BANX - ArrowMark Financial Corp: Can You BANX On This Yield?

2023-05-04 18:04:08 ET

Summary

• BANX is a rather unique closed-end fund, investing heavily in regulatory capital relief securities.
• Given this exposure, one might be concerned about this fund due to financial exposure.
• However, the latest NAV estimate at the end of March 2022 showed that it barely budged.

Written by Nick Ackerman, co-produced by Stanford Chemist. A version of this article was originally published to members of the CEF/ETF Income Laboratory on May 3rd, 2023.

ArrowMark Financial Corp ( BANX ) is a unique closed-end fund. They have exposure to the financial sector, coming primarily from regulatory capital relief securities. However, they also have some exposure to other banking debt securities.

Despite the banking failures, the fund's latest NAV estimate for the period ending March 2023 barely budged, given the heightened volatility. This fund has also benefited from higher interest rates as regulatory capital relief securities come with a floating rate. BANX last listed that 83% of its portfolio was invested in floating-rate assets.

Since our last update , the fund's share price has been quite volatile, just as the overall financial sector has been. The market price has been much more volatile when compared to the NAV provided. This has resulted in the fund's discount continuing to provide an attractive discount. In fact, the discount has moved even wider.

The Basics

• 1-Year Z-score: -1.54 (previous close, but after deep sell-off it will be lower)
• Discount: -29.83% (based on 3/31/2023 estimated NAV)
• Distribution Yield: 9.20%
• Expense Ratio: 4.09%
• Leverage: 27.52%
• Managed Assets: $191 million
• Structure: Perpetual

BANX's primary investment objectives are "income generation, capital preservation, and providing total risk-adjusted returns."

To achieve these investment objectives, they will invest in "banking-related assets across the spectrum of community banks to global money center banks. The company invests across asset classes including term loans, structured debt, regulatory capital relief securities and, to a lesser extent, equity. Under normal circumstances, we intend to invest at least 80% of the value of our net assets plus the amount of any borrowings for investment purposes in these assets."

The fund is leveraged, and given the recent volatility, that would mean it adds even further to its volatility. Additionally, the borrowings are based on floating rates. So as interest rates continue to increase (another 25 basis point increase is being announced as I'm writing this), it means higher borrowing costs. Their borrowings are based on SOFR + 2.61% as of May 25th, 2022. Before this, it was previously based on LIBOR but was changed due to the discontinuation of LIBOR.

This rate is higher than what we often see in CEFs. In their last annual report for the period ended December 31st, 2022 , the average interest rate was 4.21%. This higher interest rate contributes to the higher total expense ratio this fund carries. While their leverage costs are rising, this is being more than offset by the floating rate underlying portfolio.

At the latest year-end, the expenses, including leverage costs, came to 5.64%. Certainly, it isn't helped by the 1.75% management fee that is in place, either. This is something to consider before investing in this fund.

However, while this is high, this is certainly a unique fund. So we often see higher expense ratios in more unorthodox portfolios; that's why we similarly see the CLO funds having expense ratios of 5-10%+.

Performance - Deep Discount Opens With Jitters In The Market

Over time, the fund has provided fairly attractive results. This is especially true if we compare the results against other fixed-income benchmarks. Remember, this is also factoring in the fund's expense ratio too.

The other thing worth noting is that this fund is also different from what it used to be. It was taken over by ArrowMark Partners in 2020 and renamed to ArrowMark Financial Corp later in 2022.

The fund previously was a bit more diversified across different financial sector instruments offered. It wasn't long after ArrowMark Partners took over that they began putting in sizeable allocations to regulatory capital securities .

StoneCastle Financial purchased $62.6 million of Regulatory Capital Securities in 11 transactions in 2020. At year-end, the Company held 13 Regulatory Capital Securities in the form of credit-linked note investments totaling $88.1 million, or 49.4% of total investments. Regulatory Capital Securities are securities issued by both U.S. and foreign issuers that assist a bank in managing its regulatory capital requirements.

With that said, I believe the more important changes came recently with the banking crisis. While we don't know what April brought us with yet another bank failure, we do know that at the end of March 2023, the NAV was estimated to be $20.62. That was a fairly shallow decline from the $21.12 it reported at the end of February 2023 . It meant just a 2.37% decline month over month.

