FCNCO - BDJ: A Relatively Safe Way To Earn Income And Still Invest In Equities

2023-11-20 02:30:15 ET

Summary

• BlackRock Enhanced Equity Dividend Fund offers a current distribution yield of 8.94%, higher than the S&P 500 Index's 1.44% yield.
• BDJ's recent performance has been disappointing, with a decline in share price since June 2023.
• The fund focuses on dividend-paying equities and employs a covered call strategy to enhance distributions, making it appealing to income-focused investors.
• BDJ's portfolio does not include the Magnificent 7 stocks, which has hurt its returns so far this year.
• The fund currently trades at an attractive discount to net asset value and appears to be able to sustain its distribution.

The BlackRock Enhanced Equity Dividend Trust ( BDJ ) is a closed-end fund that income-seeking investors can employ to accomplish their goals. The fund's 8.94% current distribution yield is certainly a testament to this, as that yield is substantially higher than the 1.44% current distribution yield of the S&P 500 Index ( SPY ). Thus, it is substantially higher than can ordinarily be achieved by investing in equities, and as this fund is an equity fund, this appears to be the best point of comparison. It is worth noting that the fund's distribution is quite a bit lower than most fixed-income funds though, so investors who simply care about achieving the highest level of income possible might want to hide out in one of those funds for as long as interest rates persist at their current level.

As regular readers may recall, we last discussed this fund in early June of this year. At that time, the only real complaint that I had about the fund is that it failed to completely cover its distribution over the course of 2022. That is a problem that many closed-end funds share however, as just about the only ones that did manage to fully cover their distributions in that year are those funds that invest in the energy sector or in floating-rate fixed-income securities. Unfortunately, the fund's performance from the date that my previous article was published has not been especially inspiring. As we can see here, the BlackRock Enhanced Equity Dividend Trust has seen its share price decline by 6.91% since that date. This almost perfectly mirrors the S&P 500 Index ( SP500 ), which has seen its share price go up by 6.94%:

This performance is certainly going to be unlikely to get the attention of any investor. After all, nobody likes to lose money. However, as I have pointed out numerous times in the past, it is best to consider the impact that a fund's distribution has when comparing its returns to those of any other asset. This is because closed-end funds tend to pay out all of their investment profits to the shareholders, which causes their yields to be rather high. These large distributions can sometimes offset the impact of share price declines, allowing an investor to actually make money even if the fund's share price declines. This was, unfortunately, not the case during this period, as an investor who purchased shares of the fund on the date that my prior article was published has lost 2.83% of their investment as of the time of writing. This is much better than might be expected based on the fund's price performance alone, but it is still nowhere near as good as the S&P 500 Index has delivered over the same period:

Despite this underperformance though, the BlackRock Enhanced Equity Dividend Trust may still have some characteristics that will appeal to traditional income-focused investors, who tend to be somewhat conservative and are more concerned about the preservation of capital and safety of principal than some other investors. In particular, this fund is historically much less volatile than the broader stock market due to the strategy that it employs.

About The Fund

According to the fund's webpage , the BlackRock Enhanced Equity Dividend Trust has the primary objective of providing its investors with a high level of current income and current gains. This is a bit unusual for an equity income fund for two reasons:

1. Common stocks are generally not especially good at the provision of income. This is because their yields are far lower than that of fixed-income securities. For example, even the utility sector ( IDU ), which is historically favored by income-focused investors, only yields 2.82% at the current price. Common stocks have generally had very low yields for more than a decade.
2. While current gains are certainly possible to achieve by investing in common stocks, long-term investing strategies tend to be more popular due to a combination of effectiveness and taxation. This is the same with funds as well, as many equity funds tend to have a higher emphasis on tax-advantaged long-term capital appreciation than on trading equities for current gains.

As the name of the fund implies though, the BlackRock Enhanced Equity Dividend Trust is not a traditional equity closed-end fund. The fund employs a few uncommon strategies to increase its ability to satisfy income-focused investors. The fund's website explains its basic strategy pretty well:

BlackRock Enhanced Equity Dividend Trust's primary investment objective is to provide current income and current gains, with a secondary investment objective of long-term capital appreciation. The Trust seeks to achieve its investment objectives by investing in common stocks that pay dividends and have the potential for capital appreciation and by utilizing an option writing (selling) strategy to enhance distributions paid to the Trust's shareholders. The Trust invests, under normal market conditions, at least 80% of its total assets in dividend paying equities. The Trust may invest directly in such securities or synthetically through the use of derivatives.

