The DoubleLine Income Solutions Fund (NYSE:DSL) with $2.0 billion in net assets under management is a closed-end fund that invests in fixed-income securities with an objective of high income and capital appreciation. The fund utilizes leverage to achieve a yield of 8.8%, which is paid through a monthly distribution. While the fund technically has a global mandate, the portfolio is currently concentrated among emerging market corporate and U.S. high-yield debt. DSL has favorably outperformed its global bond index benchmark since inception and is currently benefiting from the environment of low-interest rates. Impressively, the fund is up 6.7% year to date on a total return basis. Recognizing the quality structure of the fund, we take a more cautious view of DSL over the near-term considering some weak trends for credit and emerging markets. (Source: Finviz.com)
DoubleLine is the asset management firm of famed investor Jeffrey Gundlach. DSL’S marketing material explains that asset allocation decisions are made by the investment committee led by Mr. Gundlach while the underlying security selection is made by the separate portfolio management team.
DSL’s current portfolio is concentrated in emerging market, “EM,” corporate bonds with a 44.2% weighting along with high-yield corporate debt that represents 20.9%. The remainder of the fund is invested across related instruments including mortgage-backed securities, bank loans, and CLOs. Notably, all investments are denominated in the U.S. dollar and thus there is no foreign exchange risk. The leverage ratio is currently 29%
The credit profile of the fund is primarily in non-investment-grade issuers which is consistent with the high-yield and EM focus. The duration of the fund at 4.23 years implies an intermediate-term maturity.
In terms of the fund’s exposure by country, the weightings here are titled towards Latin America including 14.7% in Brazil, 12.8% in Mexico, 9.7% in Argentina, among others. On the other hand, emerging market investments beyond Latin America are limited with only small positions in Asia-Pacific countries like Indonesia at just 2.3%, India at 2.0% and China a 0.2%. A common theme among emerging markets is the significant trade ties with China and thus the overall portfolio remains exposed to global cyclical trends.
Overall, we think this investment strategy and fund composition capture exposure to an interesting market segment. The combination of U.S. high yield debt and EM-Latin America bonds is relatively unique among CEFs in this context.
With a fund inception date of April 2013, DSL has convincingly outperformed the “Bloomberg Barclays Global Aggregate” bond index as its performance benchmark. The context here is that this particular index is a broad market benchmark that includes a wider range of bonds beyond high-yield and EM.
The Global Aggregate Bond index with large weightings towards developed markets and investment-grade corporates has underperformed high-yield over the past decade in the environment of structurally declining interest rates globally. By this measure, DSL with its specific asset allocation has proven capable of capturing major strategic market trends. Over the past three years, DSL’s NAV has returned 7.38% on average per year compared to 4.3% for the benchmark on a total return basis.
The chart below highlights DSL’s cumulative total return compared to widely traded exchange-traded-funds for reference. Over three years, DSL has returned 35.5% compared to 17.8% for the iShares iBoxx $ High Yield Corp Bond ETF (HYG) and 18.5% for the iShares JPMorgan EM Corp Bond ETF (EMB) which we think are relevant for comparison purposes. HYG specifically tracks the high-yield bond market while CEMB is a good benchmark for EM corporate bonds. Again, it’s important to recognize that the specific strategies and exposures are different as DSL is not constrained to any tracking index. DSL’s use of leverage and declining interest rates help explain its performance drivers over the period.
The fund pays a monthly distribution of $0.15 per share that represents a current yield of 8.6%. In 2019, the fund paid a separate special distribution of $0.044. We note that all distributions for the fiscal year 2019 were made as part of the regular investment or ordinary income. The fund does not utilize return of capital, “ROC,” distributions other than a fractional amount (under 5%).
YTD 2020 Gains Driven By Higher Premium to NAV
Beyond the history of a solid return since inception, DSL has come to our attention this week for its rather curious outperformance thus far in 2020. Data through February 12th shows the DSL fund has climbed 6.7% year to date on its market price compared to a more muted 2.0% for CEMB and 0.9% for HYG. DSL’s market price return thus far in 2020 is nearly double the 3.4% total return on net asset value as per the chart below.
The implication here is that a widening premium to NAV is responsible for the bulk of the gains in recent months. Compared to trading at parity to NAV at the start of 2020, DSL’s premium to NAV has climbed to a current 4.7%.
While it’s difficult to explain or quantify the actual reasoning for the higher premium, it’s understandable that investors like this fund given the strong returns in recent years as a reasonable justification for attaching a higher premium. The fund traded at a discount for much of its history considering a five-year average discount of 5%. By this measure, DSL is relatively expensive.
Analysis and Forward-Looking Commentary
While we typically tend to avoid funds that have witnessed a climbing premium to NAV, that’s not the primary reason we are taking a cautious view on DSL in the near term. We note the fund’s exposure to commodity type companies including names in energy, mining, pulp & paper, and steel/metals together represents 23.4% of the fund’s net asset.
We bring this up in consideration of developments in recent weeks with growing global growth concerns since the emergence of the coronavirus outbreak in China. Commodities including oil & gas, along with industrial materials like copper, have been particularly week. We highlight that benchmarks like Brent crude oil and copper are down by 18% and 8.9% each respectively from their highs in January.
DSL and global credit including high-yield and emerging market debt have benefited more from declining interest rates this year beyond the exposure to weaker themes in commodities. The U.S. Treasury 10-year yield has dropped to 1.6% compared to 1.9% at the end of 2019. The rally in bonds has been positive for most bond funds including DSL.
Still, some scenarios are bearish for high-yield and EM credit which warrants caution in DSL at current levels in our opinion. The setup here is that a further deterioration of the global growth outlook could lead to a sell-off of bonds should credit spreads widen particularly as it relates to the operating and financial profile of issuers in the DSL portfolio.
Emerging market credit also face pressures as those companies operate in countries that are often exposed to trade ties with China. The other side of this discussion is the potential for a faster-than-expected recovery in China. In this case, a strong rebound of global growth expectations could lead to a reflation type of setup with climbing interest rates that would also be bearish for DSL.
When we consider the exceptional rally in shares of DSL year to date, the widening premium to NAV, and higher risks related to EM credit, our view is that risks are overall tilted to the downside.
DSL is a quality fund with an impressive performance history. While we like the fund’s strategy and structure investing across emerging market and U.S. high-yield bonds, a weaker global growth outlook and bearish trends for commodities force us to temper near-term optimism of the fund at current levels.
For current shareholders, one defensive strategy is to simply pause any automatic dividend reinvestments and take the cash option to redeploy in the future at a more attractive level. Potential investors should keep this one on the radar because we think a future sell-off returning the fund to a discount to NAV and a reset of expectations could represent a compelling long-term buying opportunity.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.