Money

This 40%-Discounted Fund Is A Nice Approach To Lose Cash

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One of the things that we contrarian closed-end fund seekers (CEFs) love is that they often sell for less than they are worth.

The discounts from CEFs are particularly attractive these days as the market floats into the stratosphere. Because if you buy stocks through a CEF that trades, for example, at a 10% discount on net asset value (NAV or the value of the investments in its portfolio), you can get into great companies such as Apple (AAPL), Microsoft (MSFT) or Visa (V) for 90 cents on the dollar.

This is a great trick that you can’t find in ETFs or mutual funds. Plus, CEFs averaged 7.3% return today, so you get a monster payout on top of your discount.

But you can’t just buy the lowest discounted CEF and name it a day because sometimes a CEF is “cheap for a reason”. This is often the case when a fund’s discount becomes extreme – 20% or more.

That brings me to the fund I want to look at today: the NexPoint Strategic Opportunities Fund (NHF), Holder of a whopping 40% discount. NHF is a diversified CEF debt security that specializes in loans that real estate developers take out to pay for their properties. The fund can best be viewed as a kind of developer-focused investment bank.

As you can probably guess, the pandemic has had a huge impact on NHF: with COVID-19 shutdowns and lower property use, NHF’s portfolio has taken a hit.

The funny thing is, as you can see above, NHF’s portfolio has almost completely recovered to pre-pandemic levels. Investors remain cautious however, which is why NHF’s total return is still in double digits based on market price. This interruption is the reason why the fund gives this huge discount of 40% on the net asset value.

So what’s going on here? The truth is that investor caution is well founded – and goes well beyond the battles some commercial real estate rental companies have faced due to COVID-19.

NHF is a black box

NHF had already announced in the middle of last year that it would convert its legal status from a registered investment company to a real estate investment trust (REIT). It would remain a closed-end fund in the short term, but management hopes that switching to a REIT will help NHF “reduce the fund’s historical discount to net asset value, as REITs have on average traded cheaper than closed-end funds relative to net asset value . “

In reality, the announcement did little to shrink NHF’s discount. In fact, it got bigger in the weeks following the announcement.

This is because NHF’s portfolio contains many illiquid assets that are difficult to value: only about 20% of its holdings are regularly valued at market value. Most of the others are so-called “Level 3 assets” with values ​​that can be subjective and can be assessed with great difficulty. These holdings, which include the real estate assets shown in the breakdown below, are also valued far less often than those that are traded on the stock exchange.

NexPoint portfolio allocation

NexPoint

The REIT’s announcement worried investors that these assets are currently overvalued and the conversion could cause the fund’s net asset value to fall rather than meeting management’s hopes that the change would result in an increase in the market price of NHF .

Add in the fact that NHF’s return is well below the CEF average at 5.2% and you see why investors are refusing to buy the fund at anything other than a fire sale price.

The future of NHF

This does not mean that NHF is a disaster. Indeed, some tailwinds could help the fund perform well.

Most notably, these include rising interest rates, which are beneficial to some of NHF’s assets, particularly the Collateralized Loan Obligations (CLOs) that increase with interest rates. In addition, the rapid pace of vaccination in the US and NHF’s focus on American assets could lead to an increase in demand for real estate in the Fund’s portfolio portfolio and the real estate that supports the loans it invests in and the net asset value and the Increase net asset value This will quickly shrink the discount.

Needless to say, such a bet is speculative at best, as the discount could last for some time given the uncertainty surrounding the conversion.

However, the wide range of the NHF discount on the net asset value in just three years (from 3.6% in January 2018 to 64% in March 2020) underscores a key strategy that we always apply when investing in these funds: buying the stark discounted funds when the market mispriced them and sell them when their discount becomes too small. The best part is that CEFs give you high returns of 7% or more (sometimes a lot more) while you wait for the discount to go away.

Michael Foster is the lead research analyst for Contrarian Outlook. For more great income ideas, click here for our latest report. “Indestructible Income: 5 bargain funds with safe dividends of 8.3%.

Disclosure: none