Overview
December, default fears were exacerbated by anticipations of a wider high yield spread due to an increase to the Federal funds rate target. As a result, high yield bonds saw sudden and extreme declines, as seen by the fall in HYG, the iShares high yield corporate ETF:
The decline was partly the result of excess selling pressure from investors looking to escape the high yield market, causing several junk bond funds to liquidate and freeze redemptions.
At the same time, U.S. equities have seen a week December despite seasonal tailwinds that usually cause the end of the year to show some improvement over the broader year’s trend. At the time of writing, the S&P 500 is up 3.48% including dividends, and up 0.9% excluding.
BDCs experienced extreme volatility, reversing the November outperformance and causing the ETF that tracks the sector (BDCS) to lose 5% in a month. The selling pressure spared BKCC, a strong outperformer for the year, but did not spare so-called “best of breed” BDCs that have been favored by the market in recent months, notably Main Street (MAIN), TPG Specialty Lending (TSLX), and Gladstone Capital (GLAD), which went from being up YTD to being flat or slightly negative (in the case of MAIN and TSLX respectively) to sharply negative (in the case of GLAD).
While CEFs investing in high yield assets saw a sharp downturn at the beginning of the month, the sell-off has not continued and several high yield CEFs are roughly in-line with their price point of a month ago. At the same time buy-write CEFs have seen a sharp downturn in value that is likely to be short-lived (see below).
In economic data, oil continued to fall as the export embargo brought WTI futures to $35 a barrel before seeing a slight recovery to around $37 as of the time of writing. Third quarter GDP rose by 2% annualized in the third quarter, based largely on private inventory investment—a leading indicator of more retail activity in the future. However, corporate profits fell 1.7%, implying further potential difficulties for debtors, particularly with lower credit ratings and higher coupon rates.
1. REITs
While some property REITs saw a slight improvement in pricing in December, many saw prices little change in the past month. The standout exception is Digital Realty Trust (DLR), a topic we covered in two articles: 1, 2. In both articles we pointed to strong tailwinds that were undervalued by the market. Meanwhile, Lexington Realty Trust (LXP) has seen a significant decline that has made its price-to-FFO more attractive, especially in light of its high dividend coverage, as discussed here.
2. BDCs
BDCs have seen accelerating volatility in the last month after a very difficult year, with only BKCC being spared the carnage. Regardless of credit quality, dividend coverage, or perceived portfolio quality, BDCs with few exceptions are down YTD excluding dividends, and most are still down YTD including dividends. The extreme volatility may continue, but also indicates a clear need for set price targets to enter and exit these names as the vicissitudes of the credit market impact these lenders.
3. CEFs
Sell-offs among high-yield CEFs were not as severe as in the BDC world, with some notable exceptions. However, sell-offs relative to NAV declines were not as severe as one would expect from a rational market, as discussed in this article. This presents an income-seeking investor with a dilemma; to truly maximize the profit potential of buying these CEFs, price targets and entry/exit points will be essential to avoid the losses that have accrued for names like NCV, PHT, and NCZ. The fact that interesting performance divergences are appearing between similar funds, such as between PHK and PHT, underlines the importance in careful fund purchases in this volatile universe.
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