What to Buy: Western Asset High Income Opportunity Fund (NYSE: HIO)

Why to Buy Now: The bear market in crude has spilled over into the high-yield bond market, with many speculative-grade securities now trading below par, particularly those issued by companies that operate in the energy sector.

Earlier this week, in fact, Barron’s reported that one-third of the energy sector’s junk bonds were now trading at distressed levels, with average yields above 10%. The average energy-sector bond in the high-yield market recently traded at 84.9 cents on the dollar, versus 97.1 cents for the broader high-yield index.

While the downward pressure on energy prices could certainly push crude even lower and take energy sector bonds along with it, Martin Fridson, who Institutional Investor has dubbed the dean of high-yield bond analysts, recently noted that this is a “concentration of distressed issues ordinarily seen only near troughs in the credit cycle.”

That certainly qualifies as blood in the streets. Fridson says that at recent levels, high-yield energy bonds were implying a default rate of 6.6%.

The glut of production from the North American energy renaissance led to a similar glut of borrowing to finance it. According to Barclays, the energy sector now accounts for 14% of the junk market, a jump from just 5% in 2007.

As of the end of September, the energy sector was the second largest weighting in HIO’s portfolio, at 11.5% of assets.

That allocation, along with a general flight from high-yield bonds amid uncertainty over Federal Reserve policy, as well as geopolitical tension, has pushed HIO’s units well below their net asset value (NAV). The closed-end fund (CEF) currently trades at a 9.9% discount to NAV.

To be sure, many CEFs trade at persistent discounts to NAV, but even on that basis HIO appears oversold. The current discount is 7.5 percentage points below its trailing three-year average discount of 2.4%.

When otherwise solid CEFs trade below their NAV, they offer value-oriented investors the rare opportunity to buy a basket of securities at bargain prices. And with the hit the NAV has taken from the high-yield selloff, we’re getting the investing equivalent of double coupons.

The discount to NAV also serves to enhance HIO’s distribution rate. The distribution rate based on the NAV is 7.1%, but the fact that HIO’s actual units are trading at a discount to NAV adds another 80 basis points, for a total distribution rate of 7.9%.

Equally important, HIO is one of the few CEFs that doesn’t use leverage to juice its yield. That’s a crucial attribute, particularly when the high-yield market, or the financial markets in general, hit a rough patch.

And if management sees that investment income is failing to cover the distribution, it will simply lower the payout rather than engage in the widespread industry practice of destructive returns of capital. Many high CEF payouts are illusory because fund managers support them via returns of capital that are basically giving unitholders their money back net of investment fees.

HIO has a seasoned management team that draws upon the expertise of 12 credit analysts that specialize in high-yield bonds. Management charges a reasonable advisor fee of 0.80%, with a total annual expense ratio recently at 0.88%.

Market dislocations, such as what junk bonds are currently experiencing, create opportunities. And we believe this team will take full advantage of the recent selloff.

Finally, HIO earns a Bronze analyst rating from Morningstar, which means the rating firm’s analysts have a high level of conviction about the overall quality of the fund.

HIO is a buy below 5.50. The CEF has reasonable trading volume, averaging around 334,000 units daily over the past three months, but we’d still recommend using limits when buying or selling.