Highland Opportunities and Income Fund (HFRO) is drawing a caution flag rather than a buy signal, even with its common shares trading at a 43.19% discount to published net asset value. The reason is not valuation alone: HFRO leverage risk has moved close enough to the fund’s preferred-share constraints that common shareholders face a real possibility of forced asset sales or an equity rights offering.
Why the Preferred Prospectus Matters Now
The fund’s HFRO.PR.A preferred shares carry a coverage requirement tied to the preferred share prospectus and the Investment Company Act of 1940. That requirement sets a 200% leverage coverage threshold. In practical terms, the fund must maintain enough asset coverage behind its preferred leverage, and recent developments have narrowed the cushion.
Buybacks and Rates Tighten the Cushion
Two forces are pulling in the same direction. First, HFRO has been buying back common shares. Second, higher interest rates have weighed on interest rate-sensitive holdings. Together, those factors heighten the risk that the fund breaches its 200% leverage coverage requirement if buybacks continue while those holdings perform poorly.
The concern is compounded by NexPoint affiliated holdings. The combination of leverage and those affiliated positions presents forced-selling risk, meaning the fund could be pushed into selling assets at unfavorable prices to restore compliance.
What a Breach Could Mean for Common Shareholders
If the coverage requirement is breached, the remedies available to the fund are not painless for common holders. A forced asset sale could lock in losses. An equity rights offering could dilute existing common shareholders. Either path could result in severe losses to HFRO common shareholders.
Saba's Retreat and the Discount Outlook
Activist Saba has stopped buying HFRO common shares. Without that buying pressure, the expectation is that HFRO common shares will widen back to a 60% discount. That outlook reinforces the no-buy stance on the common shares at the current 43.19% discount to published NAV.
The Bottom Line
HFRO common shares may look cheap on a headline discount, but the preferred-share leverage constraints have become too near for an investment. The fund’s buyback activity, higher interest rates, and interest rate-sensitive holdings have combined to raise the probability of a coverage breach. For common shareholders, the potential outcomes — forced selling or a dilutive rights offering — are severe enough to outweigh the appeal of the current discount.