The NAV at the end of December 2022 came in at $20.79. That was in their audited annual report. In the first quarter overall, that meant a decline of less than 1%. Given the environment in the financial space, I don't see that as an overly concerning decline. Instead, what it has done is open up a deep discount on this unique fund.

As of writing, BANX shares show a market quote of $14.47.

That puts the fund's current estimated discount based on the March 2023 estimated NAV at 29.83%. History has shown that this is generally a fairly strong time to consider investing in this fund.

Distribution - Floating Rate Boost

As the fund's portfolio is primarily allocated to floating rate investments, this has come through in rising income for the fund. It resulted in the fund paying out a year-end special in 2022, and they could also bump up the distribution to start in 2022. Year-over-year, NII rose 15%. That's when interest rates started out in 2022 at zero, meaning we should see this grow even further.

While NII continued to rise due to rising rates, they haven't been overly aggressive with raising their distribution since. My assumption here is that while they can raise, they don't want to get overly aggressive if they might have to cut in the future. They could have to cut due to damage in their underlying portfolio due to rapidly rising interest rates. At some point, higher rates become damaging - which is exactly what the Fed wants to do to reduce inflation. We don't have to look any further than the latest bank failures on financial preferred and debt investments.

Additionally, at some point, the Fed will have to cut rates. That's almost inevitable. It's always a time of when and not if. So that's why they could feel more comfortable with paying out specials should the need arise rather than aggressively raising their regular quarterly distribution. Given their history of regular special distributions, this is a fairly reasonable conclusion.

Thanks to the fund's large discount, the distribution rate on this name comes to 10.78% for its regular. At the same time, the fund's NAV rate comes to a more modest 7.57%. In my opinion, this is a yield you can 'BANX' on, given their earnings that were expected to grow since their last report.

BANX's Portfolio

The fund experienced a higher turnover rate in 2020 of 60% when it started to transition to what they are today. The latest portfolio turnover rate was at 29% so that moderated now that they are getting their portfolio settled in.

As noted at the article's opening, 83% of their portfolio is listed as floating rate. That also aligns with the exact portion of their regulatory capital relief securities portfolio. This allocation was as of the end of December 2022. It's also the same exact weighting that was noted in our previous update.

The regulatory capital relief securities are credit-linked notes. To give a better idea of what these are, they describe them as:

...senior unsecured debt obligations that are credit linked to the performance of a reference portfolio of certain loan related claims on corporate and similar entities. The fair value of regulatory capital securities is generally based on broker quotes. Regulatory capital securities are generally categorized as Level 2 or 3 in the fair value hierarchy, depending on the availability of broker quotes.

They noted that these securities are generally BBB to BB weighted average, with individual exposures carrying a range of AA to B-. While that is generally higher credit quality, the latest banks to go under were also considered investment-grade until the writing was on the wall.

Having level 3 securities will always open up a fund to some scrutiny. The valuation of these becomes questionable since they are valued basically through the best guess as there are "significant unobservable inputs."

Since their semi-annual report of June 30th, 2022 , they've had more flow into the level 3 category. It was an increase from $47.197 million or 23.95% of their portfolio to 34.15% of the portfolio by the end of 2022. All of the level 3 category is comprised of these regulatory capital relief securities.

Overall, these securities are fairly opaque in terms of what exposure there really is in these notes. They dedicate several slides in their investor presentation talking about greater details and hypothetical examples. However, it really comes down to being able to trust management. At this point, ArrowMark Partners has a few years of a track record which shows a promising start even as we go through this banking crisis.

There are some details we can see in their annual and semi-annual reports on holdings. Those include the interest rate being received and the maturity. It also includes the par amount and the fair value.

They don't hedge against rising rates directly through any derivatives, as their underlying portfolio is essentially a hedge itself. However, it should be noted that they have hedged against currency risk through forward foreign currency contracts. Those have contributed positively to the latest results of the fund in the prior year. This can be important when investing in global positions of varying currencies.

Conclusion

BANX has been holding up well despite the banking crisis. As interest rates have risen, they've benefited due to higher yields. That has been enough to offset the higher borrowing costs due to their leverage. This unique fund invests in a non-traditional area of the fixed-income space, which has shown positive historical results relative to more traditional bonds. At a deep discount, due to what seems to be an unwarranted sell-off, that could provide an opportunity for investors willing to dive into this market area.

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