ARDC - ARDC: Another Distribution Hike For This 11%-Yielding CEF

2023-09-20 11:17:44 ET

Summary

• Ares Dynamic Credit Allocation Fund has increased its distribution for the fourth time in 18 months, reaching its highest distribution since inception.
• The ARDC closed-end fund's net income has risen to a record high since 2020, driven by the rise in base rates and a re-leveraging of the fund.
• ARDC has a portfolio split of 60/40 between floating-rate and fixed-rate corporate assets, with overweight allocations in the Energy, Leisure, and Technology sectors.
• The discount remains wider of the loan CEF sector average, creating an attractive entry point. ARDC is trading at a 11% current yield and a 9.4% discount.

In this article, we take another look at the Ares Dynamic Credit Allocation Fund, Inc. ( ARDC ). The closed-end fund, or CEF, has recently released its latest semi-annual shareholder report, and we take this opportunity to highlight the key numbers.

In our updates over the past year, we remained focused on ARDC as one that was likely to continue to ratchet its distribution higher. And that is a trend that keeps delivering. ARDC hiked its distribution once again this week to $0.1175 or by over 4% - the fourth time it has hiked the distribution in the last 18 months. ARDC now features its highest distribution since inception over a decade ago - a rare feat for credit CEFs.

In our last update, we noted that the fund's drop in net income was likely temporary, in part due to its partial deleveraging. The last net income figure confirms this view as net income has risen to a record high since 2020.

The continued rise in base rates and a re-leveraging of the fund back to its previous level have driven net income higher, resulting in the latest distribution hike. We expect net income to keep drifting higher, though, at a slower pace than before given the lag with which base rates translate into reported net income figures.

ARDC is trading at a 11% current yield and a 9.4% discount.

Fund Snapshot

The fund's portfolio is roughly split 60/40 between floating-rate and fixed-rate corporate assets. The floating-rate side is composed of individual loans as well as both CLO Equity and CLO Debt securities.

In its bond/loan allocation, it is overweight Energy, Leisure and Technology sectors.

The fund has continued to reduce its CCC allocation from 10% about a year ago to 3.6% now.

Finally, the fund has a duration of around 1.2 which it reduced from 1.7 about six months ago. Given its mixed bond/loan allocation this is below the duration profile of bond funds and above that of loan funds.

Income Profile

The fund's semi-annual net income rose to a post-COVID high of $0.72 as of June. Even with the latest distribution hike, coverage is above 100%.

ARDC's net income is less leveraged to short-term rates than that of pure loan CEFs. For instance while loan CEF net income roughly rises 1 for 1 with higher base rates, net income of ARDC rises about 0.65% for each 1% rise in base rates.

The fund's earlier drop in net income was likely due to two factors. First was the deleveraging by the fund in 2022. ARDC reduced its credit facility to $63m or by 17% of its overall liabilities. Although this reduced the fund's overall income, it also reduced the fund's cost of leverage since the interest expense of the credit facility is more than double what the fund pays on the preferreds.

Another reason for the drop in net income is likely due to its reduction in the CCC allocation by around two-thirds. These lower-quality securities tend to feature higher coupons and so tend to contribute disproportionately to net income.

A key feature of the fund and what truly sets it apart from nearly every other credit CEF is the fixed-rate preferreds it uses as a primary leverage instrument. Specifically, the fund's liabilities are composed of $99m term fixed-rate preferreds and a $99m floating-rate credit facility. The preferreds have maturities of 2026-2028 and a weighted-average interest rate of 2.81%. This is at the same time that nearly all credit CEFs pay north of 6% for their cost of leverage.

Apart from the fund's income, it's also worth having a look at the fund's portfolio yield profile. This is because net income misses an important contributor to yield which is pull-to-par. Once we take this into account we see that the fund's portfolio yield on price is closer to 12.85%, well above its 11% NAV distribution yield.

This yield gap has two consequences. One, it's not surprising to see the fund continue to raise the distribution. And two, the excess yield will accrue directly to the fund's NAV, supporting it.

Takeaways

Ares Dynamic Credit Allocation Fund, Inc. remains an attractive credit CEF for income investors. Specifically, it has three key advantages. One, is that its net income is more efficient given it pays less than 3% on half its liabilities while loan CEFs pay north of 6%.

Two, it has a longer duration profile than loan CEFs which means its net income will hold up better if the Fed starts cutting rates, allowing it to benefit from a drop in rates if a recession hits.

And three, its relatively wide credit mandate across bonds, loans and CLOs, creates more opportunity for relative value and alpha opportunities.

ARDC has outperformed the loan sector on a 3-year basis in total NAV terms. It has underperformed loan CEFs over the past year due to the back up in Treasury yields.

The fund's discount remains wider of the sector average, creating an attractive entry point. ARDC remains in the High Income Portfolio.

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