GHY: Large discount, but distribution coverage has decreased

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Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published for members of the CEF/ETF Revenue Lab on March 24, 2022.

PGIM Global High Yield Fund (NYSE: GHY) initially appears to be quite an attractive fund in terms of basic parameters. A steep double-digit discount with a payout yield reaching 9.60%. However, where the fund falls short is in distribution coverage. I suspect there might be a cast trim as the cover continues to slip. We would also have to consider credit risk in the high yield space at this time.

Higher interest rates also pushed this fund down. It is offered with a leverage-adjusted duration of 5.2 years. One of the main impacts on the duration of a portfolio is the maturity of the underlying portfolio. GHY’s portfolio has an average maturity of 6.6 years.

It’s not the worst duration we’ve seen of higher-quality bond funds, and municipal funds would have a higher duration. This translates to the fact that for every 1% increase in rates, GHY’s underlying portfolio should fall by around 5.2%. If the Fed pushes rates up to 2%, GHY’s underlying investments could drop more than 10%.

Graphic

Y-Charts

On a YTD basis, it would appear that the NAV has already fallen by a significant amount. The stock price fell even faster. Of course, this opened the fund’s largest discount.

I think if a reduction in distribution is announced, the discount could widen a little more from here. Since the fund’s discount is already quite large and the fund has experienced such declines before, this might not create a big drop. I would suggest that some of the timing trim at this point is included in the price.

The basics

  • Z-score over 1 year: -2.33
  • Discount: 10.57%
  • Distribution yield: 9.60%
  • Expense ratio: 1.23%
  • Leverage: 18.80%
  • Assets under management: $739 million
  • Structure: Perpetual

GHY seeks to “provide a high level of current income by investing primarily in below investment grade fixed income instruments of issuers located anywhere in the world, including emerging markets”.

This is a fairly straightforward high yield bond fund with greater flexibility to invest more internationally. Investing outside of the United States can help provide greater diversification for investors, moving away from the “country of origin bias”. In our previous article on GHY, I noted how highly correlated it was with its US counterpart, PGIM High Yield Bond Fund (ISD). So, despite its global focus, these two had historically shown a strong correlation.

The fund’s expense ratio is 1.23%; it amounts to 1.56% including the leverage effect. With higher interest rates coming, their borrowing expenses will also increase. In 2019, when rates were higher, the fund had an expense ratio of 2.56%. Given inflation expectations, rates should be even higher in this cycle. Can’t say for sure until it actually happens, but it could suggest we’re seeing fund expense ratios surpass previous highs of 2019. For GHY, they’re paying USD LIBOR interest at 1 month plus 0.75%.

The amount of leverage the fund uses is rather modest, relatively speaking. The size of the fund also reaches a fair size of nearly $740 million in total assets under management.

Performance – Attractive discount

If we compare GHY and ISD again, we can see that the most recent YTD returns show that ISD is slipping back in performance. It’s not a lot, but I think it highlights the current geopolitical risks. Both being high yield bond funds, they are sensitive to credit risk.

Graphic

Y-Charts

Exposure to Russia and Ukraine for GHY is minimal, but it appears that these are not the only countries investors are concerned about.

In this case, what looks better for GHY is the fund’s current discount. If we look at the longer term chart, the fund has been subject to larger discounts. Pushing around the 15% discount market repeatedly, but bouncing around those levels pretty quickly. Over the past year, the average discount is 6.99%, resulting in a 1-year z-score of -2.33.

That’s pretty substantial, and it’s something we’ve seen happen so far in 2022. Discounts have widened significantly from the end of 2021. For most of 2021, discounts were in the historically narrow ranges for the closed-end fund. space out.

Below over the past ~10 years showing that GHY is currently even slightly deeper than its average. They launched at the end of 2012, so it’s not quite a 10-year period that we’re looking at. That being said, this is why it could represent quite an attractive time to enter position at this time. However, higher rates could continue to play a role in keeping the share price and net asset value under pressure.

Graphic

Y-Charts

Distribution – A cut could be possible

GHY has kept its distribution rather stable for the past few years now. They’ve had a series of cast cuts and then a few bumps throughout their history. However, lack of coverage is a concern here.

