HYI: Term CEF Lacking A Matched Collateral Base

seekingalpha06-14

Western Asset High Yield Defined Opportunity Fund is a fixed-income CEF with a term maturity date of September 30, 2025.The fund's holdings do not match the maturity profile, leading to significant ...

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What sets this fund apart is its term maturity date: Provides a non-leveraged high-yield corporate fixed-income portfolio with a limited term structure that will liquidate on or about September 30, 2025 We covered the fund two years ago, when we highlighted its structure and collateral composition. In today's market, where credit spreads are extremely tight, HYI presents an interesting dilemma for holders. In today's article, we are going to highlight why holders should switch away from the fund, and underline the hidden market risk present in the CEF's structure. What exactly is a term fund? Term CEFs are funds which have a pre-determined liquidation date spelled out in their prospectuses. In this case, the fund will liquidate its assets close to the termination date and distribute all remaining cash flows. Set term dates can only be changed via shareholder vote into perpetual funds. We can see why term funds make sense in the ETF space, where there is a matched collateral profile. The most popular ones come from Invesco, where the maturity date of the fund is matched with the collateral, thus creating a diversified bullet bond in effect. For example, the Invesco BulletShares® 2030 Corporate Bond ETF (BSCU) contains a portfolio of investment grade corporate bonds that mature in 2030. Term funds thus serve the purpose of creating diversified vehicles when the underlying collateral matches the maturity date of the fund. Market risk for non-matched holdings HYI is a term CEF, but its holdings do not match the maturity profile of the fund. The HYI portfolio has a weighted average life of 5.4 years, and its top holdings have very long maturities: Top Holdings (Fund Website) We can see how the Mexican Bonos mature in 2031, while the Sprint bonds have a 2028 maturity date. This translates into HYI taking market risk if it does liquidate late next year: Market risk is the risk of losses on financial investments caused by adverse price movements. Examples of market risk are: changes in equity prices or commodity prices, interest rate moves or foreign exchange fluctuations. Market risk is one of the three core risks all banks are required to report and hold capital against, alongside credit risk and operational risk. The standard method for evaluating market risk is value-at-risk. When you do not maturity match the underlying collateral, you can have significant fluctuations in price that can negatively affect the liquidation value. A collateral pool that has the same maturity date runs only one risk - default risk. If the company does not default, then as a fund you will receive 100% of your principal and interest back. Conversely, if we have a risk-off event in 2025 on the back of a hard landing scenario, the CEF's holdings can lose significant value all while they will need to be liquidated. It is basically akin to selling at the bottom and crystalizing losses. Performance in line with ETF peers HYI is an unleveraged CEF, and its performance is in line with the SPDR Bloomberg HY ETF (JNK) and the VanEck Fallen Angel ETF (ANGL): Data by YCharts Please note the close correlation among the three names, with HYI the underperformer on a 3-year lookback. The fund has a high expense ratio of 0.95%, which has dragged down its total return when compared to its peers. No reason to continue holding HYI As we explored in the above sections, HYI will start running significant market risk as it approaches its termination date. The CEF is not an outperformer, having performed in line or worse than cheaper vanilla ETFs such as JNK or ANGL. At the current macro stage, with extremely tight credit spreads, there is no reason to hold a fund like HYI. It does not yield more than its competition, and it runs higher risks than its peers at a higher cost. A CEF structure needs to justify its high fees via outperformance or layering of leverage. HYI does not do any of those, and in fact, is running higher risks via its lack of collateral maturity matching. Holders would do well to sell and replace the holding with JNK or ANGL as applicable for risk appetite. Credit spreads are very low While a retail investor can take their cash out of HYI and move it to JNK or ANGL, we would actually be more conservative and just do short-term bond funds for now. Credit spreads are at historic lows currently, which is never a good sign: Credit Spreads (The Fed) Currently, single-B credit spreads as measured by the ICE BofA Single-B US High Yield Index OAS reside at 279 bps (or 2.79%). Today's level is below the one observed in the 2017-2020 period in terms of minimums. While critics argue that the all-in yield is much higher, in reality, credit spreads are the ones that compensate investors for the probability of default of a corporate. When credit spreads are too low, an investor is taking excessive risk versus historic default rates. While nobody can predict the future, we are much more inclined to buy high-yield on the back of some sort of market dislocation that would see spreads move higher. When you buy spreads at the bottom, there is nowhere to go but up, which would translate into losses for investors. Conclusion  HYI is a fixed income CEF. The vehicle has a term maturity in September 2025, but its holdings have very different maturity profiles. This mismatch introduces a high amount of market risk, which the fund does not compensate for via outperformance or yield. HYI has performed in line with vanilla HY ETFs in the past 3 years, despite charging much higher fees. With credit spreads very tight currently, investors are best served to sell out of HYI and either circulate some of the capital into JNK or ANGL or utilize high-yielding short-term bond funds such as MINT.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.24.0","shortVersion":"4.24.0","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2443062049"}