Highland Income Fund -- Moody's places A1 preferred share ratings of Highland Income Fund on review for downgrade

Rating Action: Moody's places A1 preferred share ratings of Highland Income Fund on review for downgrade

Global Credit Research - 17 Dec 2020

New York, December 17, 2020 -- Moody's Investors Service ("Moody's") has placed the A1 preferred share ratings assigned to preferred shares issued by Highland Income Fund (NYSE: HFRO) on review for possible downgrade.

The rating action is as follows:

Issuer: Highland Income Fund - Perpetual Preferred Shares, aggregate outstanding of $145 million (5,800 shares, liquidation preference of $25 per share) -- at A1, rating under review for downgrade

RATINGS RATIONALE

The review for possible downgrade reflects deterioration in the fund's asset profile and fixed charge coverage metrics relative to peers. The fund's asset profile has weakened driven by high single asset exposure within the fund's investment portfolio. The fund's median issuer concentration remains well above that of rated senior loan closed-end funds which typically range between 1%-2%. The rating action also reflects reduced coverage of the fund's annual fixed charge coverage ratio which stood at only two times net investment income for the last twelve months ended 30 November. The fund's lower fixed charge coverage metrics have been driven by a decline in the fund's net investment income as well as the high 5.375% dividend rate on its outstanding preferred shares relative to the current low rate environment. The negative trend in these two metrics together has negative impacted the fund's overall credit profile.

Positively, the net asset value of the Highland Income Fund has showed resilience during the market shocks of the coronavirus pandemic which has supported the fund's strong risk-adjusted asset coverage metrics. The fund manager has recently reduced the fund's leverage from its November 30th, 2020 level of approximately 33% by reducing borrowings from its outstanding credit facility from $300 million to $200 million and we expect the fund may look for more opportunities to reduce fund leverage. Additional deleveraging, if sustained, would be positive for the fund's credit profile.

During the review, we will focus on the ability of the fund to implement its deleveraging plan. We also focus on what impact the fund's deleveraging will have on the fund's high issuer concentration metrics.

HFRO's A1 preferred share rating reflects its solid risk adjusted asset coverage and capacity to service its obligations. The fund has taken advantage of opportunities in the real estate market driven by the current market and interest rate environment to increase its real estate exposure. Moody's notes that the increase in real estate investments has lowered the portfolio's credit quality and added concentration and illiquidity risk to a portfolio already exposed to the low credit quality of the leveraged loan market.

In addition to assessing the key rating factors described above, Moody's considers the priority of claim of a fund's specific security types and other qualitative factors relevant to the fund's credit profile. A one-notch downward adjustment from the rating suggested by the key factors is applied to the preferred securities to reflect the level of subordination and weaker position of investors holding preferred stock relative to those holding senior unsecured debt obligations.

HFRO's preferred share ratings could be confirmed if there is 1) a significant and sustained decrease in the fund's leverage; or 2) an improvement in the credit quality or diversity of the fund's investment portfolio; and 3) fixed charge coverage is sustained above four times net investment income.

Conversely, the following factors could lead to a downgrade of the preferred share ratings: 1) the reduction in fund's leverage is not sustained; 2) a deterioration in the credit quality or concentration of the fund's investment portfolio; and 3) fixed charge coverage is sustained below three times net investment income.

The principal methodology used in this rating was "Securities Issued by US Closed-End Funds" published in August 2018 and available at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1125868. Alternatively, please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

REGULATORY DISCLOSURES

For further specification of Moody's key rating assumptions and sensitivity analysis, see the sections Methodology Assumptions and Sensitivity to Assumptions in the disclosure form. Moody's Rating Symbols and Definitions can be found at: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004.

For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

The ratings have been disclosed to the rated entity or its designated agent(s) and issued with no amendment resulting from that disclosure.

This rating is solicited. Please refer to Moody's Policy for Designating and Assigning Unsolicited Credit Ratings available on its website www.moodys.com.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Moody's general principles for assessing environmental, social and governance (ESG) risks in our credit analysis can be found at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1243406.

The Global Scale Credit Rating on this Credit Rating Announcement was issued by one of Moody's affiliates outside the EU and is endorsed by Moody's Deutschland GmbH, An der Welle 5, Frankfurt am Main 60322, Germany, in accordance with Art.4 paragraph 3 of the Regulation (EC) No 1060/2009 on Credit Rating Agencies. Further information on the EU endorsement status and on the Moody's office that issued the credit rating is available on www.moodys.com.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Rokhaya Cisse, CFA AVP-Analyst Financial Institutions Group Moody's Investors Service, Inc. 250 Greenwich Street New York, NY 10007 U.S.A. JOURNALISTS: 1 212 553 0376 Client Service: 1 212 553 1653 Robert M. Callagy Associate Managing Director Financial Institutions Group JOURNALISTS: 1 212 553 0376 Client Service: 1 212 553 1653 Releasing Office: Moody's Investors Service, Inc. 250 Greenwich Street New York, NY 10007 U.S.A. JOURNALISTS: 1 212 553 0376 Client Service: 1 212 553 1653

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