Aberdeen Income Credit Strategies Fund: 30% return in two years

Nuthawut Somsuk

Thesis

Aberdeen Income Credit Strategies Fund (New York Stock Exchange: ACP) is a closed-end fund investing in high yield debt securities from North America, the United Kingdom and Europe. The primary objective of the fund is current income. Credit risk “CCC” and “B” credits represent more than 90% of the portfolio of this funds. Since the overall effective yields of “CCC” bonds are now north of 15%, the fund is able to pay real and high dividend yields. Add to that the high leverage effect of the CEF (currently 46%) and you get the image of a very risky fund in terms of credit, but able to pass on to investors a real return, based on the cash flows of the underlying assets.

Effective yields in the junk bond sector are now very high due to the Fed’s aggressive monetary tightening policy. We haven’t seen rates this high in almost a decade (with 2-year Treasuries poised to break above 4%), which, coupled with high credit spreads, results in the current environment favorable to dividend yields. New issues in space are now forced to offer very attractive yields, but they are not always valued due to the current risk sentiment in the market, as we saw with LNG darling Tellurian.

The ACP is a high-risk, high-return vehicle. CEF offers a very high real cash return, but with that return comes volatility. We do not believe that the current recession will lead to an outsized increase in default rates, so we believe that long credit risk positions offer attractive risk/reward profiles. The downside of being long ACP is the incorporation of substantial volatility. A retail investor should have an investment horizon of at least two years if buying ACP now, and be able to accept declines of -10% to -15% in the short-term name. Can credit spreads widen? Absolutely. Can the fund’s premium to net asset value compress in a risk-free environment? You bet. Will ACP provide an investor with a 30% net return in two years if the fund is held as a buy and hold? Yes, we are strongly in this camp.

ACP does not currently use any ROC from the available data we have, and this pairs well with the very high all-in returns currently available on the market. Investors realized the value inherent in this high real yield and increased the supply of CEF at a 10% premium to net asset value. Expect this vector to fluctuate and return flat to NAV during risk-free combat. ACP is a high risk/high reward bet and should only be purchased with a long-term time horizon and with the ability to withstand significant bouts of volatility.

State of the High Yield Market

Due to rising risk-free rates, CCC’s all-in yields soared above 15%:

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All-in returns (the Fed)

This figure shows an investor what a fund can get by buying CCC credits in the secondary market. When the CPA has cash on hand and moves to secondary, it can obtain credits at annualized returns in excess of 15%. We haven’t retested the COVID highs, but we’re pretty close.

We think current global yields are attractive because credit spreads have not widened as much:

What

Credit spreads (the Fed)

The chart above tells us that the Fed is responsible for most of the overall high yield, rather than the overall risk (i.e. probability of default) in the high yield market. This is very constructive for investors as it represents an attractive risk/reward profile.

Assets

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

What

Credit (Fund Fact Sheet)

It can be seen that the “CCC” credits represent almost 40% of the fund, while the “B” and “CCC” credits represent more than 90% of the portfolio. This is an extremely risky portfolio in terms of credit, and this is where the fund gets the cash flow needed to pay such high dividends.

As a reminder, “B” and “CCC” credits come under the “Highly speculative” and “Substantial risk” tranches:

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Credit risk (Wolf Street)

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

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Sectors (fund fact sheet)

We can see that almost 30% of the fund belongs to this sector bracket. It’s a pretty high concentration. We generally don’t like to see sector buckets above 17% in a high yield fund.

From a unique name perspective, the vehicle is quite granular:

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Top Holdings (Fund Fact Sheet)

The vehicle does well in spreading the portfolio across many credits. The rule of thumb here is that no name should exceed 2.5% of a portfolio. Here we have only two issuers exceeding this threshold.

Distributions

If we look at the most recently available Section 19A report, we will notice that the fund does not currently use ROC:

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May Section 10A (Notice of Funds)

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May Section 19A (Notice of Fund)

Premium/Rebate to NAV

The fund currently trades at a premium to net asset value:

Chart
Data by YCharts

The fund trades at a premium due to its very attractive dividend yield. However, we can notice that the premium is highly dependent on the risk-on/risk-off moves in the broader market. Expect the premium to shrink on the next risk move.

IVH CEF Merger/Absorption

We wrote a long article here regarding the potential merger between ACP and IVH. On August 11, the Delaware Ivy High Income Opportunities Fund (IVH) announced that its board of directors had approved the reorganization of the fund into the Aberdeen Income Credit Strategies Fund (ACP). According to the announcement:

It is currently expected that the reorganization will be completed in the first quarter of 2023 subject to (I) the approval of the reorganization by the shareholders of the Acquiring Fund, (II) the approval by the shareholders of the Acquiring Fund of the issuance shares of the Acquiring Fund, and (II) satisfaction of customary closing conditions.

We believe the merger will go through and will be beneficial to both sets of shareholders, with ACP finding itself with more assets under management.

Conclusion

ACP is a fixed income CEF whose primary focus is current income. The fund invests more than 90% of its portfolio in “B” and “CCC” credit risk securities. With all-in returns above 15%, the fund is able to pass on true annualized dividend yields of 15% (i.e. no return of capital) to investors. The fund is currently trading at a 10% premium to net asset value as investors have identified the attractive risk/reward proposition. ACP is set to expand with the IVH CEF merger pending shareholder approval.

We do not believe that the current recession will lead to an outsized increase in default rates, so we believe that long credit risk positions offer attractive risk/reward profiles. The downside of being long ACP is the incorporation of substantial volatility. A retail investor should have an investment horizon of at least two years if buying ACP now, and be able to accept declines of -10% to -15% in the short-term name. We believe that at current levels, a two-year holding period can provide an investor with a 30% total return, but with significant volatility.