Aberdeen Income Credit Strategies Fund: 30% return in two years – looking for alpha | Jewelry Dukan

Nuthawut Somsuk

thesis

Aberdeen Income Credit Strategies Fund (NYSE: AKP) is a closed-end fund investing in high yielding debt securities in North America, the UK and Europe. The main objective of the fund is current income. Credit risky “CCC” and “B” loans make up more than 90% of the portfolio fund. Given that effective all-in yields for “CCC” bonds are now over 15%, the fund is able to pay high, true dividend yields. Add to this the CEF’s significant leverage (currently 46%) and you get the picture of a fund that is very credit risky but able to pass real returns on to investors based on the cash flows of the underlying assets.

Effective yields on junk bonds are now very high due to the Fed’s aggressive monetary tightening policy. We haven’t seen interest rates that high in almost a decade (with 2-year Treasuries on the verge of exceeding 4%) which, combined with wide credit spreads, makes for today’s benign environment for dividend yields. New issues in this space are now being forced to offer very attractive yields but are not always valued due to the current risk aversion in the market, as we saw with Tellurian, an LNG darling.

ACP is a high-risk, high-reward vehicle. The CEF offers a very high true cash flow return, but that return comes with volatility. We do not believe that the current recession will lead to an excessive increase in default rates, so we believe that long positions in credit risk offer attractive risk-reward profiles. The downside of being long in ACP is absorbing significant volatility. A retail investor must have at least a two-year investment horizon if they buy ACP now and be able to sustain short-term losses of -10% to -15% in name. Can credit spreads widen? Absolutely. Can the fund’s premium to NAV fall in a risk-off environment? You bet. Will ACP offer an investor a 30% net return two years from now if the fund is held as a buy-and-hold? Yes, we are strong in this camp.

ACP is not currently using a ROC from the available data that we have and this aligns well with the very high all-in returns currently available in the market. Investors have recognized the value of this high true yield and have bid the CEF at a premium of 10% to NAV. Expect this vector to fluctuate and flatten back to the NAV during a risk-free fight. ACP is a high risk, high reward game and should only be bought with a long time horizon and the ability to withstand significant surges in volatility.

State of the high yield market

Due to the increase in risk-free rates, all-in CCC yields have risen above 15%:

where is the fed

All-in returns (The Fed)

This figure shows an investor what a fund can achieve by buying CCC credits on the secondary market. If ACP has cash left over and goes to the secondary side, it can borrow with annualized yields in excess of 15%. We haven’t retested the COVID highs, but we’re pretty close.

We believe current all-in yields are attractive as credit spreads have not widened as much:

What

Credit Spreads (Fed)

The chart above tells us that the Fed is responsible for most of the high all-in return and not for the overall risk (ie probability of default) in the high yield market. This is very constructive for investors as it represents an attractive risk/reward profile.

holdings

The CEF focuses on the riskiest part of the capital structure, namely “B” and “CCC” loans:

What

Credit (Fund Fact Sheet)

We can see that “CCC” loans make up almost 40% of the fund, while “B” and “CCC” loans make up over 90% of the portfolio. It’s an extremely credit-risk portfolio, and it’s where the fund draws its cash flows to pay such large dividends.

As a reminder, “B” and “CCC” loans fall into the “Highly Speculative” and “Significant Risk” categories:

Impressive

Credit Risk (Wolf Street)

The fund has a high concentration in the “Consumer Discretionary” sector:

what are you

Sectors (Fund Fact Sheet)

We can see that almost 30% of the fund falls into this sector area. That’s a pretty high concentration. We don’t typically like it when individual sectors in a high yield fund exceed 17%.

From a single name perspective, the vehicle is fairly granular:

What do you have

Top Holdings (Fund Fact Sheet)

The vehicle does a good job of spreading the portfolio across many credits. The rule of thumb here is that no name should make up more than 2.5% of a portfolio. We only have two issuers here that exceed this threshold.

distributions

If we look at the latest Section 19A report available, we will see that the fund is not currently using a ROC:

What

May Section 10A (Fund Notice)

what is the note

May Section 19A (Fund Notice)

Premium/Discount on NAV

The fund currently trades at a premium to NAV:

diagram
Data from YCharts

The fund trades at a premium due to its very attractive dividend yield. However, we can see that the premium is very sensitive to risk on/risk off movements in the broader market. Expect the premium to tighten on the next risk aversion.

IVH CEF Fusion/Inclusion

We have written an in-depth article about the possible merger between ACP and IVH here. On August 11, the Delaware Ivy High Income Opportunities Fund (IVH) announced that its Board of Trustees approved the fund’s reorganization into the Aberdeen Income Credit Strategies Fund (ACP). According to the announcement:

The reorganization is currently expected to be completed in the first quarter of 2023, subject to (I) the approval of the reorganization by the absorbing fund’s shareholders, (II) the acceptance of the absorbing fund’s shareholders to the issuance of shares in the absorbing fund, and (III ) the fulfillment of usual closing conditions.

We believe the merger will occur and will be beneficial to both groups of shareholders as ACP will end up with more assets under management.

Conclusion

ACP is a fixed income CEF whose primary objective is current income. The Fund invests more than 90% of its portfolio in ‘B’ and ‘CCC’ credit risk securities. With all-in yields ranging in excess of 15%, the fund is able to pass true 15% annualized dividend yields (ie no return of capital) to investors. The fund is currently trading at a premium of 10% to NAV, with investors recognizing the attractive risk/reward trade-off. ACP is in the process of growing with the IVH CEF merger, subject to shareholder approval.

We do not believe that the current recession will lead to an excessive increase in default rates, so we believe that long positions in credit risk offer attractive risk-reward profiles. The downside of being long in ACP is absorbing significant volatility. A retail investor must have at least a two-year investment horizon if they buy ACP now and be able to sustain short-term losses of -10% to -15% in name. We believe that a two-year hold at current levels can offer an investor a 30% total return, albeit with significant volatility.

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