Analysis of FHI, a unique approach to strategic-income
First Trust Portfolios, an Illinois-based money manager famous for their unit investment trusts, has entered the worlds of ETF's. Their newest fund consists of an index licensed from Morningstar which tracks dividends. The ticker is FDL. They also put out a closed-end fund with an eye-popping high-yield. The ticker on that one is FHI. I’d like to focus on the latter (FHI) as I believe the managers may be seeking out value in a unique way.
The fund has three traits which distinguish it from its peers:
1 – focus on structured finance rather than on corporate bonds
2 – 10% yield
3 – no leverage
The fund managers use structured finance because they believe corporate debt is overvalued and the demand for such funds could decrease along with yield. They also believe collateralized debt carries less risk since the payments are secured by the underlying assets of the issuing company. For example, collateralized mortgage obligations are a re-sale of packaged mortgages back to the public. The yield is guaranteed by the underlying real estate which could be repossessed if a borrower defaults on enough payments. The sale of the assets would pay back the bondholders. Sounds safe, right? It is in the sense that backing up an asset with collateral dramatically reduces default risk. However, it often creates an operational hazard with the management. Many ABS’s (asset-backed securities) are issued by limited-partnerships and other corporate entities which credit rating agencies tend to shy away from. This results in low ratings (B’s and C’s) which detract investors who are rating-agency snobs.
Many types of packaged debt that FHI buys are ultimately backed by real estate. However, there are other types of assets than can be collateralized as well. The fund deals in limited partnerships which do equipment, auto, and airplane leasing. By using a broader group of assets than plain-vanilla corporate bond funds, FHI is inherently more diversified. That being said, the fund gives itself the right to buy some corporate bonds, equities, and money market instruments as well. The fund is currently 98% invested and will probably remain that way considering the sky-high yield which they plan on maintaining. FHI gives itself the right to leverage as well but doesn’t currently, and plans to avoid it so long as they can maintain the yield.
While the fund managers may be good at seeking out unconventional debt, the overall credit quality of the investments, as rated by both Moody’s and S&P, is low. Some types are not even graded, and most of the rest fall in the low B, high C range. For all you inexperienced fixed-income investors out there, these ratings scream volatility. I would normally be concerned about default risk as well, but the managers do a good job of explaining how they plan on diversifying the risk in the prospectus. I think they can achieve their objective if they combine good management with unconventional investments. The fund’s style is a reflection of the two co-managers, Justin Ventura- formally of Fitch, a credit rating agency, and Rip Mecherle- a former closed-end fund manager that focused on high yield.
The managers believe they are approaching the fund from a value-oriented perspective. They identified all available instruments that could produce a high-yield and selected those which had an attractive combination of yield mixed with the potential for capital appreciation. The ideal situation for the fund would be a general industry shift towards structured finance and away from corporate bonds. This would fill the funds secondary objective of capital appreciation. Combined with the cost-effective nature of exchange-traded funds, an investor could potentially get a 15% total return if management is consistent. This would require dedication to researching industries (and credit issuers) which are undervalued and selling their debt when appreciation occurs.
I like this fund as both a cost-effective alternative to fixed-income mutual funds, and a portfolio diversification tool to both equities and corporate bonds. An investor may need to hold on through the volatile days, but I think doing so will pay off nicely.
Russell Bailyn
rbailyn@gmail.com
This article is for informational purposes only. My blog is in no way a solicitation, or recommendation to purchase or sell any investment product. There are many risks inherent in investing and you should speak to your financial consultants prior to making any decisions.
Comments
ETF connect is run by Nuveen asset management, who runs closed end funds. They are trying to rebrand CEF's with the advantages of ETF's.
The key difference between an ETF and a CEF is that ETF's shares can be created or destroyed at any time (in the form of large blocks called "creation units"). Because of this feature, ETF shares tend to trade very close to NAV, since authorised participants can engage in arbitrage by aggregating shares into creation units and then redeeming them.
The supply of ETF shares is infinite. CEF shares cannot be redeemed, and there is a limited number of them as authorised in the CEF's prospectus.
CEF shares tend to trade a persistant discount to NAV. Although the reasons for this are poorly understood.
CEF's have a bad repution because they tend to change high fee's and destroy shareholder value via the discount. As a result there is very little investor investor interest in CEF's, and so Nuveen is trying to remarket CEF's as exchange traded funds. For the most part CEF's are bad investments, with some rare exceptions.
First trust knows that the days of CEF/UIT's are numbered and so has started to offer ETF's.
Posted by: Market Participant | April 3, 2006 02:14 PM