Barings Global Short Duration High Yield Fund: Avoid At Narrow Discount To NAV

\"Junk bond\" closed-end fund maintains a weighted average duration of less than 3 years, which represents lower interest rate exposure.

The 10% yield is enticing, but the lower-rated credit and bond portfolio represents higher risk should spreads widen.

Discount to NAV has narrowed significantly this year, suggesting the fund is relatively expensive.

The Barings Global Short Duration High Yield Fund (NYSE:BGH) is a closed-end fund with current total assets under management at $365 million. The fund invests in short-term debt and credit securities seeking to maintain a weighted average portfolio duration of less than 3 years. What sets BGH apart from other short-duration funds is that its portfolio is exclusively comprised of high-yield or effectively "junk bonds" for the purpose of generating a high level of income. On one hand, the short-duration focus minimizes overall exposure to changes in interest rates, while the lower-rated securities represent higher credit risk. Investors may be attracted to the monthly distribution that currently yields 10%. While we like BGH and think it serves a good function by providing investors exposure to an important segment of fixed income, we highlight some concerns over the fund's volatility along with a historically narrow discount to NAV.

BGH's primary objective is to seek a high a level of current income and capital appreciation. The fund invests globally, and beyond its general constraints, it does not have a stated benchmark. The defined strategy includes the following methodology:

We use the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) for comparison purposes, which is appropriate, in our opinion, as HYG is one of the most actively traded "high yield bond" funds, although the underlying composition and strategy is different. We note that HYG has a longer effective duration at 3.37, which compares to BGH at 2.27 but still relatively close. BGH has a distribution yield of 10% compared to 5.3% for HYG. Favorably, BGH has returned 39.6% since its inception in 2012 on a total return basis compared to 37.2% for HYG over the period.

Data by YCharts

What's concerning, however, is the wider volatility observed in BGH compared to HYG over the period, suggesting a lower risk-adjusted return. BGH suffered a drawdown of 25% between 2014 and 2016 compared to 15% for HYG including the dividend income. In late 2018, BGH fell 20% on a total return basis compared to 7% for HYG. The point here is that there is indeed a tradeoff between the higher yield in BGH that has been accompanied by higher volatility. This is overall a high-risk fund despite the "short duration" categorization.

Returns for BGH have been mixed. Year to date 2019, the fund has returned a relatively impressive 18% (16.4% to end Q2), but much of that has been based on a narrowing discount to NAV, which we discuss in more detail further below. The fund presented a negative return in the calendar years 2012, 2014, 2015, and 2018 on a total return basis. The performance drivers will largely be based on the changes in interest rates along with moves in credit spreads. 2015 was a particularly weak year which coincided with the collapse of energy prices and wider spreads among speculative grade corporates overall.

BGH semi-annual report

The financial statement above shows that the total dividend to shareholders currently set at $0.1482 per month has been adjusted lower "cut" since inception. NAV has declined from the offering price of $25.00 in 2012 to a current $18.15 (as of 09/06/2019), while the total return to shareholders has been positive only if the distributions were reinvested. Essentially, the fund has paid out more than it has earned since inception, but has not required a rights offering.

BGH appears to have ample liquidity and recurring investment income to support the distribution for the foreseeable future. Nevertheless, the lower market value share price in recent years reflects the gap between higher distribution outflows compared to income. A future dividend cut cannot be ruled out if the performance deteriorates. Year to date through Q2, the fund generated $1.18 per share of income from investment operations, which compares to the $0.89 distribution over the first six months.

BGH monthly distribution

We point out that there is a wide divergence this year between the market price and NAV of the fund. Year to date though, BGH NAV is up 5.44%, while the market price has increased 18.1%. The dynamic here is a tightening of the discount to NAV, which is currently at 3% compared to a low of 17% as recently as December 2018. The 5-year average is closer to an 8% discount. By this measure, BGH is relatively more expensive than what investors have paid for the fund previously.

Data by YCharts

We believe the narrowing of the discount here is in part related to the trend lower in interest rates this year with an expectation of further rate cuts by the Fed, which is supportive to the BGH bond portfolio but also considering this is a leveraged fund and a lower rate lowers its borrowing costs. At least over the past 5 years, a discount to NAV around this level appears to have been something of a Sell signal prior to corrections in the fund. For us, it's just one more reason to remain cautious here, and investors could consider reducing exposure.

The attraction to junk bonds is clearly the income component, as these securities have a wider yield to maturity. The idea here is simply higher risk, higher reward. The risk, of course, is that one of the issuers should default, although this is mitigated, as BGH's portfolio is currently represented by 126 issuers. Nearly 85% of the fund is rated "B" or lower.

BGH portfolio composition

According to data from Moody's Ratings, U.S. "speculative grade" corporate defaults remains at relatively muted levels at 2.4% to end Q1, down from 2.8% at the end of 2018. From the Moody's report:

There's also the point that just because an issuer has a "technical" default, such as a late payment, does not mean the entire principal is lost. Overall, we're not concerned with the quality of the portfolio as much as the outlook for the credit spreads, which we expect to widen from here and which would pressure the performance of the BGH portfolio. The market trend has been for a widening of high yield spreads as indicated by the below chart published by the St. Louis Fed tracking trends in High Yield CCC or Below Option-Adjusted Spreads, which we use as a proxy for trends in the segment. Note that a higher spread here is negative for the prices of "junk bonds" in general.

U.S. High Yield Spread

This is a delicate time in the market with deep uncertainty regarding the momentum in the economic growth outlook. The Fed cutting rates, on one hand, is supportive to highly leveraged companies, but this is balanced against an expectation of a decelerating operating environment. We note that global PMI indicators have trended lower and U.S. manufacturing is relatively weak. A lot of the moves in the underlying credit and bond holdings will be based on sentiment, which has deteriorated in recent months.

Here is what BGH management said in the company's semi-annual report regarding the high yield current market conditions, taking an overall more optimistic look at least from when it was published back in July:

While the current move lower in rates is indeed favorable to most fixed-income securities, the concern is more related to the scenario should there be a steepening of the yield curve going forward. Junk bonds, particularly through this vehicle, is not an area of the market we feel is worth betting on at the present time.

Data by YCharts

We like the concept and structure of the Barings Global Short Duration High Yield Fund but have some concerns related to its high volatility, historically narrow discount to NAV, coupled with our overall bearish opinion on junk bond credit spreads. We are going to keep this one on our radar and would consider initiating a position on a meaningful pullback, looking for a discount to NAV closer to the 10% level as a Buy signal. For long-term investors, it's worth considering reducing exposure, as we recommend a rotation into higher-quality credit.

I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.