GHY Distribution History

GHY Distribution History (CEF Connect)

When we last talked about the fund, it had a distribution coverage of 81.3% for the previous 3-month period and a YTD tax coverage of 81% with higher leverage. They’ve deleveraged their portfolio, it seems, which could drive some of the hedge drops. The leverage was 26% before. The latest report at the end of February 2022 shows us a coverage rate of 77.7% and a YTD tax coverage rate of 78.2%.

PGIM coverage report

PGIM coverage report (PGIM)

Based on their latest semi-annual report, we see a similar lack of hedging in the fund. NII coverage, in this case, was about 88%, which is better. Still, we would like to see NII at over 100% coverage for a bond fund. This would be for the previous six months ending January 31, 2022.

Half-year report GHY

Half-year report GHY (PGIM)

For tax purposes, there was some return of capital in their distribution for fiscal year 2021.

For the year ended July 31, 2021, the tax character of the dividends paid by the Fund was $45,046,004 of ordinary income and $6,518,084 of return of capital. For the year ended July 31, 2020, the tax character of dividends paid by the Fund was $51,359,468 of ordinary income. Annual Report

The ROC is expected given that the NII and capital gains were not sufficient in terms of income. Being a high yield bond fund, the majority classified as ordinary income would also be expected here. This would make the fund more suitable for a tax-sheltered account.

GHY Portfolio

GHY managers can be quite active in managing the fund represented by higher turnover in some years. In the past six months, it has been reported at 23%. In fiscal year 2020, the fund’s turnover rate was 49%. In fiscal year 2019, it was quite high with a turnover rate of 96%.

That being said, they have hundreds of positions in their portfolio. At the end of February, they listed 336 positions. This is typical of high yield bond funds. These are riskier holdings; some of the holdings are in companies classified as defaulting or in imminent default with little prospect of recovery. This is why it may be important to spread the portfolio over hundreds of positions. The idea is that hopefully a minority of the debt securities you hold default or go bankrupt while others pay off par as expected.

GHY credit quality

GHY credit quality (PGIM)

The trade-off here is that returns are higher for junk-rated companies. This helps compensate for the fact that there will be flaws in the wallet. All of this raises another significant risk in this time of credit risk. If the economy is expected to slow due to the Fed’s rate hike, it could be more difficult for these lower-investment-grade companies to operate under tighter financial conditions. I would say that certainly weighed on a fund like GHY in addition to the geopolitical risk with its international exposure.

The fund’s geographic allocation has the largest exposure to the United States. This is common to most CEFs, even those with a global slant.

Geographic allocation GHY

Geographic allocation GHY (PGIM)

If we look at their last semi-annual report, they listed Russia as a 0.6% weighting and Ukraine as 0.3% of their portfolio.

Since we last approached the fund, exposure to the US has decreased relative to allocation by 47%. There does not appear to be any specific change they are choosing to adopt when reducing their exposure to the United States. Most of the countries listed all received a slight increase in their allocation, as well as the “other” category.

GHY largest holdings

GHY largest holdings (PGIM)

Looking at the top ten, the total exposure is 15.1%. Considering there are 336 positions, these top ten still represent a fairly large weighting relative to the rest of the portfolio. However, we can see how diverse the exposure is by the representation of different sectors and countries.

Ford (F) used to be the largest position in the fund, but it’s now dropped down the list a bit. Petroleos Mexicanos took the top spot and Chesapeake Energy (CHK) also climbed higher. Both were also positions before.

Conclusion

Bonds and high yield funds are not necessarily the best place to position yourself for the short term if you are an active trader. They have taken a hit with higher interest rates, geopolitical risks and credit risks due to an economy that is expected to slow. The lack of distribution coverage for GHY could also play a role in the current valuation. On the other hand, the steep discount could present an opportunity for a longer-term investor, with the understanding that it could continue to be bumpy in the short term. All in all, I’d take a pass for now, but it might be a firm grip. I could also see an argument for wanting to take a stand now, just in case things bounced back from here.

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