AIF - AIF: 11% Yield From This Loan CEF On Top Of The Discount

2023-07-24 13:35:51 ET

Summary

• Apollo Tactical Income Fund (AIF) has delivered robust returns over the past year, thanks to its floating rate collateral, with a 15% total return on a 1-year look-back.
• The fund has an 11% distribution yield, and the market is pricing higher rates for the entirety of 2023, meaning the fund is likely to maintain the current distribution level.
• AIF has had a very range bound discount to NAV, which is now -12%, providing predictability of returns.

Thesis

Apollo Tactical Income Fund, Inc. ( AIF ) is a fixed income closed-end fund. The vehicle is mostly composed of leveraged loans, which make up the vast majority of the collateral, with the rest allocated to high-yield debentures and structured products. As per its literature:

Apollo seeks to generate current income and preservation of capital primarily by allocating the Fund's assets among different types of credit instruments based on absolute and relative value considerations and its analysis of the credit markets. Under normal market conditions the Fund invests at least 80%of its managed assets (which includes leverage) in credit instruments and investments with similar economic characteristics .

Source: Fund Fact Sheet

This CEF has been a winner since the start of the Fed hikes, given the floating rate structure of the underlying collateral:

While the overall fixed income market experienced a severe drawdown in 2022, bringing its trailing 1-year performance to a negative figure, AIF is up substantially. We are using the iShares Core US Aggregate Bond ETF ( AGG ) as a proxy for the overall fixed income market here.

Not only has the fund delivered a substantial return, but its dividend yield has kept going up as risk free rates have risen:

We can see the change in the fund's dividend yield closely matching the 500 bps in Fed Funds increases we have seen in the past year. The leveraged loan asset class is a nice 'pass-through' niche for higher rates.

In the article we discuss the fund's holdings, its pass-through feature for the higher yield environment and the fund's stable discount to NAV performance. AIF is the leveraged version of the ( FTSL ) structure discussed here , and it provides for a higher risk/reward take on the leveraged loan market. We expect the current high-yield to persist until late 2024, and the fund to experience drawdowns up to -7% during another market risk-off event. The fund provides for a clean high dividend, appropriately priced for today's high rates environment, therefore continue to Hold and clip the high income.

CEF Holdings

The fund contains mostly leveraged loans:

Akin to Total Return Swap structures, leveraged loan CEF structures contain mostly loans, but they can alternate the composition depending on credit risk appetite. The bond slice here is slim, but in a risk-on environment it can become larger. Bonds have higher volatility profiles and are generally fixed rate, thus introducing more market risk via rates (i.e., duration profiles).

The fund is allocated to the riskier part of the capital structure, namely single-B loans:

The 'CCC' bucket is sizable here, going above 10% of the collateral pool. The higher you are in the rating structure, the lower the volatility for the fund. The fund gets compensated for the higher credit risk it is taking via a higher spread profile:

So before leverage is factored in, we have here a collateral pool which yields close to 10%: the floating rate spread is 4.81%, and with SOFR around 5% that gives us a figure very close to 10%.

The fund does not take any industry-specific risk, with the highest sectors under 20% of the fund portfolio:

From our perspective, an investor should be concerned when the figures in sectoral concentration tables exceed 20% for one or more sectors.

Premium/Discount to NAV

Since the start of the Fed hiking cycle, the CEF has been stuck in a narrow -15% / -10% range for its discount to NAV:

We expect this range to hold, without too much of an impact to the CEF's performance from the premium/discount to NAV moves. I think this is a good aspect for the name since it introduces less volatility in the fund's returns.

Higher for longer

The fund currently has an 11% distribution yield, paid monthly:

Despite significant volatility through the year, the market is now pricing higher rates for the entire 2023, with the first-rate cuts not seen until spring 2024. That will translate into the CEF maintaining this high distribution level for the foreseeable future.

One of the main issues with floating rate funds is the low standard deviation associated with the underlying asset class. Leveraged loans do not typically experience massive gains or losses, due to their senior presence in the capital structure. Therefore, this asset class is more of a 'clip the coupon' asset class, where yields are enhanced via leverage. AIF for example has a 36% leverage ratio right now. The quantum of the distributions on the CEF therefore are directly correlated with risk-free rates.

Despite the cuts expected for 2024 however, the market is not pricing a return to the zero rates environment of years past. This will actually translate into higher sustainable yields for longer for this name. This seems a positive feature for a buy and hold investor.

Risk Factors

As discussed above the vehicle to a certain extent is a pass-through for higher rates. Higher for longer suggests the fund will continue to pay very high yields for the foreseeable futures. When rates do go down, expect the fund to adjust its dividend to reflect a lower cash flow. We do not expect this to kick in until late 2024.

Just like any high yield fixed income instrument, the fund is subject to credit risk via credit spreads and defaults. The asset class is first lien so we are not that concerned about defaults. Just like past events during 2022 the credit spread can widen temporarily. You can pencil in a -7% drawdown here following another significant risk-off event like in October 2022.

Performance since last coverage

The fund is up since our last coverage of the name here last November, where we encouraged readers to Hold to the name:

In the article we outlined the benefits of holding leveraged floating rate loans, a thesis which fully came to fruition:

Floating rate debt has been one of the safest places to be in fixed income this year, and even a high leverage ratio has not torpedoed results. The results speak to the resiliency of leveraged loans and the fact that CEFs that are based on this asset class should be preferred in a rising rates environment.

Conclusion

AIF is a premier leveraged loan CEF from Apollo. The vehicle has delivered very robust returns in the past year given its floating rate collateral. AIF is up +15% on a 1-year look-back, while the overall fixed income market as measured by the iShares Core US Aggregate Bond ETF ((AGG)) is down -1%. With the LIBOR transition now behind us, AIF might profit from some short-term Alternative Base Rate pricing for its collateral.

We expect risk-free rates to stay higher for longer, and even when the Fed does decrease Fed Funds, it will not move back to its zero percent range from before. We expect 3% to be the new base going forward. To that end AIF will continue to distribute clean high dividends for the rest of the year, and has a nice forward ahead even in a lower rate environment. Continue Holding here given the nice risk/reward profile.

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