The Highland Revenue Fund (NYSE:HFRO) invests in mounted revenue and fairness securities with a specific deal with the actual property sector and floating fee debt devices. It is a phase that has confirmed resilient in 2022 amid rising rates of interest regardless of the difficult financial atmosphere. Certainly, HFRO managed to generate optimistic returns over the previous 12 months, impressively outperforming numerous benchmarks as probably the greatest performing closed-end funds in its class.
There’s so much to love about HFRO given its 9% yield and month-to-month distribution. We see room for additional capital appreciation because of continued favorable market headwinds. Though rates of interest have stabilized over the previous few months, HFRO is well-positioned to profit from a nonetheless excessive fee atmosphere with a path to narrowing credit score spreads in opposition to an bettering macro backdrop going ahead. Latest fund withdrawal together with the widening of the low cost to NAV makes HFRO compelling at present ranges.
What’s the HFRO fund?
The attraction of HFROs is the fund’s technique of allocating into what could be thought-about various investments which can be sometimes reserved for institutional traders. Please notice that the fund is actively managed, which means it’s not supposed to trace any underlying index, and every holding is on the discretion of the funding group at NexPoint Asset Administration.
We talked about funds deal with actual property and securities with a variable rate of interest. This publicity consists of assorted constructions together with collateralized credit score obligations (CLOs), convertibles and most well-liked securities, together with non-public and public equities.
Inside the actual property allocation, which represents greater than 70% of the fund, positions are represented by monetary firms and REITs. On this regard, HFRO invests in some non-public REITs and others which can be individually managed by the identical NexPoint Group as a completely owned subsidiary.
Examples among the many finest properties embrace “NexPoint Houses”, a developer of reasonably priced household properties. right here can be NexPoint Actual Property Finance Inc. (NREF) which is a publicly traded mortgage REIT. We additionally discover “NexPoint Storage Companions” which owns and manages a portfolio of storage amenities. The biggest present place in “SAFStor” can be the storage capability operator, which was taken over by NexPointStorage on the company degree in introduced transaction simply final December.
Transferring by means of the portfolio, different main investments embrace EDS Legacy Companions, which controls company workplace growth in Plano, Texas. “IQHQ” is a personal REIT that focuses on life science actual property growth. There’s typically a broad vary of actual property investments mixed with some smaller tactical positions in different unrelated sectors. The fund has additionally traditionally used derivatives for hedging functions leading to a gearing ratio presently listed at 12%.
The underside line is that HFRO presents publicity to a novel group of belongings and investments which can be managed to generate constant revenue for fund shareholders.
HFRO technically makes use of a “leveraged loans” index as a benchmark, nevertheless it’s clear that the precise publicity is extra nuanced with respect to fairness positions and REIT holdings. What we will say is that HFRO is doing one thing proper as a result of the numbers converse for themselves.
HFRO has returned 11% on a NAV foundation on a complete return foundation, which compares to a 0% return from the Invesco Senior Mortgage ETF (BKLN) as a reference level. The fund managed to buck the development in high-yield bonds and broader actual property, which confronted greater volatility final 12 months. As a CEF benchmark, the PIMCO Company & Revenue Alternative Fund (PTY) fell -7% over the interval, whereas the actual estate-focused Cohen & Steers Complete Return Realty Fund (RFI) misplaced -11%.
At a share value degree, HFRO rose 5% over the identical interval with a margin provided that its low cost to NAV elevated over the interval. Regardless of this, the distribution of efficiency throughout the identical group of funds is analogous.
There are a number of components at play that assist clarify the distinctive 12 months. First, HFROs’ publicity to non-public fairness has helped with returns given their working and monetary developments, which are sometimes decoupled from publicly traded shares. Energetic administration additionally seems to have performed a task in security choice.
We are able to additionally point out the $40 million share buyback program that was accomplished within the first quarter of final 12 months. Contemplating the fund has greater than $1 billion in belongings beneath administration, the repurchase could have modestly boosted shareholder returns, although it is seemingly not the principle perpetrator.
