What to Buy: Western Asset High Income Opportunity Fund (NYSE: HIO)

Why to Buy Now: The bear market in crude has spilled over into the high-yield bond market, with many speculative-grade securities now trading below par, particularly those issued by companies that operate in the energy sector.

Earlier this week, in fact, Barron’s reported that one-third of the energy sector’s junk bonds were now trading at distressed levels, with average yields above 10%. The average energy-sector bond in the high-yield market recently traded at 84.9 cents on the dollar, versus 97.1 cents for the broader high-yield index.

While the downward pressure on energy prices could certainly push crude even lower and take energy sector bonds along with it, Martin Fridson, who Institutional Investor has dubbed the dean of high-yield bond analysts, recently noted that this is a “concentration of distressed issues ordinarily seen only near troughs in the credit cycle.”

That certainly qualifies as blood in the streets. Fridson says that at recent levels, high-yield energy bonds were implying a default rate of 6.6%.

The glut of production from the North American energy renaissance led to a similar glut of borrowing to finance it. According to Barclays, the energy sector now accounts for 14% of the junk market, a jump from just 5% in 2007.

As of the end of September, the energy sector was the second largest weighting in HIO’s portfolio, at 11.5% of assets.

That allocation, along with a general flight from high-yield bonds amid uncertainty over Federal Reserve policy, as well as geopolitical tension, has pushed HIO’s units well below their net asset value (NAV). The closed-end fund (CEF) currently trades at a 9.9% discount to NAV.

To be sure, many CEFs trade at persistent discounts to NAV, but even on that basis HIO appears oversold. The current discount is 7.5 percentage points below its trailing three-year average discount of 2.4%.

When otherwise solid CEFs trade below their NAV, they offer value-oriented investors the rare opportunity to buy a basket of securities at bargain prices. And with the hit the NAV has taken from the high-yield selloff, we’re getting the investing equivalent of double coupons.

The discount to NAV also serves to enhance HIO’s distribution rate. The distribution rate based on the NAV is 7.1%, but the fact that HIO’s actual units are trading at a discount to NAV adds another 80 basis points, for a total distribution rate of 7.9%.

Equally important, HIO is one of the few CEFs that doesn’t use leverage to juice its yield. That’s a crucial attribute, particularly when the high-yield market, or the financial markets in general, hit a rough patch.

And if management sees that investment income is failing to cover the distribution, it will simply lower the payout rather than engage in the widespread industry practice of destructive returns of capital. Many high CEF payouts are illusory because fund managers support them via returns of capital that are basically giving unitholders their money back net of investment fees.

HIO has a seasoned management team that draws upon the expertise of 12 credit analysts that specialize in high-yield bonds. Management charges a reasonable advisor fee of 0.80%, with a total annual expense ratio recently at 0.88%.

Market dislocations, such as what junk bonds are currently experiencing, create opportunities. And we believe this team will take full advantage of the recent selloff.

Finally, HIO earns a Bronze analyst rating from Morningstar, which means the rating firm’s analysts have a high level of conviction about the overall quality of the fund.

HIO is a buy below 5.50. The CEF has reasonable trading volume, averaging around 334,000 units daily over the past three months, but we’d still recommend using limits when buying or selling.

Khoa: Junk, huh?

Ari: I know it sounds bad, but bear with me.

Though speculative-grade bonds are colloquially referred to as “junk,” they took off as an asset class when studies showed that the long-term default rate of a diversified portfolio of junk bonds wasn’t nearly as bad as the name suggested.

Indeed, the long-term average default rate for high-yield bonds is 4.5%, and it’s been considerably lower more recently.

Khoa: That’s all fine and good over the long term, but what happens during a downturn?

Ari: At the height of the Great Recession, for example, the default rate for junk bonds hit 10.8%, so that gives us a sense of what to expect during a worst-case scenario.

In 2008, HIO, itself, dropped 25.3% on a price basis, while it’s NAV fell 30.5%. However, it came roaring back the following year, with units skyrocketing 70.3% on a price basis, while the NAV jumped 57.9%.

And while I’m admittedly skeptical about many aspects of an economy fueled by Federal Reserve largesse, I don’t think we’re on the cusp of another downturn of that magnitude.

Though some money managers and other institutional investors are starting to see attractive opportunities in the high-yield space, it’s important to be highly selective since some of the smaller players, particularly those in the energy sector, are already facing serious cash-flow challenges.

And unlike in the past, they probably won’t be able to tap the capital markets to roll over problematic debt or grab a lifeline from a credit facility. Obviously, dividend cuts can help free up capital to bolster balance sheets, as we saw recently with Baytex, while paring capital expenditures will also help firms stay current on their obligations.

As we’ve often said about high-yield equities, you don’t get a high yield without high risk. The same holds true for bonds, though at the very least they’re higher up in a firm’s capital structure, so bondholders are the first in line to get paid in the event of bankruptcy.

Given the present turmoil, rather than try to identify individual high-yield credits that are worth a gamble, I prefer to go with the experts.

Khoa: Tell me more about the fund’s management team and investment process.

Ari: First, it’s important to note that HIO can be pretty daring, even for a high-yield fund. Of course, that’s how we get that high distribution rate without layering on additional leverage.

The fund tends to hugely overweight bonds rated triple-C or below relative to its benchmark and peers. At the end of the third quarter, for instance, 28.5% of assets had a triple-C rating. Issuers with this rating are considered highly vulnerable to default.

However, management did increase the fund’s overall quality during the third quarter in other areas, by reducing its allocation to B-rated securities to 42.9%, while boosting its allocation to BB-rated securities to 16.4%.

