WEA CEF: Buy It For The Corporate Exposure, Stay For The High Yield (NYSE:WEA)

Thesis

The Western Asset Premier Bond Fund (NYSE:WEA) is a hard and fast earnings closed finish fund. The car is an attention-grabbing CEF that gives a mix of funding grade securities and excessive yield. Funding grade (‘IG’) securities make up over 69% of the collateral pool, whereas the remainder consists of ‘BB’ securities. The fund is a bit uncommon in its combine, because it tends to run largely charges threat by way of its funding grade bond portfolio, with credit score spreads secondary. The excessive yield sleeve acts as a dividend enhancer right here, producing extra cash-flow to assist the CEF’s 7.9% yield.

We live by historic instances, and we imagine in hindsight traders will acknowledge this era because the ‘peak charges’ one. This function is just not misplaced on the funding neighborhood, which has plowed a file amount of money in bond funds in November:

After important outflows beginning in August, traders have pumped file money into funding grade and excessive yield company bond funds, ranges not seen since July 2020.

There may be an inverse relationship between charges and bond costs, and as charges transfer decrease, bond costs will transfer larger. WEA’s portfolio has a 5.6 years period, and is ideally set as much as benefit from the run-up in IG company bond costs as charges transfer down (the principle threat issue for IG debt).

On this article we’re going to take a look at WEA’s composition, its analytics and threat components, and articulate why this CEF seems enticing on the present juncture for a long run holder.

We have now coated this title earlier than right here, at first of 2023, when the shortage of readability on the rate of interest path had us at ‘Maintain’ for the title. On the time we expressed a desire in the direction of the BlackRock Multi-Sector Revenue Belief (BIT), a CEF which efficiently hedged its period profile throughout this financial tightening cycle. We had been appropriate in that view, with BIT outperforming 2x this yr:

The score improve is because of the foremost threat issue for WEA peaking, particularly charges. As charges are set to maneuver decrease, a retail investor could be effectively served to realize extra period of their funding account to profit from the decrease charges/larger bond costs impression.

Analytics

• AUM: $0.13 billion.
• Sharpe Ratio: -0.5 (3Y).
• Std. Deviation: 10 (3Y).
• Yield: 7.9%.
• Premium/Low cost to NAV: -3%.
• Z-Stat: 1.2.
• Leverage Ratio: 27%
• Period: 5.6 years

Portfolio

The fund holds a mixture of funding grade and excessive yielding bonds:

If we add up the AAA, AA, A and BBB securities, we get an funding grade sleeve in extra of 69% at the moment. The fund has the flexibility to regulate the precise exposures, so anticipate a dynamic portfolio that may, nonetheless, be chubby funding grade bonds.

From a sectoral standpoint on the funding grade facet the fund has the biggest exposures to financials and vitality:

Threat Components

The primary threat issue for this CEF has been constituted by charges, with the car down from its period drag because the Fed moved charges larger:

The iShares iBoxx Funding Grade Bond ETF (LQD) has the very best period from the cohort (8.3 years), therefore its drawdown is the biggest throughout the Fed financial tightening course of.

With charges in a bottoming course of, and the final Fed fee hike behind us within the opinion of many analysts, we’re considering a 2024 that will likely be marked by fee cuts. The actively traded SOFR futures market is telling us that a lot, with 100 bps of cuts priced in for 2024.

Decrease charges will translate into larger bond costs for WEA, all else equal. The fund has a 5.6 years period, thus we should always anticipate a 5.6% optimistic value efficiency along with the fund’s dividend yield.

The one remaining threat issue to be thought-about is represented by a deep recession, which might widen out credit score spreads and thus negate the optimistic transfer in costs from decrease charges. When credit score spreads rise (i.e. the market requires a bond issuer to pay extra in unfold on new points) bond costs fall. There are diverging opinions on this subject, with the fairness market telling us {that a} soft landing is within the playing cards, whereas many main financial indicators are turning damaging.

In our base case the optimistic windfall from decrease charges will likely be negated by wider credit score spreads. With funding grade company spreads at the moment at 120 bps, the present projected fee fed funds cuts are effectively set as much as negate a doubling in credit score spreads. The bottom case assumes a parallel shift within the yield curve (i.e. the 5 yr node will carry out the identical because the entrance finish).

Yield and distributions

The fund has a coated distribution, with the excessive yield sleeve getting used to generate a better yield than a traditional funding grade bond fund:

A retail investor must be very weary of CEF buildings which overdistribute, as a result of finally they are going to simply return your capital again, lower their NAV, and hamper their capability to carry out sooner or later. We are able to see that sort of conduct within the MFS Intermediate Revenue Belief (MIN), which we coated on Searching for Alpha up to now with a ‘Promote’ score, particularly on account of its propensity to overdistribute:

We are able to observe the huge distinction between a fund like WEA which solely sees NAV hits throughout recessions or durations of financial tightening like 2022/2023, whereas the likes of MIN have a NAV efficiency that resembles a downward pointing arrow.

Low cost to NAV

The fund shows a variety sure low cost to NAV that has fluctuated with the transfer in charges:

The car has not too long ago gained in extra of 4% from its low cost narrowing on the again of the aid rally in fastened earnings. We are able to see the CEF being nearly flat to NAV throughout the low charges setting that characterised 2021.

Anticipate extra of the identical into 2024/2025. As charges normalize decrease the fund will transfer once more to being flat to NAV, however for the reason that present low cost could be very low there may be not a lot to realize from this structural facet for the CEF.

Conclusion

WEA is a hard and fast earnings closed finish fund. The car focuses on funding grade bonds which make up over 69% of the collateral pool. The remaining stability is invested in U.S. excessive yield bonds. WEA has charges as its main threat issue, and with a peak in yields acknowledged by many analysts, we have now seen file flows into company bond funds. WEA has been a beneficiary, with a 4% narrowing of its low cost to NAV, and a transfer up within the worth of its collateral. We’re at first of a major bull market in funding grade bonds, primarily pushed by decrease charges as priced by SOFR futures. The CEF’s distribution and historic NAV efficiency denote a sturdy car that doesn’t overdistribute. We’re a purchaser for the title on the present ranges.