TGNA - ARDC: An Excellent High-Yield CEF For The Current Environment

2023-03-07 14:21:46 ET

Summary

• Ares Dynamic Credit Allocation Fund invests in a well-diversified portfolio of fixed-rate and floating-rate securities to provide investors with a high level of income.
• The fund's allocation to floating-rate securities should help cushion the portfolio against interest-rate risk as it appears unlikely the Fed will pivot in the near future.
• The portfolio is very well-diversified, helping to keep down any default risks.
• The fund appears able to maintain its distribution since it is only paying out its net investment income.
• The fund is trading for a reasonably attractive valuation today.

One of the biggest problems suffered by Americans today is the rapidly rising cost of living. This is being driven by some of the highest inflation rates that we have seen in more than forty years. In fact, there has not been a single month over the past year in which the consumer price index did not rise by at least 6.4% year-over-year:

This has pushed up the prices of many goods, especially food and energy. As these are both necessities, the rising prices have obviously caused a great deal of hardship for people of lesser means. That has naturally forced many of these people to take on second jobs in order to simply maintain their lifestyles. This may be one reason why the jobs reports have remained stubbornly strong despite the substantial number of layoffs that we have seen over the past few months.

As investors, we have not been left unscathed by this as we are also consumers of food, energy, and other products. However, we have other methods that we can employ to get an extra income rather than taking on additional work. For example, we can put our money to work for us. One of the best ways to do this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income. These funds are not exactly well-followed by many market participants, which is a real shame because they have a lot to offer. In particular, closed-end funds provide easy access to a diversified portfolio of assets that can usually deliver a higher yield than pretty much anything else in the market.

In this article, we will discuss the Ares Dynamic Credit Allocation Fund ( ARDC ), which is one fund that investors can use for this purpose. As of the time of writing, this fund sports an impressive 10.17% yield, which is more than enough to turn anyone's head and easily enough to provide a noticeable boost to our incomes. The fact that the fund is trading at a reasonably attractive valuation today only adds to its appeal. Therefore, let us investigate and see if this fund could prove to be a worthy addition to your portfolio today.

About The Fund

According to the fund's webpage , the Ares Dynamic Credit Allocation Fund has the stated objective of providing its investors with a high level of total return. This is somewhat unusual for a debt fund as credit securities do not usually offer much in the way of capital gains potential. This is because they do not have any inherent link with the growth and prosperity of the issuing company. After all, companies do not increase the interest payments that they make to creditors just because their profits improve. Rather, these securities are priced based on interest rates. When interest rates rise, debt securities decline in price and vice versa. This is important today because the Federal Reserve has been raising rates over the past year in an effort to combat the high level of inflation. We can see this by looking at the federal funds rate, which is the rate at which the nation's commercial banks lend to each other on an overnight basis. Back in February 2022, this rate was at 0.08% but it sits at 4.57% today:

It is widely expected that the central bank will increase rates again tomorrow as several economic measures are still stronger than the bank wants to see, and the inflation figures remain stubbornly high. This can be expected to have a negative impact on the assets in the fund. We have already seen this as the fund's share price declined by 12.37% over the past year:

This is slightly worse than the 11.38% decline of the Bloomberg US Aggregate Bond Index over the same time period, but the Ares Dynamic Credit Allocation Fund has a substantially higher yield, so it did deliver a better total return over the year. One reason for this is that the Ares Dynamic Credit Allocation Fund does not only invest in traditional fixed-income securities. In fact, the fund has a significant allocation to floating-rate securities, which currently sits at 45.1% of its total assets:

A floating-rate security is very different from a traditional bond and the difference gives them a stark advantage in today's environment. In short, the interest rate paid by these securities increases alongside rates in the broader economy. Thus, when rates increase, holders of these securities receive higher payments. This should allow them to hold their value better in a rising rate environment than traditional fixed-income securities. This should reduce the fund's losses when compared to an all-bond portfolio as well as provide it with rising income as time goes on. Investors should be able to appreciate this.

Unfortunately, the fund's portfolio has not actually performed as well as its shares in the market. During the month of January, the fund's portfolio only grew by 5.21% but the market price went up by an impressive 10.33%. The same is true over the past three and past five years, as the fund's market price returned more than the actual underlying portfolio:

This is a common occurrence with closed-end funds, and it is something that we should always watch out for. As these funds are not constantly issuing new shares in the market, the performance of the shares in the market can be radically different than the portfolio itself. Over time, that can lead to the shares becoming overvalued compared to the actual underlying assets. Fortunately, this is not the case with this fund today as we will see in a bit. Still, though, it is a good idea to keep an eye on the performance of both the portfolio and the shares in the market to look for buying opportunities.

One of the unfortunate things about floating-rate securities is that they are frequently issued by entities that already have substantial amounts of debt. As such, they are frequently considered to be at higher risk of default than many conventional bonds. However, even among conventional bonds, closed-end funds like the Ares Dynamic Credit Allocation Fund frequently invest in high-yield bonds (colloquially called "junk bonds") in order to boost their income and ultimately the yield that can be paid out to investors. Thus, the fund is overall investing in somewhat riskier debt than many conservative investors would like. Fortunately, this may not be as big of a deal as may be expected. Here are the credit ratings of the bonds across the fund's portfolio:

An investment-grade bond is anything rated BBB3 or higher, which would represent 10.3% of the fund's portfolio. The remainder looks to be speculative-grade debt. However, we can see that fully 75% of the fund's fixed-income assets have either BB or B ratings. This should provide some comfort to more risk-averse investors because according to the official bond ratings scale , companies whose securities have these ratings do have the financial wherewithal to cover their existing debt and should be able to weather through short-term economic problems. While they may be somewhat more vulnerable to long-term economic problems, we have not encountered a situation like that since the Great Depression so the probability of such an event is quite low. Overall, the risk of losses due to default here does not really appear to be particularly great.

