AIF - AIF: Hedge Your Interest Rate Risk With This Affordable CEF

2023-04-20 12:36:07 ET

Summary

• Investors today are in desperate need of income due to the rapidly-rising cost of living.
• Apollo Tactical Income Fund Inc. invests primarily in a portfolio of floating-rate senior loans in order to provide investors with a high level of current income.
• The fund's portfolio should be reasonably well-protected against rising interest rates, which could be critical given the terrible performance of most traditional assets in 2022.
• The fund appears to be paying out its NII and capital gains, so the distribution should be sustainable as long as interest rates do not decline.
• The fund is trading at an incredibly large discount to the net asset value.

It is unlikely to be a point of contention that one of the biggest problems facing average Americans today is the rapidly rising cost of living, as indicated by the fact that the last year saw inflation hit the highest level that we have seen since the early days of the Reagan Administration. In fact, the consumer price index showed a 6% or higher year-over-year increase in eleven of the past twelve months:

When we consider that two of the categories that saw the greatest price increases were necessities such as food and energy, we can understand how this situation would be particularly devastating to those individuals of lesser means. These price increases have caused people all across the nation to take on second jobs or enter the gig economy just to sustain their lifestyles and keep their families fed. I have discussed this in a number of recent blog posts, such as this one .

As investors, we are by no means immune to this as we need to eat and consume energy to maintain our lifestyles too. We do have other methods that we can employ to obtain income though. After all, we have the ability to put our money to work on this task. One of the best ways to do this is by purchasing shares of a closed-end fund, or CEF, that specializes in the generation of income. These funds are unfortunately not very well followed in the investment media and even few investment professionals are familiar with them. As such, it can be incredibly difficult to find information on many of these entities. That is unfortunate because these funds can have some advantages over open-end mutual funds and exchange-traded funds. For example, a closed-end fund is able to use certain strategies that boost its yield well beyond that of other types of funds and even beyond the yield of the underlying assets.

In this article, we will discuss the Apollo Tactical Income Fund Inc. ( AIF ), which is one fund that investors can use to generate income from their portfolios. As of the time of writing, the fund yields an impressive 11.75%, so it can certainly do wonders at increasing anyone's income. The fund has also been holding up rather well in the choppy market that we have been experiencing over the past eighteen months, as it is up 4.09% over the past six months:

Despite this reasonable performance, the fund looks to be dramatically undervalued today, so there are still reasons for an investor to pick up some of its shares. Let us investigate and see if it could be a good addition to your portfolio today.

About The Fund

According to the fund's webpage , the Apollo Tactical Income Fund has the stated objective of providing its investors with a high level of current income while still ensuring the preservation of the principal. This is certainly not surprising for a fixed-income fund. As we can clearly see here, this fund's portfolio consists almost entirely of bonds:

At this point, there may be some readers that point out that the fund's allocation to bonds is substantially above 100% of the fund's total assets. This is because this fund employs leverage as a method to boost its returns. We will discuss this later in this article. The point, for now, is that the Apollo Tactical Income Fund is a fixed-income fund that invests in debt securities issued by various entities. However, these are not necessarily the traditional bonds that most other fixed-income funds invest in. According to the fund's webpage,

"Apollo Tactical Income Fund, Inc. (the 'Fund') is a diversified closed-end management investment company. The Fund's primary investment objective is to seek current income with a secondary objective of preservation of capital by investing in a portfolio of senior loans, corporate bonds, and other credit instruments of varying maturities. The Fund seeks to generate current income and preservation of capital primarily by allocating assets among different types of credit instruments based on absolute and relative value considerations. 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."

