FSD: This CEF’s Short Treasury Position Appears To Be Working (NYSE:FSD)

The First Trust High Inc Long/Short Fund (FSD) is a closed-end fund, or CEF, that income-focused investors can purchase as a method of achieving their goals of earning a high level of current income from the assets in their portfolios. The fund does fairly well at this task, as its 10.45% current yield is higher than most other funds in its class. We can see that here:

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As we can clearly see, the First Trust High Income Long/Short Fund has a higher yield than most other closed-end funds that invest in high-yield bonds. However, this fund may not be perfectly comparable to all of these peers. As the name of the fund suggests, the First Trust High Income Long/Short Fund can short bonds that the fund’s management suspects with fall in price. If done properly, this can provide the fund with an investment return that exceeds that provided by the junk bonds that constitute the long positions in the portfolio. If we assume that this fund pays out all of its investment profits, then this can provide it with a yield advantage over peer funds that do not have the extra boost from this strategy.

As regular readers can likely remember, we previously discussed the First Trust High Income Long/Short Fund in early October 2023. The bond market has been quite volatile since then, as November and December 2023 saw rapidly rising bond prices on expectations of interest rate cuts in 2024. However, the bond market has not been nearly as strong this year now that it has become increasingly obvious that there will not be six 25-basis point cuts this year (as was priced into bonds back in late December). As such, we might expect that the fund’s performance has been somewhat mixed since the previous article was published. This has, however, not been the case. As we can see here, shares of this fund are up 15.06% since the date of the prior article’s publication:

As we can clearly see, the First Trust High Income Long/Short Fund has outperformed both the Bloomberg U.S. Aggregate Bond Index (AGG) and the Bloomberg High Yield Very Liquid Index (JNK) by quite a lot. This is not exactly surprising, as we have seen just about every fixed-income closed-end fund outperform the broader market indices over the past eight months or so. This is partly because the leverage that these funds employ boosts the gains that they get during a bull market run, which is precisely what occurred over the period in question.

While the 15.06% gain in the fund’s share price alone would be a reasonable performance over an eight-month period, investors in this fund actually did better than this. I explained why in a recent article:

A simple look at a closed-end fund’s share price performance does not necessarily provide an accurate picture of how investors in the fund did during a given period. This is because these funds tend to pay out all of their net investment profits to the shareholders, rather than relying on the capital appreciation of their share price to provide a return. This is why the yields of these funds tend to be much higher than the yield of index funds or most other market assets.

When we include the distributions that were paid out by the First Trust High Income Long/Short Fund and the two indices over the period in question, we get this alternative performance chart:

As we can immediately see here, the First Trust High Income Long/Short Fund provided its investors with a 23.72% total return over the eight-month period. That beat both domestic investment grade and domestic bond funds by quite a lot over the period even when we consider that the two bond indices were also paying out distribution yields that many investors who have lived through the past two decades of ultra-low interest rates will consider to be reasonable. Overall, this performance seems likely to endear this fund to many market participants.

However, we all know that past performance is no guarantee of future results. As such, we should take a look at this fund as it is today to determine whether it still makes sense to put money in it. This article will seek to accomplish that task.

About The Fund

According to the fund’s website, the First Trust High Income Long/Short Fund has the primary objective of providing its investors with a very high level of current income. This makes a lot of sense given the fund’s investment strategy, which is explained in detail on the fund’s webpage:

