FMD Capital Management

The Pioneer Diversified High Income Fund Deserves Its Premium

Written by Michael Fabian, November 14th, 2013

I’ve always been intrigued by brands that command a consistent premium in the market they compete in; just as Apple (AAPL) products demand a premium over the likes of Samsung’s (OTC:SSNGY), despite equal or greater performance and features. Its difficult to quantify at first glance, but when the fine detail and intricacies are examined, it becomes obvious a premium product was designed to stand out amongst a sea of mediocrity.

Pioneer Investments is a firm that’s been around nearly a century, and currently manages roughly 66 billion in assets based in the U.S., although it is owned by the much larger Pioneer Global Asset Management based in Italy. To put that sum in perspective, their AUM is nearly identical to what DoubleLine Capital has raised since its launch in April of 2010. While both firms pale in comparison to the asset gathering might of PIMCO, with several trillion under management. To my point, Pioneer is likely a firm many investors have passed over for more prominently marketed counterparts.

However, this is one contributing factor to my interest in the firm, its boutique approach to investment selection and risk management. So how have Pioneer closed-end funds (CEFs) been able to maintain consistent premiums undeterred by the difficult fixed-income environment in 2013? The answer is obviously in the details, and for the purposes of this analysis, Id like to focus on the Pioneer Diversified High Income Fund (HNW).

The fund is designed to seek a high level of income through the investment in fixed income securities in various sectors of the high yield market. More specifically, the fund specializes in global credit, with the majority of its portfolio allocated to U.S. high yield, senior loans, event-linked securities, and emerging markets. With the exception of the catastrophe bond sleeve, the stated portfolio mix is not uncommon in the CEF market place. The primary reason the portfolio has performed so well in light of interest rate volatility is the floating rate exposure through senior loans and event-linked securities, which make up roughly 36% of the holdings.

For those that are not familiar with catastrophe bonds or cat bonds, they are sold by insurance companies seeking alternative means of reinsurance and risk-transfer through capital market investment. The coupon rate traditionally floats in relation to an index similar to senior loans, while the principal value is attached to natural disasters or other insurance claims. For example, if a natural disaster does occur, there are triggers that lead to principle forgiveness or write-downs by investors. Conversely, if no loss claims occur, investors stand to collect attractive cash flow as event-linked bonds are typically rated below investment grade. Cat bonds have posted great returns over the last several years as hurricane/tropical storm related damage throughout the U.S. has been relatively low by historical standards. HNW’s management has exhibited superior expertise in security selection in this relatively unknown alternative asset class, adding additional value to retail investors searching for diversification outside traditional fixed-income strategies.

In sum, the fund’s concentration of floating rate issues, and unique diversification amongst high yield issuers globally has contributed to excellent NAV returns despite 2013 interest rate volatility. In fact, the effective duration of its 424 holdings currently rests at just 2.36 years. Furthermore, the fund currently yields 8.97% on it’s market price, but more importantly it has built up a UNII surplus of 0.11 as of its most recent annual report with data compiled through April (an updated semi-annual report is due out shortly with data through October 31st). Overall the fund has an excellent history of meeting or exceeding it’s dividend distribution, contributing to investor confidence in HNW as a core position, and potentially reducing retail turnover. In addition, it has been able to do so with a leverage ratio of 29.4%, a percentage that is in-line with comparable funds with less than stellar NAV performance.

Investors should take caution with several factors currently surrounding HNW; first being the funds relatively small size, and second being the current premium exceeding it’s trailing twelve month average. For clients in our Dynamic CEF Income portfolio, we exited the position in mid October when it became temporarily stretched above its 52 week average with the intent on buying it back during the next correction. Friday’s CEF volatility afforded us that opportunity, as we were able to purchase the position back below the key average. I believe that absent a large amount of volatility in the credit markets, HNW will continue to trade at a healthy premium to NAV due to its unique qualities. I believe the fund strikes an excellent balance of traditional asset management and expertise in a relatively small area of the fixed income markets investors would have a difficult time accessing otherwise. As with many other unique strategies we currently utilize for our clients, we don’t have a problem paying a premium price for a premium product. However, monitoring the fund’s health on an ongoing basis will contribute to our investment process alongside it’s size and place within our portfolio.

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