WDI: A Compelling Combination In This 12%-Yielding CEF

In this article, we provide an update on the Western Asset Diversified Income Fund (NYSE:WDI). The fund has continued to raise its distributions on the back of a substantial floating-rate asset base as well as stable borrowings. However, unlike bank loan funds, which have also enjoyed distribution hikes, WDI has a duration north of 5.0, which is a compelling feature given the high level of longer-term yields as well as the potential drop in yields if the macro picture worsens. WDI trades at a 12.1% current yield and a 9.1% discount.

Fund Snapshot

WDI is a multi-sector credit fund. About half of the portfolio is allocated to corporate bonds, primarily to high-yield (i.e. sub investment-grade) corporates.

The rest of the portfolio is allocated to mortgage-related securities (both residential and commercial) as well as bank loans and CLOs, most of which are floating-rate.

The fund’s credit exposure is firmly in the sub investment-grade space. That said, it’s not quite bottom-of-the-barrel, as CCC and below-rated exposure is just 12.5%.

Income Profile

The net income of WDI is positively geared to higher short-term rates. This is because about half its assets are floating-rate, primarily bank loans, CLOs and CMOs. Specifically, roughly $594m (of $1.1bn) of its total assets are floating-rate. Relative to its $378m of floating-rate borrowings, that leaves $216m of net floating-rate assets, or about 29% of the NAV. In other words, for each 1% of rise in short-term rates, net income rises by around 0.3%.

We can see the steady (if a bit noisy) increase in its quarterly net income in the chart below. As short-term rates have flat-lined somewhat, we shouldn’t expect a big push higher in net income, however.

Another positive support of the fund’s net income is the fact that its borrowings have increased from the start of 2022. This is in contrast to many CEFs having had to deleverage, creating a headwind to net income. Its ability to add borrowings is a function of its relatively low level of leverage in 2022, its relative NAV stability, as well as its sizable floating-rate asset base.

All of this translated into a steady hiking regime, with the fund recently making its sixth distribution increase since inception in mid-2021. It’s worth noting that UNII also increased from $0.03 to $0.22 over the same period. This is the best regular distribution performance in the sector and across nearly all but pure bank loan CEFs. The chart below does not capture the latest hike to $0.14.

On paper the fund’s distribution coverage is around 98%, however, in reality it’s very likely to be well north of 100% as the latest net income figure we have is from Q1 and short-term rates have increased by around 0.8% since then.

Valuation Profile

The market continues to ignore WDI despite its relative outperformance since inception and its history of distribution hikes.

The chart below shows its discount (blue line) relative to other multi-sector CEFs (red line). Here we see that the fund’s discount remains wider of the sector average, with the differential close to a record wide level.

Arguably, one reason for that is the sharp rally in PIMCO CEFs, six of which are trading at double-digit premiums. However, even in the broader sector, its discount is on the wider side.

Takeaways

WDI remains an attractive option in the broader credit CEF space. It has a combination of a significant floating-rate base as well as a relatively long duration profile – both attractive in the current environment. The fund continues to trade at a relatively wide discount versus other multi-sector CEFs and remains in our Income Portfolios.

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