First Trust High Income Long/Short Fund is a diversified closed-end management investment company. The Fund’s primary investment objective is to provide current income. The Fund’s secondary objective is capital appreciation. The Fund seeks to achieve its investment objectives by investing, under normal market conditions, a majority of its assets in a diversified portfolio of U.S. and foreign high-yield corporate fixed-income securities of varying maturities that are rated below-investment grade at the time of purchase. For purposes of this strategy, “corporate fixed-income securities” include corporate bonds, debentures, notes, commercial paper and other similar types of debt instruments, including instruments issued by corporations with direct or indirect government ownership, as well as asset-backed securities, preferred shares, senior floating-rate loan participations, commitments and assignments, payment-in-kind securities, zero-coupon bonds, bank certificates of deposit, fixed time deposits, bankers’ acceptances and derivative instruments that provide the same or similar economic impact as a physical investment in the above securities. Below-investment grade fixed-income securities are commonly referred to as “high-yield” or “junk” bonds and are considered speculative with respect to the issuer’s capacity to pay interest and repay principal. As part of its investment strategy, the Fund intends to maintain both long and short positions in securities under normal market conditions. The Fund will take long positions in securities that the Fund’s Sub-Adviser believes offer the potential for attractive returns and that it considers in the aggregate to have the potential to outperform the Fund’s benchmark, the ICE BofA US High Yield Constrained Index. The Fund will take short positions in securities that the Sub-Adviser believes in the aggregate will underperform the Index. The Fund’s long positions, either directly or through derivatives, may total up to 130% of the Fund’s Managed Assets. The Fund’s short positions, either directly or through derivatives, may total up to 30% of the Fund’s Managed Assets.

As this description makes apparent, the fund only invests in debt instruments of various types. Bank certificates of deposit, which many people hold as a very safe savings vehicle, are debt securities issued by banks, so they would also fall under this description. The fact that this fund is investing in debt securities (as well as potentially preferred stock) is why the current income objective makes sense. Over their lifetimes, the only net returns that debt securities deliver are the interest and coupon payments that they make to their owners. These payments are the income to the fund, so the objective works.

This fund does add a bit of a twist to the normal current income objective that would be possessed by a bond fund, however. The fact that this fund actually goes short implies that it is going to try and take advantage of the fact that bond prices move over time due to both interest rates and issuer-specific factors to earn some capital gains profits. Interestingly, though, the fund’s 35.00% annual turnover is lower than its peers:

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(all figures are as of each respective fund’s most recent annual report.)

This could suggest that the fund is holding long and short positions for an extended period of time. It could also mean that the fund is somewhat actively trading its short positions, but basically using a buy-and-hold strategy for the long positions. It seems unlikely that the fund is holding short positions for a long period of time while trading its long positions. For one thing, the long positions are much bigger. The fact sheet states that the fund’s net short positions are only 12.52% of total assets, versus net long positions totaling 95.53% of total assets. If the fund were actively trading its long positions to any great degree, then it would have a much higher portfolio turnover than it currently does.

In addition, short positions require a bit more attention than long positions because the losses can be much greater. After all, the worst that happens with a long position is that the asset goes to zero, and you lose your investment. With a short position, the losses can be potentially infinite (although this is not likely to occur with a short bond position). Thus, the fund would probably be engaging in more trading activity on the short side rather than on the long side.

As was the case the last few times that we discussed this fund, the long positions are almost entirely corporate bonds and notes. The fund’s short positions consist entirely of U.S. Treasury securities. The fund’s first quarter 2024 holdings report states that the fund had the following asset allocation on January 31, 2024:

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We can immediately notice a slight difference here between the fact sheet’s statements about the percentage of total assets sold short and the figures given in the first quarter holdings report. The figures all come from the fund sponsor’s official documents, so we cannot just dismiss the difference as we could if one of the numbers came from a third-party source. The discrepancy can be explained by the different dates, though. The fund’s first quarter holdings report provides the fund’s asset allocation as of January 31, 2024. However, the fact sheet states what it had on April 30, 2024. Thus, we can conclude the fund reduced its short positions somewhat over the three-month period between the two documents. That actually reinforces my earlier statement that the fund is probably more active with trading on the short side than on the long side.

