ARDC - ARDC: Earn A Nice 11.45% Yield With This CEF

2023-06-02 12:46:00 ET

Summary

• Investors today are desperately in need of income due to the rapidly rising cost of living.
• Ares Dynamic Credit Allocation Fund, Inc. invests in a portfolio of both fixed-rate and floating-rate debt securities to provide investors with diversified exposure to the asset class.
• The ARDC closed-end fund is well-positioned for today's uncertain rate and economic environment.
• The fund pays its distribution solely out of net investment income, which should be sustainable.
• The fund is trading at a very attractive discount to the market value of its assets.

There can be hardly any doubt that one of the biggest problems facing the average American today is the rapidly rising cost of living. This is very clearly evidenced in the consumer price index, which claims to measure the price of a basket of goods purchased by the average American on a regular basis. As we can see here, over the past twelve months, there have only been two in which this index posted a less than 6% year-over-year increase:

This has had a particularly devastating effect on individuals and households of limited means because much of the rising prices were caused by food and energy prices. These are necessities, so it is difficult to avoid purchasing them if the prices rise beyond one's comfort level. While we have seen the reported rate of inflation begin to moderate in recent years, this is likewise caused by the decline in energy prices that we have seen. As I pointed out in a recent blog post , the inflation rate continues to remain very high when energy prices are excluded from the equation.

As investors, we are certainly not immune to the rapidly rising cost of living. After all, we have bills to pay and require food for sustenance just like anyone else. We do, however, have methods to obtain the extra income that we need in such an environment without needing to resort to taking on a new job. This is because we can put our money to work earning an income. Perhaps the best way to do this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income. These funds are, unfortunately, not very well followed by the investment media so it can be difficult to obtain the information that we would like to have to make an informed decision. This is unfortunate because these funds have a number of advantages over ordinary open-ended or exchange-traded funds. In particular, they are able to employ certain strategies that have the effect of boosting their yields well beyond that of any of the underlying assets, as well as pretty much anything else in the market.

In this article, we will discuss the Ares Dynamic Credit Allocation Fund, Inc. ( ARDC ), which is one closed-end fund that can be purchased by investors that are seeking to earn a high yield. The fund yields a very impressive 11.43% at the current price and is managed by one of the premier alternative credit fund houses in the world. These two factors alone will likely appeal to any investor, and the fact that it is currently selling for a very attractive price will undoubtedly seal the deal. We do not want to make an investment decision based on these factors alone though, so let us investigate and see if this fund could be a worthy addition to a portfolio today.

About The Fund

According to the fund's webpage , the Ares Dynamic Credit Allocation Fund has the objective of providing its investors with an attractive level of total return. This is a somewhat surprising objective for a fund like this, as the name of the fund implies that it will be investing primarily in fixed-income securities. The fund's portfolio confirms this, as it is currently invested in debt securities along with a small allocation to cash:

At this point, there may be some readers that point out that the fund's bond allocation is well over 100%. This is because this fund employs leverage as part of its investment strategy, which we will discuss later in this article. The important thing to know for now is that the fund is investing in debt securities.

The reason why the emphasis on total return is surprising for a debt fund is that debt securities are by their nature income investments, not total return ones. After all, anyone that buys a debt security at issuance will pay the face value, receive a stream of interest payments for a period of time, and then receive the face value back at maturity. The only investment return comes in the form of the interest payments that the investor receives. There are no capital gains over the lifetime of one of these securities because there is no link to the growth and prosperity of the issuing company.

With that said, the management of this fund does appear to recognize that fact and has emphasized income as a target. From the webpage (emphasis ours):

Ares Dynamic Credit Allocation Fund is a closed-end management investment company. The fund's investment objective is to provide an attractive level of total return, primarily through current income and, secondarily, through capital appreciation. There can be no assurance that the fund will be able to achieve its investment objective or structure its investment portfolio as anticipated.

The fund, therefore, appears to be focusing on providing its investors with a high level of current income, although it will take capital gains when it can get them. This is a reasonable goal for a debt fund.

