Home Discount rate FRA and BGT: Distribution Increases and Significant Discounts (NYSE: BGT)

FRA and BGT: Distribution Increases and Significant Discounts (NYSE: BGT)

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Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on October 14, 2022.

BlackRock Floating Rate Income Strategies Fund (NYSE: FRA) and BlackRock Floating Rate Income Trust (NYSE: BGT) were two of the latest changes to payouts for the BlackRock range of funds. Fortunately, these two funds were distribution relays for their shareholders. Since these are funds exposed to variable rates, this was generally expected.

In fact, as rates continue to be pushed higher by the Fed, we could likely see even more hikes going forward. At the same time, both of these funds are offered at quite attractive prices with significant discounts. These haircuts arise from the fact that there are credit risks in the assets. Since they are issued by lower quality companies, the risk of default or bankruptcy is higher during tough economic times. Consequently, investors sell the funds faster than the actual underlying performance of the portfolios.

Here’s a look at the year-to-date total share price and total net asset value return performance between these two funds. We can clearly see that total net asset value returns have held up much better relative to stock prices. So, the latest big discounts we’ve seen pop up.

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The rate hike is very likely to put the economy in a tough spot as the Fed works to slow the economy to fight inflation; hence why discounts opened on uncertainty about the severity of an economic downturn.

That being said, just because there is a default or bankruptcy does not mean there is no collection of some of the loans. Recoveries have actually been quite strong, according to a report from Fitch. Of course, this is for historical data only and does not guarantee future results.

The latest UNII report showed that the distribution coverage rate peaked at over 100% for FRA and BGT. That was for the end of August 2022. Then there was another 75 basis point increase from the Fed in September. With at least one, possibly two increases of more than 75 basis points at the end of this year.

This will only see even more net investment income from these funds. In turn, this will essentially mean that new distributions will or will likely be covered by the NII.

BlackRock UNII Report

BlackRock UNII Report (Black Rock)

However, it can be noted that the UNII is always negative. For distribution changes, the direction of NII seems to mean more than what UNII shows. UNII is simply undistributed net investment income. So this only tells us where the payment was, but not where the payment might go.

BlackRock Floating Rate Income Strategies Fund

  • Z-score over 1 year: -1.67
  • Discount: 11.85%
  • Distribution yield: 8.71%
  • Expense ratio: 1.17%
  • Leverage: 28.69%
  • Assets under management: $613.7 million
  • Structure: Perpetual

FRA’s investment objective is “to provide shareholders with high current income and capital preservation consistent with investments in a diversified leveraged portfolio of debt securities and floating rate instruments”.

To achieve this investment objective, “at least 80% of its assets in floating rate debt securities, including floating or variable rate debt securities which pay interest at rates which adjust each time ‘a specified interest rate changes and/or resets on predetermined dates’. As is generally the case with these types of funds, the portfolio “invests a substantial portion of its investments in floating rate debt securities consisting of lower rated secured or unsecured floating rate senior loans. to investment quality.

It hasn’t been long since we last covered FRA. However, in this volatile market, a lot can happen. We’ve seen an increase in distribution, but a lower price has also pushed up distribution yield along with that increase. Market volatility also pushed the fund into an even wider discount and what I would consider an even more attractive discount.

The boost for FRA was good for a 20.5% increase, taking the monthly payment from $0.0667 to $0.0804. This was the first increase in this fund since rates rose. These funds tend to focus on more even payment to shareholders rather than more regular adjustments. For floating rate funds, being so sensitive to changes in interest rates, they tend to see fairly regular changes, relatively speaking.

FRA distribution history

FRA distribution history (CEF Connect)

From another angle, the fund is now paying well above its historical payout level. This is due to the decline in the stock price, but with heavy hedging, I think it’s attractive.

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The effective duration of the fund is incredibly low at 0.33 years. This is common for these floating rate loan funds. This is partly why they are a hedge against other fixed rate debt in nature.

Despite this, we have seen the fund’s discount widen significantly. It is wider than its historical range and is bouncing near the lows we have seen from 2019 to the COVID pandemic.

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BlackRock Floating Rate Income Trust

  • Z-score over 1 year: -1.39
  • Discount: 12.30%
  • Distribution yield: 8.76%
  • Expense ratio: 1.18%
  • Leverage: 28.92%
  • Assets under management: $378.8 million
  • Structure: Perpetual

BGT’s investment objective is “to provide a high level of current income”. To achieve this, the fund will invest “at least 80% of its assets in floating and variable rate instruments of US and non-US issuers, including a substantial portion of its assets in global floating and variable rate securities, including including floating rate senior secured loans made to corporations and other business entities.”

For BGT, it’s been a while since I specifically covered this fund. It has many similarities to FRA as a whole. Almost the same expense ratio, even though it’s a smaller fund. The leverage used by the fund is quite high, but it is typical for these types of funds. The effective duration of the portfolio is also exactly the same at 0.33 years.

Even the payout increase for BGT was quite similar to that of FRA with an increase of 20.7%. It went from a monthly payment of $0.0647 to $0.0781. It’s also not too surprising to see such similarities, given that the cast coverage was quite similar in the last UNII report. BGT had a slightly better coverage rate of half a percent. It was also BGT’s first increase in this latest rate hike cycle.

BGT distribution history

BGT distribution history (CEFConnect)

Looking at the performance of distribution over the past decade, we can see almost a mirror image of what we saw from FRA above. Again, the higher distribution yield is a function of lower prices. Given that distribution coverage is quite strong and likely to improve, this is a positive development.

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The fund’s discount also shows that BGT is trading above its long-term average level. Both of these funds had rising valuations as we approached the end of 2021. Credit risks, however, completely took over and drove down haircuts to near decade lows – excluding the period of the COVID crisis.

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An interesting thing to note for BGT is that the fund generally trades at a narrower discount than FRA. Yet right now it has an even bigger discount as of the last close on October 13th. I hold FRA but not BGT. I had at some point in the last hiking cycle. That being said, the difference in valuation right now is not necessarily large enough to make an exchange an obvious choice.

Conclusion

FRA and BGT have recently increased their distributions. This seems like an obvious outcome as a floating rate fund in a rising rate environment. However, although the underlying portfolios are doing quite well, the credit risks of their portfolios seem to be making investors nervous. This penalized the real share price of these funds, opening up to the latest discounts. I think these are priced attractively right now. But I recognize that – at least for FRA – the market does not agree with me.

FRA performance since May update

FRA performance since May update (Looking for Alpha)

I originally went bullish on FRA in May. Again, just at the end of August. In May, the discount amounted to around 13%. It then tightened in August to around 7%. Now it is again offering a discount of almost 12%. This has at least played a role in the losses generated since the August update.

FRA performance since August update

FRA performance since August update (Looking for Alpha)

FRA has produced losses each of these times, holding up much better than the S&P 500, but it’s not an appropriate benchmark. This can help provide some context. In the long term, equities should be able to smoke investments into loans. If we take more risks, we should expect to be better rewarded. At least that’s the general idea.

Ultimately, the higher revenue generated resulting in higher fund distributions is a welcome sign that things are still working out on this front.