The management team mitigates credit risk by keeping durations short. The fund’s effective duration is 3.6 years. That also makes the fund less sensitive to changes in interest rates.

But most important, perhaps, is their attention to detail.

The three fund managers along with their research team employ deep fundamental analysis that not only covers key financial details such as leverage, cash flow adequacy and liquidity, but also evaluates the overall quality and integrity of each company’s management team.

They complement this bottom-up analysis with a top-down approach at the macroeconomic and sector level to guide the portfolio’s overall risk level, as well as its weightings among the various sectors.

Khoa: We’ve spent a lot of time talking about the energy sector, but what’s the breakdown for the other sector weightings?

Ari: At the end of the third quarter, the fund’s five largest sector weightings were in communications, at 15.7% of assets, followed by energy (11.5%), consumer discretionary (10.6%), consumer defensive (10.3%) and capital goods (8.3%).

Also of note, total assets are around $452 million.

Khoa: We’ve also spent a lot of time talking about yield, but how has the fund actually performed?

Ari: Over the trailing five-year period, the fund’s NAV has grown by 8.8% annually, while on a price basis it’s risen by 6.5% annually, owing to the fact that it tends to trade at a discount to NAV.

On a year-to-date basis, the fund is down by 2.0% in terms of price, while the NAV is off by 0.8%.

However, those numbers mask the recent carnage: HIO’s units are currently down nearly 13% from their trailing-year high.

Khoa: What about tax considerations?

Ari: HIO’s net investment income is largely derived from the interest paid by bonds, which means the distributions would be taxed as ordinary income if the security is held in a taxable account. As such, it’s best to hold it in a tax-advantaged account such as an IRA.

HIO is a buy below 5.50. The CEF has reasonable trading volume, averaging around 334,000 units daily over the past three months, but we’d still recommend using limits when buying or selling.

Portfolio Update

Baytex Energy Corp (NYSE: BTE) continues to bring the pain. Despite its sharp selloff since the ill-fated timing of our recommendation, we still like the company for the long term. But given the stock’s decline, we’d certainly understand if investors were ready to throw in the towel.

The latest evidence of our poor timing? The company has announced that it’s cutting its monthly dividend to CAD0.10 per share from CAD0.24 per share, effective with the January payout.

Although that news is certainly disappointing, Baytex has cut its dividend in the past when faced with extreme downward volatility in oil prices, so this wasn’t entirely unexpected once crude entered official bear market territory.

But while this latest move means lower income as a shareholder in the near term, it also helps the company preserve capital for the long term.

Though Baytex had been paying out a large percentage of its earnings to shareholders, in other respects it tends to be somewhat more conservative than its peers when it comes to managing its dividend, with an emphasis on maintaining its payout from current cash flows rather than artificially supporting it via debt or equity issuance like some other high-yield companies do.

Though it could be argued that such conservatism should probably extend to the payout ratio during both good times and bad times, we’d rather the company keep a solid balance sheet than engage in financial engineering to support an unsustainable payout.

The stock actually got a brief bump as a result of this news, so that suggests investors saw this as a step in the right direction, despite the lower payout.

Like many of its E&P peers, Baytex also announced a reduction in its capital budget for 2015, with plans to pare it by 30% to realign spending with the new reality of lower crude.

“Given the recent collapse in world oil prices, we believe our 2015 budget strikes the right balance between preserving our operational momentum in delivering organic production growth and managing our dividends prudently to maintain strong levels of financial liquidity,” said Baytex CEO James Bowzer.

About 75% of next year’s capital spending will be allocated toward the Eagle Ford, which makes sense given the better economics of this play.

Baytex’s Eagle Ford play accounted for 37.6% of third-quarter production, or about 34,000 barrels of oil equivalent per day (BOE/D), with a breakeven threshold of USD49 per BOE/D. The company didn’t offer breakeven analysis of its other plays, though presumably the Eagle Ford offers better economics than its heavy-oil Peace River and Lloydminster plays.

The last time Baytex cut its dividend was during the Great Recession, when its monthly payout bottomed at CAD0.12 per share after briefly reaching a high of CAD0.25 per share in 2008. The company began boosting its dividend again exactly a year following the first cut as oil prices recovered.

Let’s hope the lower level of the payout is similarly short-lived this time around.

Baytex is now a hold.

Norbord Inc (TSX: NBD, OTC: NBRXF) said it’s agreed to buy Ainsworth Lumber in a deal worth CAD763 million.

This follows an attempt by Louisiana-Pacific earlier in the year to buy Ainsworth for CAD951 million. The plan fell through due to opposition from U.S. and Canadian regulators. Both companies will be controlled by Brookfield Asset Management, which will own about 53% of the merged entity.

The combined companies will be valued at about $2 billion, creating the world’s largest producer of oriented strand board (OSB).

The merged company boasts 15 mills (11 from Norbord and four from Ainsworth) and 7.7 billion square feet of OSB capacity.

OSB is made from compressed layers of wood strands. It’s cheaper than plywood and is often used as a substitute in flooring and wall sheathing for housing projects. Benchmark OSB prices have dropped 9.6% in the past year, to about $217 per 1,000 board feet.

In the all-stock deal, shareholders will receive 0.1321 shares of Norbord for each share of Ainsworth. This represents a 15% premium to Ainsworth’s 20-day market price.

Norbord CEO Peter Wijnbergen said, “Norbord and Ainsworth are each low-cost producers in their respective regions, and with our complementary operations and a more diverse range of specialty products, we will be better able to serve our customers.”

The combined company expects to achieve savings of up to $45 million annually.

Norbord’s dividend will continue, and it is expected that the new board will set the dividend at CAD0.25 per share for the first quarter of 2015.

Norbord is a buy below 26.