It is not contradictory that the fund would attempt to get capital gains when possible, despite the fact that debt securities cannot deliver capital gains over their lifetime. This comes from the fact that the price of bonds will move based on interest rates. It is an inverse relationship, so when interest rates go up, bond prices decline and vice versa. Thus, it is possible for the fund to earn capital gains by opportunistically trading bonds prior to their maturity date. Unfortunately, as everyone reading this is no doubt well aware, interest rates have been rising rapidly over the past year as the Federal Reserve and other central banks around the world attempt to combat the incredibly high inflation rates found in most nations today. This can be clearly seen by looking at the federal funds rate, which is the rate at which the nation's commercial banks lend money to one another on an overnight basis. As we can see here, the effective federal funds rate has risen from 0.77% a year ago to 5.06% today:

While the Federal Reserve has been more aggressive than most other central banks at tightening monetary policy, we have seen a similar trend in other nations. In fact, Japan and China are the only nations in the G20 that have not increased their benchmark interest rate over the past twelve months. Thus, the rising rate environment applies to just about everyone reading this.

As a result of these rising rates, the bond market has been slaughtered. Over the past twelve months, the Bloomberg U.S. Aggregate Bond Index ( AGG ) has declined 3.50%, but it was down much more back in October of last year:

The reason why the index has rebounded from its October lows is that many market participants believe that the Federal Reserve will cut interest rates as the economy falls into a recession during the second half of the year. That is, to put it mildly, very unlikely if the current hawkish posturing of numerous central bank officials is anything to go by. Thus, we could very easily see this index fall again later this year once the market wakes up to this reality.

The Ares Dynamic Credit Allocation Fund has certainly not been immune to this trend as it has declined a more significant 11.87% over the past twelve months:

The fact that the fund has declined much more than the index is not unusual. As regular readers are no doubt aware, just about every closed-end fund that invests in debt securities has fallen more than the index. This is partly due to leverage and partly due to the distributions that they pay out. As already mentioned, the Ares Dynamic Credit Allocation Fund has an 11.43% yield as of the time of writing. That is substantially higher than the 2.75% current yield of the index. It is also nearly high enough to completely offset the fund's share price decline. Thus, anyone that actually purchased the Ares fund a year ago would not have lost anywhere close to 11.87% of their money. Curiously, this fund does not state what its total return was over the past year. However, it has delivered a very attractive total return both year-to-date and over the past three years:

Any bond fund that can deliver a 12.08% average annual total return over the past three years must be doing something right. This is much better than the Bloomberg US Aggregate Bond Index, which is actually down over the same period:

Thus, it appears that this is one fund that manages to beat the index on a fairly consistent basis. It is important to note that all the figures above are total returns, so they imply that all distributions paid by the fund are reinvested into more shares. An investor that takes their distributions and spends them will not do nearly as well. That is true of any investment, though.

Unlike the index, the Ares Dynamic Credit Allocation Fund does not invest solely in traditional fixed-rate bonds. The fund's portfolio also includes collateralized loan obligations and other loan securities. As of the time of writing, approximately 44.7% of the portfolio is in bonds and the rest is in various loan securities:

This is something that gave this fund a significant advantage over the aggregate bond index over the past year. This is because both senior loans and collateralized loan obligations are floating-rate securities. This means that when interest rates rise, the payments made by the securities to their investors also rise. These securities should also hold their value much better when market interest rates rise as the payment made by the security will always be competitive with everything else in the market. It should be fairly obvious how a fund that holds more than half of its portfolio in securities like these would have an advantage over traditional bond funds or indices when rates rise, as has been the case over the past year.

The fund's strategy of adjusting its portfolio between traditional bonds and floating-rate securities could prove to be an added advantage over ordinary bond funds for investors in the current environment. As already mentioned, the market appears to be expecting a rate cut later this year. However, officials at the Federal Reserve are strongly implying that this will not happen. That could have a very devastating effect on fixed-rate bonds if the central bank does indeed stay the course, but the floating-rate portion of this fund's portfolio will hold up better. There are two problems with floating-rate securities, however:

• Floating-rate securities are usually issued by companies that have weak balance sheets and may be vulnerable to an economic shock. A recession combined with a high-rate environment could lead to mass defaults.
• Floating-rate securities will provide a falling level of income during a loose monetary regime and will not provide sufficient capital gains to make up for it. Fixed-rate bonds will and are generally better holdings during times when rates are falling.

