DHF: Remains A Fair Choice In The High-Yield Space

Written by Nick Ackerman, co-produced by Stanford Chemist.

BNY Mellon High Yield Strategies Fund (NYSE:DHF) is a diversified, high-yield-focused closed-end fund. In our prior coverage, we compared the fund to the Credit Suisse High Yield Bond Fund (DHY), given its many similarities. We noted that DHF looked like the better value and had stronger distribution coverage—enough coverage that a raise seemed warranted. Well, that’s exactly what happened: they increased their distribution since that update.

The fund remains at a rather attractive discount and now sports a higher payout for its investors. Even more importantly, the new payout is still being covered based on their latest earnings. This can make the fund an enticing option in the high-yield CEF space if that’s why one is looking to deploy some additional capital.

DHF Basics

• 1-Year Z-score: 2.41
• Discount: -11.48%
• Distribution Yield: 8.94%
• Expense Ratio: 1.33%
• Leverage: 28.77%
• Managed Assets: $274.551 million
• Structure: Perpetual

DHF’s investment objective is to “seek high current income.” They will attempt to achieve this by investing “at least 65% of its total assets in income securities of U.S. issuers rated below investment grade quality or unrated income securities that Alcentra NY, LLC, the fund’s sub-adviser determines to be of comparable quality.”

DHF is a leveraged fund, and that always adds additional risks to consider. There is greater volatility as both the upside and the downside moves are going to be amplified. Given that it is a high-yield-focused fund, that makes this fund less appropriate for risk-averse investors; instead, one would need to be comfortable on the higher end of the risk spectrum.

Further, leverage adds additional costs that need to be considered. When those costs are factored in, the fund’s total expense ratio climbs to 3.96% as of their latest semi-annual report. That was thanks to the much higher interest rate environment we are now in. For fiscal 2023, the total expense ratio came to 2.9%, and for 2021, it was down to 1.71%. Essentially, it was the ‘free’ money environment where the largest expense for the fund was the operating expenses, including the advisory fees. On the other hand, DHF also has some floating rate exposure that helped to limit some of the damage caused by the higher interest expenses that came in.

Performance and Valuation

Since our last update, DHY has been outperforming DHF by quite a wide margin on both the total NAV and share price return basis. DHF’s performance was primarily in line with the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), or more precisely, DHF had been able to outperform a touch during the last few months. HYG is a non-leveraged, passively managed ETF that can provide some color on what the broader sector is doing.

The outperformance of DHY isn’t new, either. That was another thing we noted in our prior update when we put these two funds head-to-head: that DHY has historically performed materially better.

That doesn’t mean DHY will always outperform, but the track record is definitely in that fund’s favor.

Still, DHF’s own performance is quite respectable against HYG. The fund has outperformed by a meaningful margin over the last decade. During the market crashes of Covid and 2022, we naturally saw both DHF and DHY’s performance drop precipitously. That’s the leverage at play.

Looking at this another way, we can see the performance comparison between the fund and its benchmark on an annual basis. During crashes, the fund crashes harder, and during good times, the fund outperforms, as expected.

Most are expecting rate cuts to come in the future; whether that is this year or next is more of the debate. In general, that should help leverage CEFs as their borrowing costs ease back.

On the other hand, it depends on why rates are being cut. Credit spreads for high yield are historically narrow. That could mean that high yield is due for a drop to raise those yields and, therefore, the spread. That’s certainly something to consider at this time because of the fact that leverage will make both upside and downside moves more dramatic.

Conversely, it does suggest that the market is quite optimistic about financial conditions and expects minimal defaults, so they are willing to take greater risk for only a bit more yield.

That’s where the CEF’s discount can come in to help potentially soften the blow to some degree. Not only is the fund invested in underlying debt instruments that are trading below par, but the fund itself is trading below ‘par’ as well.

The fund’s average bond price in their portfolio comes to $95.18, according to CEFConnect. At the same time, DHF’s discount to NAV is also attractive on an absolute and relative historical basis.

