WDI CEF: Another bump in distribution, fully covered (NYSE: WDI)

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Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on November 6, 2022.

Earlier this year, the Western Asset Diversified Income Fund (NYSE: WDI) increased their distribution a little. Now they’ve increased it a bit more since previous update.

This emphasizes once again that the decline in value of the portfolio does not affect the income generated. In fact, the latest semi-annual report shows us that income generation in the fund has accelerated with an increase in net investment income or NII. Enough that further increases in the future are a real possibility.

The value of the underlying portfolio is negatively affected due to rising interest rates. The Fed also doesn’t seem ready to end the rate hike any time soon. So there could certainly be additional pressure in the future. At the same time, the fund is trading at a steep discount, which could potentially be an attractive entry level for investors.

The basics

  • Z-score over 1 year: -0.73
  • Discount: 12.64%
  • Distribution yield: 11.84%
  • Expense ratio: 1.48%
  • Leverage: 31.19%
  • Assets under management: $1.15 billion
  • Structure: Temporary (early liquidation date, June 24, 2033)

WDI’s objective is “to obtain a high current income. As a secondary investment objective, the fund will seek capital appreciation. They will bring a “flexible and dynamic” approach. They plan to do this by rotating sectors and stocks in response to market conditions, focusing on what we believe are undervalued stocks with attractive fundamentals.

For greater flexibility, they have no restrictions on investing in above or below investment grade securities. This means that they will cover the full spectrum of credit quality, leading to a truly multi-sector bond fund with limited constraints. It can be positive if they can handle it successfully. This leaves investors a little more in the dark and more dependent on the management team to manage the fund.

The fund is leveraged, which would bring the total expense ratio to 1.82%. However, while higher interest rates will negatively impact leverage by increasing costs, the fund is also hedged. They use both forward contracts and interest rate swaps. By shorting Treasury futures, they can realize a gain if Treasury prices decline. This happens when interest rates rise. Interest rate swaps work the same way. They can essentially swap a floating rate for a fixed rate.

WDI Interest Rate Swaps

WDI (Western Asset) Interest Rate Swaps

Performance – Attractive discount

One of the most attractive features of the fund is the discount. The fund is newer, but it quickly became heavily discounted. This tends to happen with any new CEF. In particular, a fixed income fund would have a particularly hard time getting to market in a rising rate environment.

They were launched in mid-2021, so it wasn’t long after the Fed started indicating that higher rates were coming. Obviously not for the potential to generate income, but for the prices of the underlying bonds.

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Given the environment and the understanding that bond prices are discounted at higher rates, it’s not too surprising to see negative returns so far.

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The question now would be how much an investor thinks rates could rise from here. The Fed had announced that it was now seeing rates above their initial target of 5%. We are close to 4% for the effective federal funds rate. It’s been a fast and rapid rise in rates through 2022.

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The other question is how and what will the Fed break with rates rising so rapidly. There lies another risk to consider, credit risk. Credit risk exists due to WDI’s portfolio containing significant exposure to below investment grade bonds and loans. Those types of companies and issuers that aren’t as financially stable and a bump in the economy can send them into default.

So if rates go up another 1% or 2%, things could probably start to stabilize. However, if we double again from here, we could see significantly lower lows in the market and the WDI.

The effective duration of WDI is 4.40 years. This means that for every 1% increase in interest rates, WDI’s portfolio would decline by 4.4%. Given the decline in total NAV return of around 20%, we have clearly seen a lot of this play out.

Distribution – Another increase, fully covered

Another increase in the distribution of WDI brings us to a monthly payment of $0.125. This was after they launched a payout of $0.117 to start with.

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There is also room for further increases in the future. NII coverage at the end of June was 109.4%. The NII of $39.956 million was also an increase from the prior quarter. They reported $18.679 million in the first quarter, which doubled to $37.358 million to match the equivalent six-month period. Given that the first quarter is included in the half-year report, this suggests that the portfolio’s earnings generation accelerated in the second quarter.

WDI semi-annual report

Half-year report WDI (Western Asset)

However, since they have increased the payment since then, we have to recalculate how much the estimated annual payment would cost them. In this case, the annualized payout is $1.50 and they last reported 51,788,210 shares outstanding.

This gives us an estimate of the total annual payment of $77,682. This makes the potential annualized NII of $79.913, based on this latest semi-annual report, more than enough to cover the payout. There is even an additional ability to increase the payout again. This is especially true if they can raise the NII again due to their floating rate exposure.

For tax purposes, all distributions paid in 2021 were ordinary income. As a fixed income fund, this generally means it is more appropriate to hold it in a tax-sheltered account. Since they hold bonds and loans that bear interest, this is likely to be the case on a regular basis.

WDI tax character

WDI Tax Character (Western Asset)

WDI Portfolio

Now it’s time to look at what kind of bric-a-brac this fund has in its vault.

The credit quality breakdown shows us that’s a lot.

Distribution of WDI credits

WDI Credit Breakdown (Western Asset)

The overwhelming majority of the portfolio is allocated to BB and B. It’s certainly not the most junkie portfolio in the CEF space, but we also have a fairly large share allocated to CCC.

CCC is the type of debt that is “vulnerable to non-payment”. They need just about everything to do well, otherwise they will fail. Thus, an allocation of this part of the portfolio is unlikely to survive until 2023.

Portfolio turnover was last reported at 25%. For six months, that would suggest they could renew about half of their portfolio each year. This makes them not too aggressive, but also not very passive either. This is good because they can potentially squeeze out what they believe to be the most vulnerable bonds and loans in the CCC tranche.

Looking at where the portfolio is invested, it really is a multi-sector bond fund. We have the largest allocation to high yield bonds. This was followed by substantial allocations to bank loans, bonds secured by loans (CLOs) and commercial mortgage-backed securities (CMBS).

WDI portfolio exposure

WDI Portfolio Exposure (Western Asset)

We also have NARMBS. It sounds like one of those things that could break when central banks are aggressive. It’s always those acronyms that come out of nowhere.

In this case, it is not so harmful. It represents non-agency residential mortgage-backed securities.

Looking at the portfolio, bank loans and exposure to CLOs will be the ones that offer the most protection against higher rates. This is because they are going to be massively based on floating rates. This is where the higher income-generating capacity of the portfolio likely comes from as rates rise.

In addition, RMBS and CMBS may be exposed to variable rates. The vast majority, however, will be fixed rate.

Although 2023 is likely to be challenging if we experience a recession that most expect, loan exposure may have some protection. Loans are higher in the capital stack than bonds. Therefore, the recovery rate will be higher when things start to go downhill.

Looking at the top positions in the fund, we can see that the weightings of each position are quite low. This means that there is no high concentration in a single name.

WDI Top Positions

WDI Top Positions (Western Asset)

In fact, the only allocation above 2% here is WACXX. It’s a money market fund from Western Asset themselves.

According to CEFConnect, WDI had 319 positions at the end of August. For a multi-sector bond fund, a high number of securities is normal. They are spread across many holdings, so there is no significant risk that one individual, or a handful of individuals, could drive the portfolio down.

Conclusion

WDI is attractively discounted and fully hedges its high distribution yield. That makes it an interesting name right now. The main risk is of course the continuation of aggressive rate hikes. Depending on how high the rates are, the WDI will drop further. The increase in the distribution was not sufficient to offset the decline in the underlying portfolio.

Still, if rates stabilize, WDI could climb back to parity with its net asset value per share. This would provide some benefit, even if the portfolio does not appreciate from this level. As a term fund, the net asset value will be realized one day. However, we have until 2033 to start worrying about this angle of play.

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