What’s extra important might be the fund’s positions in floating fee devices since all these loans regulate in worth on to adjustments in charges. This was essential in 2022 in a number of Fed fee hikes that led to a leap in short-term rates of interest. Whereas fixed-rate devices and the broader bond market as an asset class have confronted heavy losses and historic volatility, the floating-rate elements of the portfolio have functioned as a hedge and should have even contributed to a rise in NAV.
This dynamic is expounded to the idea of bond period, which displays the sensitivity of a sure instrument to adjustments in rates of interest. In different phrases, the portion of the portfolio in floating fee loans, together with CLOs, helped the portfolio’s efficiency by lowering the implied efficient period.
One other truth to think about is the development in mortgage spreads. Apart from the headlines over the previous 12 months concerning the housing market slowdown and the autumn in property costs within the last months from the height, debt securities have in any other case been properly supported with none of the main defaults which have outlined earlier cycles.
The Fed publishes the “ICE BofA BB US Excessive Yield Possibility-Adjusted Unfold” index that we will use right here as a proxy for lending situations. The present degree has fallen over the previous few months and is properly beneath intervals of maximum market stress both in the course of the depth of the pandemic or because the 2008 monetary disaster.
Particularly, the identical degree of credit score margins is now on the lowest degree in virtually 1 12 months, reflecting the newest knowledge on easing inflationary pressures and expectations of normalization of rates of interest. All this may be optimistic for the longer term technique of NFRO funds.
What’s subsequent for HFRO?
We’re optimistic on HFRO with the baseline that the technique stays engaging within the present market atmosphere. Whereas short-term rates of interest are unlikely to repeat their 2022 highs because the Fed slows its rate-hiking coverage, barring a coverage reversal to decrease charges or greater credit score spreads, floating fee devices and CLOs ought to proceed to carry out properly.
For actual property, we additionally anticipate stabilization in comparison with volatility in 2022. Enchancment financial sentiment As inflationary pressures ease, they could possibly be a catalyst for the restoration of the broader sector. Financial indicators to observe embrace resilient developments within the labor market and company earnings to gauge the well being of the broader economic system.
HFRO is buying and selling at a particularly giant low cost to NAV of -28%, which itself has been risky over the previous 12 months. As with the fund’s efficiency, a part of the dynamic right here accounts for the distinctive funding portfolio with allocations to non-public firms and even wholly owned subsidiaries of NexPoint. The market could assign a structural low cost to this measure given the shortage of direct management that HFRO traders as shareholders have over the underlying investments, along with the character of some securities, together with financial institution loans the place day by day pricing will not be accessible.
The argument we’re making is that whereas the low cost is assured, the extent should be too excessive at this level with room to taper. Any enhance within the low cost can be an extra optimistic for HFRO shareholders.
Lastly, we will deliver up the continued litigation in opposition to “Credit score Suisse Securities” the place NexPoint is in search of greater than $121 million in damages in opposition to allegations of potential fraud.
The newest replace in October, he merely defined that the group was awaiting last judgment with a possible HFRO restoration of greater than $103 million that might add to the web asset worth. Alpha Searching for Fellow George Spritzer coated the subject in that point. There aren’t any new occasions introduced presently. We might anticipate the cash for use for a brand new repurchase authorization.
Total, we imagine HFRO is a high-quality fund that may work within the context of a broader portfolio for revenue traders. The expense ratio of 1.67% is in keeping with comparable CEFs given the institutional administration and particular asset class.
We just like the setup at HFRO by trying on the value chart of shares which have traded in a comparatively tight vary over the previous 12 months, excluding the month-to-month distribution. The chance to choose up the fund round $10.50 appears to be like like a gorgeous entry level by way of relative worth.
On the detrimental facet, the principle threat can be a deeper deterioration of the financial outlook. Though we have now painted a rosy image of macro situations, a reversal between rising unemployment, falling company earnings and falling credit score spreads would open the door for decrease HFRO costs once more.