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This 40% discounted fund is a great way to lose money

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One of the things we like about trumped-up income seekers in closed-end funds (CEFs) is that they often sell for less than they’re worth.

CEF discounts are particularly attractive these days as the market levitates in the stratosphere. Because when you buy stocks through a CEF that trades at, say, a 10% discount to the net asset value (NAV, or the value of investments in its portfolio), you can get into big companies like Apple (AAPL), Microsoft (MSFT) or Visa (V) for 90 cents on the dollar.

This is a great tip, which you can’t find in ETFs or mutual funds. Plus, CEFs earn an average of 7.3% today, so you get a monster payout on top of your discount.

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

Which brings me to the fund I want to discuss today: the NexPoint Strategic Opportunities Fund (NHF), owner of a huge reduction of 40%. NHF is a CEF Diversified Debt that specializes in loans that real estate developers take out to pay off their properties. The best way to look at the fund is as a developer-focused kind of investment bank.

As you can probably guess, the pandemic has had a big impact on NHF: With COVID-19 closures and less use of real estate, NHF’s wallet has been hit.

The funny thing is, as you can see above, NHF’s portfolio has almost completely returned to pre-pandemic levels. But investors are still wary, which is why NHF’s total return based on its market price is still down in double digits. This disconnect is the reason why the fund is offering this huge 40% reduction on net asset value.

So what is going on here? The truth is, investor mistrust is well founded – and it goes far beyond the struggles some commercial real estate owners have faced as a result of COVID-19.

NHF is a black box

In the middle of last year, NHF announced 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 for the short term, but management hopes the move to a REIT will help NHF “reduce the fund’s historical discount to net asset value, as REITs have on average traded more favorably relative to net asset value. to the net asset value than the net asset value. closed funds. “

In fact, the announcement did little to reduce NHF discounts; in fact, it actually grew in the weeks following the announcement.

The reason is that NHF’s portfolio contains many illiquid assets that are difficult to value: only around 20% of its holdings are regularly put on the market. Most of the rest are “level 3 assets”, with values ​​that can be subjective and are assessed with great difficulty. These holdings, which include the real estate assets shown in the breakdown below, are also valued much less frequently than those traded on an exchange.

The REIT’s announcement raised investor concerns that these assets are currently overvalued, and the conversion could result in a drop in the fund’s net asset value, instead of responding to management’s expectation that the change would cause the price to rise. of NHF Market.

Add to the fact that NHF’s 5.2% return is well below the CEF average and you see why investors refuse to buy the fund at anything other than an incendiary selling price.

The future of NHF

This does not mean that NHF is a disaster; in fact, certain favorable winds could help the fund perform well.

Most importantly, rising interest rates, which is a boon for some of NHF’s assets, particularly its Secured Loan Obligations (CLOs), which rise with rates. Additionally, the rapid pace of vaccination in the US and NHF’s focus on US assets could lead to increased demand for the real estate in the fund’s portfolio and the real estate backing the loans it invests in, making increasing its net asset value and causing a rapid reduction in its discount.

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

But NHF’s wide range of discounts to NAV in just three years (from 3.6% in January 2018 to 64% in March 2020) highlights a key strategy that we always use when investing in these funds. : buy those that are strongly discounted when the market is wrong. and sell them when their discount becomes too small. The best part is, CEFs will give you high returns of 7% or more (sometimes a lot more) while you wait for the reduction to go away.

Michael Foster is the senior research analyst for Contradictory perspectives. For more great income ideas, click here to view our latest report “Indestructible Income: 5 trading funds with safe 8.3% dividends.

Disclosure: none

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