April 21, 2016

Doug Kass admits BGB was a poor investment

I originally purchased Blackstone/GSO Strategic Credit Fund (BGB)  11 months ago last June in the belief that widening junk bond spreads would stabilize soon.

I was premature, as spreads continued to widen out throughout the rest of 2015. By early 2016, and with commodities prices near their lows, the spreads were so wide that they were statistically discounting a rather deep recession. At that time, Carl Icahn and many others were warning that an imminent collapse in the high-yield bond market would lead to economic catastrophe. At that time I defended my position in the belief that they were wrong, both here and here.

In my 15 Surprises for 2016, I expressed the view that the high-yield bond market would be among the best asset classes for the year. BGB's year-to-date performance is up 5.5% and I still believe in this case.

As recently as late January, I defended my position on the junk bond and senior bank loan sectors. BGB's shares steadily declined and bottomed out at approximately $12 a share in mid-February.

Since June 2015, and adjusted for its generous divided of 10.5 cents per month, BGB has fallen from about $15 to $13.90 -- a drop of about 7%. In other words, this has been a poor investment. The one-year return has been a negative 6.9%.

BGB has rallied by about 15% from the February lows, during which iShares iBoxx High Yield Corporate Bond ETF  (HYG)  rose from $76 to nearly $83. Its year-to-date gain has been 5.5%, and its six-month gain is 8.5%.

BGB is trading at a 9.7% discount to its Net Asset Value. This compares to a three-year average of -9.2%, a 12-month average of -12.95% and a six-month average discount of -12.45%.

The current distribution rate is approximately 9%. (At its low in February, BGB was yielding 10.5%).

I have averaged all the way down in BGB over the last 11 months and I now have only a slight loss (net of dividends) in the ETF position.

It clearly has not been worth the effort since June!

Importantly, this note is an acknowledgement of a poorly timed entry point, and the move I have taken is in recognition of the strong recovery in the price of the shares since the February lows coupled with renewed macroeconomic risks.

With the price of most commodities particularly of an oil-kind rising rapidly since January, a still-elevated 9% yield and only a 1.5-year portfolio duration, BGB continues to represent good long-term value. However, given my overall negative market and economic outlooks, I can no longer rationalize having an outsize position for the following reasons:

-   The shares have rallied sharply (15%) from the 2016 lows. This has reduced the reward versus risk. My guess is that the upside/downside is basically even over the balance of the year, with  $1 upside and $1 downside in BGB shares. 
-   The current discount (9.70%) to Net Asset Value is closing in on the three-year average (9.20%) after rising to as high as 15% two months ago, when the markets were in panic mode. Given continued global economic downgrades, it is not likely that the discount will contract further throughout the balance of 2016.
-    The current dividend yield of 9.0% is down from 10.5% in February. This is still an attractive return, but given the leverage of 32%, it is not an unusually attractive return anymore.
-    As mentioned previously, global economic growth expectations continue to be ratcheted down, and I am getting increasingly negative on the prospective trajectory in 2015-2017.
-    I have increased my short net equity exposure, and if I am correct in view, the junk bond and senior loan markets will not likely be spared. I am battening down the hatches and I want to further reduce my risk exposures.
-    My one-third probability associated with a garden-variety recession may be too low, particularly if an exogenous event interrupts the current modest rate of domestic growth. 

This is another difficult investment decision for me, but reflecting the above I have reduced the size of my BGB holdings from large to medium over the last two days. I plan to reduce the size of my BGB further in the week ahead.

Position: Long BG