There is one problem with short-selling anything with a positive yield. The short seller has to pay any money that the asset paid out to the party that they borrowed the asset from. In this case, that means that the fund needs to make the coupon payments on the short bonds itself. That makes this strategy a bit more of a drag on the fund’s total performance than it was a few years ago when bond yields were much lower. After all, back in March 2021 when we started discussing this fund, the ten-year U.S. Treasury (US10Y) had a yield of 1.56% according to the Federal Reserve:

That is obviously much less of a drag on the fund’s performance than if it needs to pay out a 4% to 6% yield today. It probably makes sense then that the fund is short-selling long-dated U.S. Treasury securities instead of short-dated ones. The first quarter holdings report lists two U.S. Treasury security issues that were sold short on January 31, 2024:

We can see here a 2025 note and a 2028 note. The fund does not state when these two securities were first issued, but if they are notes with those coupons, they were probably issued sometime in mid-2022. Ultimately, the issuance date is not particularly significant, though, because U.S. Treasury securities are priced based on their maturity dates. The fund only has to pay the stated coupon, so the drag on its investment return from making these payments is not as high as you would expect based on the U.S. Treasury yield curve today:

In fact, depending on when the fund sold those Treasury securities short, it almost certainly has experienced some profits from those positions. The fund’s holding sheet states that it received $54,465,000 from the sale of these securities, but the securities are only valued at $53,026,406 as of January 31, 2024. That is a 2.64% return, but how profitable that trade actually was depends a lot on the timing. After all, the coupon payments there are high enough that they may have wiped out a 2.64% profit if the fund has held those short positions for more than a few months.

We, unfortunately, have no way of knowing this for sure. All we can say for sure is that the trade has been profitable on a price basis, but perhaps not on a total return basis. This is, unfortunately, one of the problems with going short bonds. It is very difficult to earn a positive total return because of the relative stability of bond prices and the need to pay coupons.

Leverage

As is usually the case with closed-end funds, the First Trust High Income Long/Short Fund employs leverage as a method of boosting the effective yield that it earns from the assets in its portfolio. The fact that the fund uses short selling as part of its strategy alone acts as a sort of leverage because the fund can use the money that it received from the short sale (at least some of it) to purchase other securities. However, the fund also uses more traditional forms of leverage, just like other closed-end funds. I explained how this works in my last article on this fund:

In short, the fund borrows money and then uses that borrowed money to purchase junk bonds, preferred stock, and other income-producing securities. As long as the yield on the purchased securities is higher than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates. As such, this will usually be the case. With that said though, the beneficial effects of leverage are less today than they were three years ago when interest rates were at 0% because the difference between the rate at which the fund can borrow and the yield that it receives from purchased assets is less than it once was.

Unfortunately, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not employing too much leverage because that would expose us to an excessive amount of risk. I generally do not like a fund’s leverage to exceed a third as a percentage of its assets for this reason.

As of the time of writing, the First Trust High Income Long/Short Fund has leveraged assets comprising 32.65% of its assets. This is obviously more than the fund has in net short positions, which further illustrates that the upfront proceeds from short sales are not the only form of leverage that this fund has. This leverage is a decline from the 33.54% leverage ratio that the fund had the last time that we discussed it, which is understandable. After all, the fund’s net asset value has increased since the date that the previous article was published, as we can see here:

As we can see, the fund’s net asset value has increased by 4.78% since the date of our previous discussion. This is interesting since the fund’s share price increased by substantially more than that. This will have a noticeable impact on the fund’s valuation, which we will discuss later in this article. For now, the fact that the fund’s portfolio is larger obviously has an impact on its leverage, since the same level of outstanding borrowings is now a smaller proportion of a larger portfolio.

As a result of the increase in net asset value, the fund’s leverage is now under the one-third of total assets threshold that we would normally like to see. The First Trust High Income Long/Short Fund also has a very reasonable level of leverage when compared to its peers:

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(all figures from CEF Data.)

As we can immediately see, the First Trust High Income Long/Short Fund does have a higher level of leverage than most of its peers. However, it is not totally out of line with them, as it is only a few percentage points higher than two of the other funds on the list. With that said, it would be nice to see it close to the median as opposed to the high end.

Overall, it does not appear that investors need to be too worried about the leverage of the First Trust High Income Long/Short Fund today. It would be nice to see the fund’s leverage come down a bit, but it is not critical and for the most part, we should not need to lose sleep over it.

