HYT CEF: Leveraged High-Yield Bond Fund Faces Trifecta Of Headwinds (NYSE:HYT)

The BlackRock Corporate High Yield Fund (NYSE:HYT) offers investors exposure to high-yield fixed-income securities focusing on “junk bonds” and bank loans through a closed-end fund (CEF) structure.

The attraction here is the fund’s monthly distribution which currently yields 10%, making HYT a compelling vehicle for income-focused investors.

This is a market segment that has benefited over the past year amid stronger-than-expected economic conditions, supporting the credit profile of corporate borrowers. An expectation for Fed rate cuts on the horizon has fueled an impressive 21% total return over the past year, even outperforming high-yield benchmarks.

On the other hand, we’re eyeing a series of headwinds that warrant some caution toward HYT at the current level. The following points highlight why we expect to see higher volatility with the risk of a bigger correction lower.

1. Stubborn inflation is pushing bond yields higher.
2. Room for credit spreads to widen from historically low levels.
3. HYT appears relatively expensive currently trading at a premium to NAV.

What is the HYT CEF?

HYT as an actively managed CEF is not intended to track any particular index, with the underlying investments made at the discretion of the Blackrock portfolio management team. Officially, the primary investment objective is to provide shareholders with current income with a secondary mandate of generating capital appreciation.

The fund falls into the category of high-yield bond fund but has some flexibility to also invest in corporate debt, convertible securities, preferred shares, as well as foreign issuances that are rated below investment-grade quality.

HYT utilizes leverage, currently listed at 26% of its $1.9 billion in managed assets. This characteristic is intended to enhance the return potential as well as contribute to the regular distribution but also adds risk with the potential for wider swings of volatility in a down market.

Going through the current 1,130 holdings, which cover several issuances from the same entity, well-recognized major corporations are included in the fund. Bonds from Ceasars Entertainment Inc (CZR), Transdigm Group Inc (TDG), and Level 3 Financing Inc, a subsidiary of Lumen Technologies (LUMN), are among the top 10 holdings.

Down the list, we find good diversification by industries with the scale of the portfolio meaning that the high-level asset class trends and portfolio positioning have a bigger impact on the returns and risk profile more so than any individual holding.

From there, the fund’s credit profile is consistent with the high-yield profile. Approximately 55% of the holdings are B-rated, with another 15% at the C-rated level.

We can also highlight that the majority of securities have a maturity within three to seven years while the effective duration of 2.22 years reflects a smaller level of direct interest rate risk.

We mentioned that HYT has outperformed benchmarks over the past year. In this case, its 21% total return on price is above the 8% result from the iShares iBoxx $ High Yield Corp Bond ETF (HYG) which we believe offers a good baseline for comparison purposes. Naturally, the fund has benefited from its use of leverage explaining a portion of the spread.

At the same time, HYT’s return over the past year is also in line with some comparable CEFs in the same category including the PIMCO Corporate & Income Opportunity Fund (PTY) with a 22% as we as the Nuveen Global High Income Fund (JGH) at a marginally stronger 24%.

Keep in mind that these funds within a broader universe of high-yield income-focused CEFs each have their strategy differences and are not typically directly comparable.

HYT’s current 10% distribution yield based on a $0.0779 monthly payout, has been achieved in combination with a recurring return of capital that has averaged approximately 30% of the distribution in recent years. Notably, the fund’s yield is in the lower range of its peer group average.

What’s Next For HYT?

While the past year has been particularly strong for HYT and the high-yield bond sector, we’re watching what could be a shifting macro environment.

While the theme since Q4 2023 has been a building consensus that the Fed was on track to begin rolling back its restrictive monetary policy, the latest round of economic data has begun to question that narrative.

Specifically, higher-than-expected inflation in recent months alongside a backdrop of what remains a tight labor market has pushed back on the timetable for Fed rate cuts which has important implications for credit markets.

1) A More Complicated Macro Picture

We’re already seeing that as bond yields climb back toward their 2023 cycle high, effectively pricing in a higher-for-longer backdrop of interest rates. Naturally, the setup is bearish for corporate bonds that become less attractive relative to risk-free Treasuries.

As we see it, high-yield borrowers including many of the corporates within the HYT portfolio already squeezed for liquidity could face a tough time attempting to take on more debt or service existing obligations. For HYT as a leveraged fund, higher interest rates add to its borrowing costs and impact returns.

We expect investment-grade bonds or funds focusing on higher-quality credit should outperform from here.

2) Room For Credit Spreads To Widen

This is a problem in the context of what remains historically low credit spreads, as the premium the market depends on takes on credit risk.

While we haven’t seen a blowout of credit spreads consistent with a crisis, a modest widening from here would represent a bearish development for high-yield bonds irrespective of where interest rates head from here.

3) HYT Premium To NAV

As it relates to HYG, the prospect of interest rates remaining elevated or even climbing from here emerges at a time when the fund already appears relatively expensive.

We note HYT’s current 1.3% premium to NAV is well above the fund’s five-year average closer to a 4% discount. For HYT shareholders, the risk that this spread reverts lower would incrementally pressure returns or add to losses.

Final Thoughts

HYT is a solid fund with a good track record but could be in for a bumpy ride going forward. We believe now is the time to take a more defensive approach, recognizing the unique risks of high-yield bonds in the current market.

Down the line, the potential that HYT sells off and its spread to NAV reverses into a discount could offer a more attractive entry point.

For shareholders already in the fund, we recommend taking the monthly distributions in cash as a small measure to limit risk, shifting a focus toward higher-quality credit and investment-grade opportunities.