The key thing to see here is that the fund specifically states that it invests in senior loans along with corporate bonds. Senior loans are a special type of credit security that may be able to outperform in the current market environment. This is because they have adjustable yields based on some interest rate benchmark. This differs from traditional bonds that have a fixed yield that is set at the time of issuance. This is an important consideration due to the interest rate risk inherent in traditional fixed-income securities. As I have discussed in various previous articles, bond prices are inversely correlated with interest rates. In short, when interest rates increase, bond prices go down and vice versa. This is important today as the Federal Reserve has been aggressively raising interest rates in an effort to combat the very high level of inflation that has dominated the economy. In March 2022, the effective federal funds rate was 0.20% but today it is 4.65%:

This is the biggest reason why we have had such considerable volatility in the stock and bond markets over the past year. Indeed, the rapidly rising interest rates resulted in 2022 being the first year since 1969 that both the stock and bond markets posted a negative total return:

Over the past twelve months, the Bloomberg US Aggregate Bond Index ( AGG ) is down 4.56%, but it has rebounded a bit over the past few months as the market continues to (perhaps foolishly) believe that the Federal Reserve will cut rates this year:

The reason why bond prices decline when interest rates increase is that newly issued bonds will have a coupon that results in the bond having a yield that corresponds to the market interest rate at the time of issuance. Thus, a bond that was issued a year ago would have a lower yield based on its face value than a bond that is issued today. As such, there is little reason for someone to pay face value for the older bond when a brand-new one can be purchased that has a higher yield. As a result, the price of the older bond needs to decline to the point that it delivers a competitive yield on cost to that of the otherwise identical brand-new bond.

However, the securities held by the Apollo Tactical Income Fund are different. As the interest rate paid by these securities adjusts based on the market, their price should remain relatively steady. Indeed, the Bloomberg US Floating Rate Note < 5 Yrs Index as represented by iShares Floating Rate Bond ETF ( FLOT ) has been almost perfectly flat over the past year despite the significant change in interest rates:

We, therefore, should expect the Apollo Tactical Income Fund to hold up pretty well too. However, this was not the case as the fund declined 12.07% over the same period:

We do see that most of this loss came in the form of a steep decline in May and June 2022, which was the very early stages of the monetary tightening regime. The floating-rate index declined quite a bit around the same time. It is important to note that the Apollo Tactical Income Fund is different from the exchange-traded fund that tracks the floating-rate index, which accounts for some of the differences. One of the most important of these is that the closed-end fund pays out much of its capital gains to investors, while the exchange-traded fund does not. This is one of the reasons why the Apollo Tactical Income Fund has a substantially higher yield than the iShares fund. In addition, the share price of closed-end funds does not always match the actual performance of the portfolio. It is not uncommon for the share price of one of these funds to go down despite the fund's portfolio actually delivering a positive total return. Once we account for these things, we can see that the Apollo Tactical Income Fund actually delivered a very respectable total return over most of the past periods:

The above chart shows the fund's total return over a given period, which assumes that an investor reinvested all of the distributions that were received. The biggest thing that we note above is that the fund's shares actually delivered a negative return in the market during the month of February, but the portfolio itself was positive. The fund's performance over the February 2022 to February 2023 period was also very reasonable compared to the performance of both the stock and bond funds during that period. Thus, the Apollo Tactical Income Fund appears to offer a way to generate a high yield and protect yourself somewhat from interest rate fluctuations. As I pointed out in an article from yesterday, it is rather difficult to make near-term predictions about the Federal Reserve's interest rate course, so this sort of protection could be valuable today.

Leverage

In the introduction to this article, I stated that closed-end funds like the Apollo Tactical Income Fund have the ability to employ certain strategies that have the effect of boosting the effective yields of their portfolios far beyond that of any of the underlying assets. One of these strategies is leverage, which is employed by this fund to great effect. In short, the fund is borrowing money and using that borrowed money to purchase floating-rate loans and other fixed-income assets. As long as the purchased assets have a higher yield than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, that will usually be the case.

However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. This could be one reason why the Apollo fund underperformed the floating rate index over the past year. As such, we want to ensure that the fund is not employing too much leverage, as that would expose us to too much risk. I generally do not like to see a fund's leverage exceed a third as a percentage of its assets for that reason. Unfortunately, the Apollo Tactical Income Fund is currently above this ratio. As of the time of writing, the fund's levered assets comprise 36.81% of the total portfolio. This is a bit concerning in terms of risk, but when we consider that the fund's assets are reasonably safe and are mostly protected against interest rate risks, it is probably okay.

