HYT: Wait For Wider Discount To NAV Before Buying

Price relative to NAV is a key consideration for any investor considering a closed-end fund (“CEF”) investment. Currently, many CEFs are trading at historically wide discounts to NAV.

There is significant debate amongst academics to explain why CEFs tend to trade at a discount to NAV. One theory is that substantial discounts to NAV represent evidence of market inefficiency. Another theory is that the discount is warranted due to the illiquidity of underlying assets, high management fees, and potential tax liabilities as the NAV of a CEF does not reflect the capital gains tax that must be paid if assets are sold.

My view is more on the second camp. I believe CEFs generally should trade at a discount to NAV due to their high management fees, tax inefficiency, and often illiquid nature of holdings.

While each fund is different, I believe that a CEF’s historical average discount to NAV serves as a solid measure of what a reasonable discount should be. Moreover, I also view discounts on other similar funds as a useful guide.

Currently, the BlackRock Corporate High Yield Fund (NYSE:HYT) is trading at a 1.3% discount to NAV. Over the past 10 years, HYT has traded an average discount to NAV of ~7.7%. Currently, high yield CEFs more broadly are trading at a median discount of 8.8%. Thus, despite HYT’s impressive historical performance track record, I would wait for the discount to widen before buying.

CEF Overview

HYT’s primary objective is to provide shareholders with high current income. The fund’s secondary objective is to provide shareholders with capital appreciation. HYT invests primarily in domestic high-yield bonds, corporate loans, convertible debt securities, and preferred securities which are below investment grade.

HYT uses leverage to boost returns and currently is ~30% levered. HYT has net assets of ~$1.38 billion and charges a management fee of 0.84%. The fund has other expenses of 0.07% and thus the total expense ratio (excluding interest costs) is 0.91%.

High Expense Ratio Is A Negative

HYT’s total expense ratio of 0.91% is more reasonable than the total expense ratio of many other CEFs. The average CEF is estimated to have annual fees of 1.09%. However, HYT’s 0.91% net expense ratio is still very high relative to bond mutual funds more broadly which have an average expense ratio of ~0.37%.

Moreover, investors also have access to fairly low-fee products such as the iShares Broad USD High Yield Corporate Bond ETF (USHY) which charges a total expense ratio of 0.08%.

I view high fees as a negative as most actively managed funds have failed to outperform their benchmarks over long periods of time. This fact is true in the high-yield space as well. Per Morningstar data, just 28.3% of actively managed high-yield bond funds have outperformed their respective benchmark over the past 10 years.

Strong Absolute and Risk Adjusted Historical Performance

Over the past 10 years, HYT has delivered a total return of 87.5%. Comparably, a comparable passive product, the iShares iBoxx $ High Yield Corp Bond ETF (HYG) has delivered a total return of 40.3%. The fact that HYT has outperformed HYG is not all that surprising given the fact that HYT uses leverage. However, the magnitude of the outperformance is impressive.

In addition to outperforming HYG on an absolute basis, HYT has also outperformed on a risk-adjusted basis. Evidence for this can be seen by the fact that HYT has experienced an average trailing 3-year Sharpe ratio over the past 10 years of 0.58. Comparably, HYG has experienced an average 3-year trailing Sharpe ratio of 0.46 over the same time period.

While this historical performance is very impressive, it is important to note that recent research suggests that there is no evidence of persistence in terms of active fund outperformance.

Holdings Overview

HYT is well diversified with no single name accounting for more than 1.7% of the fund’s total assets. While HYT has the majority of its assets invested in U.S.-based issuers, it does hold ~15% exposure to issuers outside the U.S. However, these bonds are primarily denominated in USD as the fund has ~97.5% exposure to US dollars.

In terms of credit quality, HYT has ~35% exposure to securities rated BB or better, ~49% exposure to securities rated B, and ~12.5% exposure to securities rated CCC. While HYT’s credit quality exposure is similar to passive peers such as HYG or USHY, it is slightly more risky. USHY has ~47% exposure to securities rated BB or better, 41% exposure to B rated securities, and ~11% exposure to securities rated CCC. HYG has a similar credit quality mix to USHY.

Another key difference between HYT and its passive peers is that HYT has ~8.5% exposure to term loans while HYG and USHY only have exposure to high-yield bonds. I view this difference as fairly insignificant as below-investment-grade term loans tend to have similar credit quality to high-yield bonds. However, they do tend to carry less interest rate risk.

Currently, HYT has an effective duration of 4.1 years. Comparably, HYG and USHY have effective durations of 3.3 years and 3.4 years respectively. Thus, on a relative basis, HYT has ~20% more interest rate risk than its passive peers which is slightly less than we might expect given the fund’s 30% leverage ratio.

Share Repurchase Program

In 2016, BlackRock announced a share repurchase authorization for many of its CEFs including HYT. The program runs through November 30, 2024, and allows HYT to repurchase up to 5% of outstanding shares in open-market transactions. Since the inception of this program, HYT has repurchased ~4.7 million shares at an average discount to NAV of 11.8%. HYT did not repurchase any shares during Q4 2023. As of January 25, 2024, there are ~142.7 million shares outstanding for HYT.

I view the share repurchase program as constructive as it helps to reduce volatility around the fund’s price relative to NAV. Furthermore, repurchasing shares at a substantial discount allows HYT’s remaining shareholders to benefit from incremental accretion to the fund’s NAV.

I believe the average repurchase discount relative to NAV of 11.8% is a reasonable guide to use in terms of predicting at what level HYT might decide to repurchase shares. Thus, I would find HYT fairly attractive if the discount to NAV were to approach levels closer to this compared to the current 1.3% discount to NAV.

Conclusion

HYT is a CEF with an impressive history of delivering solid long-term absolute and risk-adjusted returns for investors.

While the fund’s management fee is highly compared to the average fixed-income mutual fund and low-fee ETFs it is lower than many comparably high-yield CEFs which offer investors the ability to use leverage.

HYT’s past performance is impressive but investors should be mindful that historical outperformance by active funds is not necessarily predictive of future outperformance. For this reason, I prefer to buy high-quality CEFs at a substantial discount to NAV as this serves as an additional margin of safety for the investment and can present an advantage over buying ETFs at NAV.

Currently, HYT trades at a 1.3% discount to NAV. Over the past 10 years, the fund has traded at an average discount to NAV of 7.7%. Additionally, high-yield CEFs more broadly are currently trading at a discount to NAV of 8.8%.

Historically, HYT has experienced a reasonable amount of volatility related to its price vs NAV and thus I expect the fund to revert back towards its historical average at some point in the future.

I currently rate HYT a hold but would consider upgrading the fund should the discount to NAV move closer to the historical average of 7.7%. Additionally, given HYT’s use of leverage, I would view the fund as more attractive if short-term interest rates decline and leverage costs for the fund decline vs underlying asset yields.