: 27.06%
- Managed Assets: $175.6 million
- Structure: Perpetual
WEA's investment objective is to "seek current income and capital appreciation." To achieve those objectives, the fund will invest in a "diversified portfolio of primarily investment-grade bonds." They also "emphasize team management and extensive credit research expertise to identify attractively priced securities."
The fund is leveraged, and that will increase potential returns, but it also increases downside risks. The fund was heavily leveraged last year and after some deleveraging, the leverage ratio has moderated. The tilt towards investment-grade credit quality could mean running with leverage is relatively less risky. However, regardless of the credit quality, any leverage is going to increase risks as volatility increases.
When including the fund's leverage expenses, the total expense ratio for the fund comes to 3.22%. As rates have increased, their borrowing costs have also risen, and that total expense ratio is up from 2.19% at the end of 2022 and up from 1.22% at the end of 2021.
Wild Discount/Premium Leads To Opportunity
The last time we covered this fund was just shy of a year ago. Through this period, the returns for the fund have been mostly flat when accounting for the distributions the fund paid.
While that might have been relatively disappointing returns when compared to the S&P 500 Index, this fund isn't an equity-focused fund. Therefore, that clearly isn't going to be a relative benchmark. However, it's actually performed fairly well, considering just how poorly investment-grade bonds have done during this time.
All fixed-income investments have been getting hit lately as risk-free Treasury yields surge to levels not seen since before the global financial crisis.
Keep in mind that WEA is a leveraged fund as well, so the fund would generally be more volatile than these non-leveraged ETF counterparts. We can also see just how much discounts/premiums play a role in adding even more volatility (or what could be considered opportunity) to the fund.
One thing to note to investors who don't often follow the investment-grade bond space is that this is actually setting up to be the third year in a row where it hasn't provided any returns to investors. Of course, the big drop was in 2022, but 2021 was also a negative year for LQD.
Additionally, since our last update, the fund has actually seen its discounts narrow just a touch. That has helped the total share price returns, but not in a material way.
However, the current deep discount as bonds face pressure makes the fund once again appeal for a potential entry for investors. It is trading below its longer-term average discount, but admittedly, this one has historically been pretty volatile in terms of swinging from deep discounts to premiums or near premiums in fairly short periods of time.
Distribution Bumped
A number of Western Asset funds have recently raised their distributions; WEA was included in this . However, not all of these were really warranted. They raised some so that they could sit at the cool kid table with some of their better income-generating funds.
The bump wasn't anything earth-shattering as the monthly distribution went from $0.066 to $0.07 per month. Given the history of the fund when it operated prior to a mostly zero-rate environment, it's barely even a noticeable bump on the graph.
That said, I don't necessarily believe it was entirely deserved or necessary because their last semi-annual report showed it actually isn't entirely covered. On a per-share basis, the fund's NII in the last six-month period came to $0.065 per month, which put coverage at just around what they were paying - even slightly lacking coverage. However, that could be due to some rounding.
This could be the case because, in their last quarterly report, they showed that NII per share would have worked out to roughly $0.0667 per share for that three-month period.
It is possible that they are seeing income generation increase, so they felt comfortable raising it to this level. Either that or they expect some capital gains to fill in what is admittedly a small shortfall in coverage. They could also be expecting the Fed to be done or nearly done raising interest rates, and that could see their borrowing costs stabilize.
As the fund is leveraged, they've been having to deal with higher interest rates, and that's one of the main reasons they would see its NII trending lower relative to where it was in 2020 and 2021. Last year, in the previous six-month report, the fund's interest expense was the second largest expense behind investment management fees at $374k. This year, it has moved to the largest expense, blasting higher to $1.49 million.
This increase in borrowing costs even came as the fund deleveraged a bit from $57.5 million to borrowings of $47.5 million. The average interest rate on the loans went from 2.42% at the end of last year to 5.51%. They pay a rate of SOFR plus a spread. Generally speaking, most funds have seen their borrowing costs rise to or above 6%. I believe that would be the case for WEA as well, but they don't provide the exact spread.
Thankfully, some of their portfolio has floating rate exposure that has been able to offset some of these higher expenses. That's why the NII per share didn't crater year-over-year. Total investment income this year was $6.817 million compared to $6.16 million. That helped compensate for roughly $650k.
Overall, it's been a fund that has been mostly a wash for the fund in terms of rising interest rates and income-generation the fund is able to provide. While a raise might be warranted if the fund sees higher income being generated now or soon, it doesn't seem like it was entirely necessary just yet.
For tax purposes , the entire distribution this year and last was considered ordinary income. As a fixed-income fund, that's what we'd expect to see most of the time, and that would make it more appropriate for a tax-sheltered account.
WEA's Portfolio
The managers in this fund are fairly active in terms of buying and selling. In the first six months of the year, the fund had a turnover rate of 23%. Annualized out, and that would put them as being a bit less active than last year with its 72% turnover.
The fund is primarily invested in corporate bonds and notes. However, the fund carries some floating rate exposure primarily through senior loans, asset-backed securities and collateralized mortgage obligations, which all have some weighting in the fund.
With a higher tilt towards the investment-grade sleeve of its portfolio, the fund naturally carries a relatively longer weighted average maturity in its portfolio. It comes in at 9.35 years. Maturity has a big impact on the interest rate sensitive measurement, with the effective duration of this fund coming in at 5.66 years. That means for every 1% increase in interest rates, the fund is anticipated to move around 5.66%.
That does mean that when the Fed cuts rates, it has a chance to provide even better returns going forward. It should also be considered that if the Fed is cutting rates, it is probably because the economy is no longer doing so hot. All this could make WEA even more appealing with a relatively higher quality bond portfolio compared to their more pure-junk counterparts. With a lower default chance , at least historically, translating into less losses likely.
Further limiting risk for the fund is the high diversification the fund carries. CEFConnect lists the number of holdings at 304, and when looking at the top ten, we don't see a heavy concentration in any specific holding.
Conclusion
WEA offers investors a tilt towards investment-grade fixed-income. The funds discount has widened substantially recently as risk-free Treasury rates have really started to blast higher.
However, the widening discount with the increased volatility in the fixed-income space could be setting up a better entry price for investors. The higher quality portfolio could also be in a better position to be in relative to their pure-junk peers during the next recession. It could limit the chance of defaults and, therefore, losses.
That said, as long as yields are rising, this fund and all fixed-income funds will continue to face pressure.
For further details see:
WEA: Discount Widening As Fixed-Income Gets Slammed By Higher Yields