Distribution Analysis

As was mentioned earlier in the article, the primary objective of the Apollo Tactical Income Fund is to provide its investors with a high level of current income. In order to achieve this objective, the fund invests in floating-rate senior loans and other fixed-income securities that deliver the majority of their total return through income. These securities tend to have fairly high yields, as evidenced by the fact that the average coupon rate of one of the securities held in the bond's portfolio is 7.88% as of the time of writing. The fund even applies a layer of leverage to this portfolio in order to boost the effective yield.

As such, we can assume that the Apollo Tactical Income Fund Inc. will have a fairly high yield itself. That is certainly the case as the fund pays out a monthly distribution of $0.1220 per share ($1.464 per share annually), which gives it an 11.75% yield at the current price. The fund's distribution has varied considerably over its history, although it has been increasing in recent months:

The fact that the fund's distribution varies with time is not particularly surprising. After all, the securities in the portfolio possess a yield that changes with interest rates. Thus, the fund should generally receive higher income when rates are high, and vice versa. We can, in fact, see a correlation between the bond's distributions and interest rates. The fact that the distribution has varied over time might still be a bit of a turn-off for investors that are looking for a stable and secure source of income to use to pay their bills or finance their lifestyles, but it does work pretty well with our thesis that this fund is a way to play rising interest rates. In addition to this, anyone purchasing the fund today will receive the current yield on their investment, so the fund's past history is perhaps not the most important thing. The most important thing for anyone buying today is the fund's ability to sustain its current distribution.

Fortunately, we do have a very recent document that we can consult for the purposes of our analysis. The fund's most recent financial report corresponds to the full-year period that ended on December 31, 2022. This is nice because this is one of the more recent reports that we have for any closed-end fund, and it should give us a pretty good idea of how well this fund handled the challenging market environment of 2022. During the full-year period, the Apollo Tactical Income Fund received $25,748,607 in interest along with $141,389 in dividends from the assets in its portfolio. This gives the fund a total income of $25,889,996 over the period. The fund paid its expenses out of this amount, which left it with $17,236,013 available for the shareholders. This was enough to cover the $17,009,694 that the fund actually paid out in distributions. That is likely to be comforting to most investors since the fund's net investment income was higher than its distributions. That is something that we generally like to see with a fixed-income fund, as it is a sign that the distribution is probably sustainable.

Unfortunately, the fund did report some losses during the period. It had net realized losses of $11,050,299 and another $28,069,497 in net unrealized losses. That is probably due to a combination of poorly timed trades and the fact that the fund does hold some securities that are not floating-rate products. This caused the fund's total assets to decline by $38,893,477 after accounting for all fund inflows and outflows. While that is not something that we generally like to see, it does not appear to be a threat to the distribution as this fund is simply paying out its investment profits. As long as its income remains around the current level, the fund should be able to maintain the current distribution. Thus, we probably do not have to worry unless interest rates start declining.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. In the case of a closed-end fund like the Apollo Tactical Income Fund, the usual way to value it is by looking at the fund's net asset value. The net asset value of a fund is the total current market value of all the fund's assets minus any outstanding debt. It is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can obtain them at a price that is less than the net asset value. This is because such a scenario implies that we are buying a fund's assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of April 19, 2023, the Apollo Tactical Income Fund had a net asset value of $14.33 per share but the shares trade for $12.28 each. That gives the fund's shares a whopping 14.31% discount to the net asset value at the current price. That is very much in line with the 14.32% discount that the shares have had on average over the past month and is overall a very attractive price. The fund's shares appear to be offering a very good value here.

Conclusion

In conclusion, the Apollo Tactical Income Fund appears to be a pretty good way for investors to hedge their interest rate risk and earn a very respectable yield at the same time. The fund is primarily invested in securities that do not suffer the same adverse effects as traditional bonds in a rising rate environment, such as the one that we are in today. In fact, this fund has been able to prosper as its income has risen over the past year, which has resulted in a rising distribution for investors. Despite this, the fund is still trading with a very large discount and yield so it might be worth purchasing Apollo Tactical Income Fund Inc. shares today.

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