The fund also attempts to minimize its risk of default-related losses by maintaining a large number of positions. Currently, the fund has 267 positions across 216 issuers. While this is not nearly as many as some other funds have, it should still be enough to limit the fund's exposure to any individual issuer. We can confirm this by looking at the largest positions in the fund:

As we can clearly see, the fund's largest exposure to any single issuer is 1.25% of its total assets. That is not nearly large enough to have any noticeable effect on the portfolio should a default occur. Of course, Tegna Inc. ( TGNA ) is a member of the S&P 400 and is very unlikely to default. Overall, the point here is that we are unlikely to have any particularly large risks just because the fund's portfolio contains a significant number of speculative-grade debt.

Leverage

In the introduction to this article, I stated that closed-end funds like the Ares Dynamic Credit Allocation Fund have the ability to boost their yields beyond that of the underlying assets. One method that is employed by this fund to accomplish that is the use of leverage. In short, the fund is borrowing money and using that borrowed money to purchase fixed-income and floating-rate credit securities. As long as the purchased assets have a higher yield than the interest rate that the fund pays on the borrowed money, the strategy works pretty well to boost the overall yield of the portfolio. This fund is capable of borrowing at institutional rates, which are significantly lower than retail rates, so that will usually be the case.

However, the use of debt in this fashion is a double-edged sword. This is because leverage increases both gains and losses. As such, we want to ensure that the fund does not have too much leverage because that would expose us to too much risk. I do not generally like to see a fund have leverage exceeding a third of its assets for this reason. Fortunately, the Ares Dynamic Credit Allocation Fund does satisfy that requirement as its levered assets currently comprise 22.28% of the overall portfolio. Thus, it appears that this fund is striking a reasonable balance between risk and reward.

Distribution Analysis

As stated earlier in this article, the primary objective of the Ares Dynamic Credit Allocation Fund is to provide its investors with a high level of total return. However, it seeks to accomplish that goal by investing its assets primarily in high-yield debt securities and then passing that money through to its investors. It even goes as far as to apply a layer of leverage to boost the effective portfolio yield. As such, it may be expected that the fund would have a very high yield itself. This is certainly the case as the fund pays a monthly distribution of $0.1075 per share ($1.29 per share annually), which gives it a 10.17% yield at the current price. Unfortunately, the fund has not been especially consistent about this distribution over the years as it has raised it and cut it multiple times:

This sort of variable distribution over time may be a bit of a turn-off for those investors that are looking for a stable and secure source of income to use to pay their bills or cover other expenses. However, it is hardly unusual for a debt-oriented closed-end fund since variations in interest rates have a substantial impact on the income that the fund itself is actually able to generate. The fund has increased its distribution twice in the past twelve months though, which is certainly appealing. Despite the variation in the distribution though, the most important thing is how well the fund can maintain its distribution. After all, anyone buying today will receive the current distribution at the current yield and does not necessarily have to worry about its past.

Unfortunately, we do not have an especially recent document that we can consult for that purpose. The fund's most recent financial report as of the time of writing corresponds to the six-month period that ended June 30, 2022. As such, it will not include any information about the second half of last year, which was a period that saw the Federal Reserve fairly aggressively raise interest rates. As such, that was a period of time that would be pretty important for a debt fund. However, the monetary tightening regime started in March of 2022 so we will still see the impact of the first three months reflected in this report. During the six-month period, the Ares Dynamic Credit Allocation Fund received a total of $22.029 million in interest income from the assets in its portfolio. This was the only income that the fund received during the period. It paid its expenses out of this amount, leaving it with $15.491 million available for shareholders. This was sufficient to cover the $13.405 million that it paid out during the period.

In fact, it appears that the fund is simply paying out most of its net investment income as the distribution since its full-year 2021 net investment income was also sufficient to cover the distributions that it paid out during that year. Thus, it appears as though the fund probably can sustain its distribution at the current level as long as it can maintain its current income. When we consider the fact that a high percentage of the fund's assets are floating-rate securities and the fact that any new bonds it purchases will have a higher yield than what it was buying a year or two ago, this will probably be true so long as the Federal Reserve does not cut rates. Recent commentary from the central bank has suggested that there will be no pivot in the near term so the fund can probably sustain its current distribution.

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 generate a suboptimal return on that asset. In the case of a closed-end fund like the Ares Dynamic Credit Allocation 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 was immediately shut down and liquidated.

Ideally, we want to buy shares of a fund when we can purchase them at a price that is less than the net asset value. This is because such a scenario implies that we are acquiring the fund's assets for less than they are actually worth. This is fortunately the case with this fund right now. As of March 6, 2023 (the most recent date for which data is currently available), the fund had a net asset value of $13.95 per share but the shares only trade for $12.61 per share. This gives the shares a 9.61% discount to the net asset value at the current price. This is a bit better than the 8.65% discount that the shares traded at over the past month, so the price today certainly seems reasonable.

Conclusion

In conclusion, the Ares Dynamic Credit Allocation Fund looks like a solid purchase for any investor that is seeking income today. The fund has a reasonably solid portfolio that should be pretty well insulated from any risks that may come about from a weakening economy, such as defaults. In addition, the fact that a large percentage of the securities in the portfolio are floating-rate issues should provide it with a rising income and much better performance given the current Federal Reserve policy. The fund appears to be easily capable of maintaining its current distribution and it is trading at a discount to net asset value. Overall, there is a lot to like here about the Ares Dynamic Credit Allocation Fund.

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