Distribution Gets A Bump

This fund has some history and goes back to 1998. When they initially launched, it was terrible timing, and the fund saw its share price and NAV drop precipitously. During the Global Financial Crisis, the fund had also been hit massively, as well as during Covid and throughout 2023. During most of this period, yields also dropped, and that meant lower income generation for the portfolio as well. So, it was a combination of lower yields and significant erosion of the fund’s assets that culminated in the distribution being cut significantly over time.

That means the latest distribution increase is likely to bring too much enthusiasm to investors, but it is at least going in the right direction.

A distribution history like this certainly doesn’t inspire shareholders’ confidence in the long term. HYG’s own dividend had been falling through most of the last decade as well; it was only more recently that HYG’s monthly distribution also started to head higher in a now higher rate environment. It’s really more of a reflection of the space rather than something that DHF did horribly wrong.

The NII coverage also reflects that it appears sustainable for now, even after the increase. Based on the last semi-annual report, the fund’s NII came to $0.11 or $0.22 on an annualized basis. That puts it on pace to rise over FY 2023. It also means that even after the distribution bump, the fund’s NII coverage comes to almost 105%.

With that bump and the fund’s discount, the distribution rate comes to an enticing 8.94%. On an NAV basis, it’s still down at 7.78%.

DHF’s Portfolio

The last reported turnover for the fund was 56.62%; however, that wasn’t annualized, which means turnover could run up to over 100% during fiscal 2024. That isn’t unheard of for this fund either, as FY 2023 saw turnover come in at nearly 120%. That means we could see plenty of changes in the fund’s portfolio as it seems quite active.

That said, the latest data reflects that across the 326 holdings, the fund’s average effective duration is 3 years. That’s fairly consistent with what we would expect to see from a fund in the high-yield space. Thanks to the higher yields and shorter maturities, they generally have lower interest rate sensitivity. The average effective maturity of the fund came to 4.62 years. When you are investing in higher-risk companies, you want your money back quickly. The faster, the better, as the longer you lend money to a financially distressed company, the greater the chance some sort of economic downturn can hit.

Investing in the high-yield space means knowing you’ll see defaults and bankruptcies and that there will be losses. The idea is that you end up with more winners than losers. Thus, the funds in this space generally invest in hundreds of different holdings and companies to help become significantly diversified. That diversification is also reflected in the fund’s top ten holdings. Sometimes a fund can hold hundreds of positions but still significantly overweight their largest. With DHF, the portfolio seems fairly well split.

Though it should be noted that bonds aren’t totally wiped out when these events occur. Instead, thanks to being higher in the capital stack above equity. How much recovery there is depends on a number of factors, but there is generally some recovery.

In terms of DHF’s credit quality, it isn’t necessarily an overly junky portfolio, with most of the weight being allocated to BB and B.

They carry 12.84% to CCC, those that are holdings that are only a rung or two above already being in default.

For some context, the KKR Income Opportunities Fund (KIO) is what I would consider a high-yield bond fund fully embracing the junk. They carry nearly 35% of their portfolio in the CCC rung, 6% in BB, and ~42% in B. There is nothing wrong with that necessarily, though. In fact, KIO has historically crushed DHF in terms of total returns. It is just knowing what you hold, and when KIO goes down, it tends to go down even harder, as we would naturally expect to be the case.

Conclusion

DHF remains a decently valued fund in the high-yield CEF space. The fund saw its distribution get a bump thanks to the strong distribution coverage it had. Even more importantly, the fund’s coverage still remains strong even after the raise. Lower rates are expected to come in the next year or two, which could help provide even more distribution coverage as borrowing costs ease lower. For these reasons, it would appear that DHF remains a fairly attractive fund to consider if one is looking for this type of exposure. Historically narrow spreads above risk-free rates and expectations for defaults to tick higher through this year would be areas of caution to note. The fund being leveraged will also be a concern if one doesn’t have a generally optimistic outlook on the overall financial shape of the economy.