The fact that this fund is holding both traditional and floating-rate debt securities helps to diversify away some of the inherent risks possessed by either type of securities. That is a real advantage, especially as the fund can adjust its allocation between the two security types in order to adjust to the market conditions. Overall, this diversification and tactical allocation ability should prove to make this fund a decent holding given the rather uncertain market and economic environment heading into the second half of 2023.

Leverage

As mentioned in the introduction, closed-end funds like the Ares Dynamic Credit Allocation Fund have the ability to employ certain strategies that boost the effective yields of their portfolios well beyond that of any of the underlying assets. One of the strategies that are employed by this fund to accomplish that task is leverage, which we hinted at earlier. Basically, the fund borrows money and uses the borrowed money to purchase fixed-rate and floating-rate debt securities. As long as the yield on the purchased assets is greater 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 a portfolio. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, this 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. That is one possible reason why this fund fell more than the aggregate bond index over the past year. As such, we want to ensure that the fund is not using too much leverage since 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 this reason. The Ares Dynamic Credit Allocation Fund has levered assets comprising 34.92% of its portfolio as of the time of writing so it is a bit above this level. However, it is probably okay in this case. Bonds, floating-rate securities, and other debt instruments tend to be much less volatile than common equities so a debt fund like this should be able to carry a higher leverage than an equity fund. In addition, this fund is barely above that one-third level and it may easily fall below it on a market uptick. Thus, the balance between risk and reward here appears to be acceptable.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the Ares Dynamic Credit Allocation Fund is to provide its investors with a high total return focusing on current income. In order to achieve this objective, the fund invests in various debt securities that principally deliver their investment return via direct payments to the buyer. The fund then applies a layer of leverage to boost the effective portfolio yield beyond that of any of the underlying assets. As such, we might expect that the fund would have a remarkably high yield itself. This is certainly the case as the fund pays a monthly distribution of $0.1125 per share ($1.35 per share annually), which gives it an 11.43% yield at the current price. The fund has been reasonably consistent with its distribution over the years, although it has varied somewhat:

While the fund's distribution has certainly varied somewhat, this is still a much less volatile distribution history than most other debt-focused closed-end funds possess. However, it may still be a bit of a turn-off for an investor seeking a safe and secure source of income to use to pay their bills or finance their lifestyles. The fund has increased its payout three times in the past twelve months though, so that is certainly nice to see as it could be a sign that the fund is benefiting from the rising rate environment via its floating-rate security portfolio. As I have pointed out before, anyone buying today will receive the current distribution at the current yield and so does not really have to worry about the fund's distribution history. The most important thing for anyone purchasing the fund today is how well it can maintain the distribution at the current level so let us investigate that.

Fortunately, we do have a relatively recent document that we can consult for that purpose. That fund's most recent financial report corresponds to the full-year period that ended on December 31, 2022. As such, it will not include data on the fund's performance over the past few months but it will still give us a good idea of how well it handled the incredibly challenging conditions of 2022. During the full-year period, the Ares Dynamic Credit Allocation Fund received $43.908 million in interest, which comprised its entire investment income. The fund paid its expenses out of this amount, leaving it with $29.947 million available for shareholders. That was sufficient to cover the $27.383 million that the fund paid out in distributions during the period. In 2021, the fund likewise had sufficient net investment income to cover the distributions in full. Thus, it appears that this fund is simply paying out its net investment income to the investors, which should be reasonably sustainable over the long term.

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 sure-fire way to earn 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 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 purchasing the fund's assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of June 1, 2023, the Ares Dynamic Credit Allocation Fund has a net asset value of $13.64 per share but the shares currently trade for $11.86 each. This is a 13.05% discount on the net asset value, which is an enormous discount in general. It is also quite a bit better than the 12.45% discount that the fund's shares have had on average over the past month, so the price certainly appears acceptable today.

Conclusion

In conclusion, the Ares Dynamic Credit Allocation Fund appears to be a pretty good way for an investor to earn a high level of income today. The fund is one of the few that balances its assets between fixed-rate and floating-rate securities, which is nice in the current uncertain environment. The fund also appears to be keeping its leverage at a reasonable level but is still able to pay out a double-digit yield solely using net investment income. The fund also trades at a very attractive valuation. As we might expect from a credit fund run by Ares Capital Management, this Ares Dynamic Credit Allocation Fund, Inc. appears like a winner.

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