GDO: An Attractive Quality Income Option

GDO: An Attractive Quality Income Option

With strong capital gains over the past six months, income investors are looking to take some chips off the table. This exercise to strengthen portfolios is a response to both less attractive valuations as well as a desire to build up a store of dry powder in order to take advantage of any volatility over the coming months.

In this article we take a look at the Western Asset Global Corporate Defined Opportunity Fund (GDO) which maintains a 2/3 investment-grade allocation. We like the fund for its portfolio quality, attractive discount valuation, potential performance tailwind given its term structure, strong returns in the sector as well as a sustainable increase in earnings. For these reasons we maintain exposure to the fund in our Defensive and Core Income Portfolios.

Taking Chips Off The Table Time

Since election day, credit valuations have taken a decisive turn higher with credit spreads downshifting to the tightest levels since late February. At current levels, high-yield spreads stand only about 1% above their pre-drawdown levels.

Source: Systematic Income

These expensive valuations present an unfavorable asymmetric risk to investors in our view. While macro activity has improved, we are far from being completely out of the woods, particularly as COVID cases and hospitalizations have increased over the last few months, which is likely to dampen the recovery. Secondly, while the Fed has improved the liquidity profile of the corporate sector, it cannot do much about its solvency issues. High-yield issuers have had decent access to markets to roll over their debt or issue additional debt, but this hasn’t done much for their already elevated and rising leverage levels. And thirdly, while credit spreads have largely retraced their widening, defaults are still rising. Oaktree expects a default rate of about 6-7% next year – a figure which is about triple that of the rate over the past few years. When combined with particularly low recoveries this time around, a tripling of the default rate versus credit spreads that are only 30% wider does not point to a very attractive risk/reward picture in our view. A back-of-the-envelope calculation of a 6.5% default rate with an average 30% recovery gets us to a loss rate of 4.5% which is nearly equal to the yield provided by high-yield corporate sector. This paltry expected return suggests that investors should look elsewhere for income.

Meet GDO

GDO is allocated around 2/3 to investment-grade bonds with another 22% in BB-rated securities – the highest “junk” rating. Country exposure is about 58% in the United States with the rest split among G10 and Emerging Market credits. In terms of sector allocation, investment-grade corporates make up 42% of the portfolio, high-yield corporates at 25% and EM debt at 20%. Current exposure is primarily USD at 86% with the rest primarily in other G10 currencies. The fund closed Wednesday at a 7.09% current yield and a 7.4% discount.

In terms of discount valuation, GDO is not trading far from the sector average. In our view, this actually makes it attractive given its term structure. In other words, if the fund goes ahead and terminates, the discount accretion to zero will provide an additional tailwind to the fund’s price relative to its NAV. However, if the fund’s termination date is extended or removed (a distinct possibility given this is precisely what happened to another Western Asset term CEF), then we don’t expect the fund’s discount to widen sharply from current levels as it is already trading at a wider discount than the sector average and its current yield is well above the sector average. This asymmetric discount risk profile is an attractive feature of the fund.

Source: Systematic Income

The way we measure this potential tailwind is through a metric we call the pull-to-NAV yield, which is simply the fund’s discount divided by the number of years to the expected termination date (which changes on each day of the calculation). At current levels, the fund’s PTN Yield is close to its historical highest levels, making it an attractive entry point.

Source: Systematic Income

GDO is ahead of the rest of the Investment-Grade CEF sector in terms of historical NAV returns across different time periods. However, it does lag the sector ETF benchmark in our view, due to its lower duration given the downtrend in interest rates over the last few years.

Source: Systematic Income

Coverage And Earnings Drivers

As we have discussed in our review of distribution coverage, CEFs offer a number of ways of tracking distribution coverage from shareholder reports to Section 19a notices to quarterly financial updates. As it happens, GDO does a pretty good job of offering relatively high-frequency updates.

Its monthly Section 19a updates paint a clear picture of an improvement in distribution coverage from around 80% to about 90%.

Source: Systematic Income

The latest quarterly NII update also shows an improvement and puts coverage also at around 90%.

Source: Systematic Income

The latest shareholder report only goes up to April month end, so it is less useful.

What has allowed the fund to improve its earnings profile?

First, the fund has a very small amount of floating-rate securities that would have seen lower coupons due to the drop in short-term rates.

Secondly, the fund has a significant proportion of non-callable assets – at least 2/3 of the portfolio but likely much larger. This means that the issuers are not able to call back the securities to take advantage of lower yields, allowing the fund to maintain its earnings level.

Thirdly, the fund appears to not have deleveraged this year, unlike a significant number of other CEFs. This partly has to do with the fund’s relatively low leverage entering the drawdown of low-to-mid 20s, which has now increased to around 29%. In fact, the fund looks to have added a repo to its credit facility, growing its borrowings by nearly a quarter between January-end and April-end of 2020 and increasing its assets by about 5% relative to January valuations. It’s not clear exactly when these assets were added but if they were added after the start of the March drawdown the managers have generated quite a lot of value for investors, in retrospect.

Fourthly, the fund’s leverage facilities are all based on short-term interest rates which have decreased sharply this year.

The result of these supportive factors is observable in the quarterly NII figures. The sizable increase for the quarter ended in July looks like a sustainable increase in our view.

The fund has kept its distributions unchanged since mid-2018, so with this recent improvement in earnings it is less likely to make a cut in our view. The last time a cut was made, coverage was below 80% and short-term rates continued to march higher. The current situation of stronger coverage levels and short-term rates that are likely to remain low for an extended period of time should support level distributions.

Takeaways

With the risk/reward picture much less attractive at current levels in the credit space, some investors have begun to take some chips off the table by selecting funds and securities higher up in quality. GDO, in our view, looks attractive, providing an attractive combination of quality and yield. The fund’s term structure profile also provides discount support and a potential performance tailwind into the termination.

Disclosure: I am/we are long GDO. 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.

Credit: SeekingAlpha

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