Distribution Analysis

The primary objective of the First Trust High Income Long/Short Fund is to provide its investors with a high level of income. To this end, the fund pays a monthly distribution of $0.1050 per share ($1.26 per share annually), which gives it a 10.45% yield at the current share price. As we saw in the introduction, this is somewhat higher than many of the fund’s peers, which might be due to the fund having a bit more leverage than other high-yield closed-end funds.

The fund has not been particularly consistent regarding its distribution over its history, but it has done better than some funds recently:

As I stated in the previous article:

This performance history is likely to be a bit of a turn-off for any investor who is seeking to earn a safe and secure income that can be used to pay their bills and finance their lifestyles. However, this fund has done better than many of its peers in the current environment, as its distribution has been stable since November 2021, and it did not have to cut in reaction to the Federal Reserve adopting a less accommodating stance. It is one of the few funds to have managed to accomplish this feat, so we should investigate and attempt to determine exactly how sustainable this distribution is likely to be going forward. After all, we do not want to be the victims of a sudden distribution cut!

As of the time of writing, the most recent financial report is the fund’s annual report that corresponds to the full-year period that ended on October 31, 2023. Admittedly, this report is much older than we would really like to see, as it will not include any information about the fund’s performance over the past seven months. However, it is still newer than the one that we had available to us the last time that we discussed this fund, so it should work pretty well to provide an update.

For the full-year period that ended on October 31, 2023, the First Trust High Income Long/Short Fund received $36,307,144 in interest and $2,650 in dividends from the assets in its portfolio. When we combine this with money that the fund received from other sources, we get a total investment income of $38,827,127 for the period. The fund paid its expenses out of this amount, which left it with $21,152,328 available for shareholders. That was nowhere close enough to cover the $41,973,584 that the fund paid out in distributions over the period.

The fund was unable to make up the difference through capital gains. For the full-year period, it reported net realized losses of $12,951,592, but these were partially offset by $10,905,730 of net unrealized gains. Overall, the fund’s net assets declined by $24,300,617 after accounting for all inflows and outflows during the period. Thus, the fund overall failed to cover its distributions over the period.

This was the second year in a row for which the fund failed to cover its distributions fully. Over the past two years, the fund’s net assets have declined by $145,375,525 partially due to distributions exceeding its investment profits. This is not sustainable over any sort of extended period.

Fortunately, the fund does appear to have resolved this problem, at least temporarily. This chart shows its net asset value since October 31, 2023:

As we can see, the fund’s net asset value has increased by 4.60% since the closing date of its most recent financial report. This tells us that the fund has managed to earn more in investment profits than it has paid out during the current fiscal year. We can take this as a promising sign, but we will want to keep an eye on things, as there is no guarantee that the fund will be able to continue to deliver this level of performance over the next few months. This is especially true given that there are quite a few risks overhanging the bond market right now that could push prices downward. These include:

• Uncertainty about the U.S. Presidential election or market participants not liking the outcome.
• The United States falling into a stagflation recession.
• A failure by the Federal Reserve to cut interest rates in September.

Thus, the fund’s distribution looks okay currently, but there is no guarantee that this will turn out to be the case going forward and investors may still want to exercise some caution.

Valuation

Shares of the First Trust High Income Long/Short Fund are currently trading at a 3.28% discount on net asset value. This is much more expensive than the 6.57% discount that the shares have averaged over the past month.

Conclusion

In conclusion, the First Trust High Income Long/Short Fund is a unique closed-end fund that has the ability to profit from either bond price appreciation or bond price declines. The fund does exhibit a long bias, however, so it will still be punished if bond prices in aggregate fall substantially. The strategy does seem to work, though, and its short position in U.S. Treasuries has provided it with a slight boost to its investment profits.

The downside here is that there is no guarantee that First Trust High Inc Long/Short Fund will be able to sustain its distributions, although it appears to be okay so far this year. The valuation is also not as attractive as it usually is, so we may want to wait for a better entry point.