Thus, the BlackRock Enhanced Equity Dividend Trust is a covered call fund. There are a few such funds in the market, including the following:

The BlackRock Enhanced Equity Dividend Trust has a higher yield than many of its peers, however. This is something that could be appealing to many investors who would be interested in a covered call fund compared to a straight equity fund. This is partly because this fund employs a different strategy than some of the others on the list.

As I have pointed out in various previous articles, many of the Eaton Vance option-income funds have substantial exposure to the mega-cap technology companies and other firms that tend to not pay much in the way of dividends. The BlackRock Enhanced Capital & Income Fund is much the same in this respect. However, the web page's description for the BlackRock Enhanced Equity Dividend Trust specifically states that this fund invests exclusively in dividend-paying common equities. This is very much the case, which we can see by looking at some of the largest positions in the fund. Here they are:

Here are the current dividend yields of these common stocks:

With the notable exception of First Citizens Bancshares, all of the companies in the fund's largest positions list have dividend yields that compare very well relative to the S&P 500 Index. That is something that we do not always see in closed-end funds that claim to invest in dividend-paying stocks. For example, most of the Eaton Vance option-income funds claim to favor dividend-paying equities in their strategy description, but the top five positions consist of companies like Amazon ( AMZN ), Alphabet ( GOOG ), Meta Platforms ( META ), and similar non-dividend-paying stocks. It is therefore nice to see that this fund takes its claim of investing in dividend-paying companies seriously.

That could be one reason why the BlackRock Enhanced Equity Dividend Trust is able to boast a higher yield than some other option-income funds. After all, the fund receives more income from the stocks in the portfolio than comparable funds that include greater exposure to pure growth companies. However, there is a trade-off in place as option premiums on dividend-paying stocks tend to be less rich than the premiums on more volatile growth stocks. As such, this fund's call-writing strategy may not be as profitable as we see with some other funds that employ call-option writing as a part of their income strategies. In the end, it appears that it reasonably balances out though, considering that this fund's yield is easily comparable to those funds that rely more on option premiums for their income.

One of the biggest problems with this fund's portfolio at present is the bifurcation that currently exists in the S&P 500 Index. I discussed this in a blog post from earlier this year and the problem has just gotten worse since then. In short, the "Magnificent 7," a term that was originally borrowed from a 1960s-era Western movie but has now come to refer to a handful of stocks in the artificial intelligence and cloud computing spaces, have been responsible for almost all of the gains of the S&P 500 Index this year. These companies are Microsoft ( MSFT ), Amazon, Meta Platforms, Apple ( AAPL ), Alphabet, NVIDIA ( NVDA ), and Tesla ( TSLA ). The Financial Times recently pointed this out, stating the following:

Seven large US tech companies have driven all of the gains in global stocks this year, pushing the US dominance of equity markets to new heights.

The so-called 'magnificent seven' - Apple, Microsoft, Meta, Amazon, Alphabet, Nvidia, and Tesla - have been propping up the S&P 500 Index of blue-chip US companies for most of the year because of investor excitement about the growth of artificial intelligence.

The remainder of the S&P 500 Index has been almost flat year-to-date. This is important because the BlackRock Enhanced Equity Dividend Trust is not invested in the Magnificent 7 stocks. As we can see from the fund's holding list above, not one of these companies is included in the fund's top-ten holdings. This is something that could be adversely impacting the fund's recent performance. After all, as we saw in the introduction, this fund has generally been underperforming the S&P 500 Index so far in the second half of this year. It certainly cannot explain all of the underperformance though, as the S&P 500 Equal Weight Index ( RSP ) has delivered a 4.33% total return since the date that my prior article was published.

That index's performance is closer to what this closed-end fund managed to deliver, but it is still quite a bit better than the fund:

The fund's performance thus still looks rather disappointing even in this light. However, as I have pointed out in previous articles on call option funds, this is what we would normally expect from this fund's strategy. A covered call writing strategy will usually underperform during bull markets because the call options put a cap on the capital gains potential. However, the strategy tends to underperform during flat or bear markets because the option premium either provides an excess return to that of the common stocks or offsets some price declines.

Thus, we would ordinarily expect that the BlackRock Enhanced Equity Dividend Trust will be less volatile than the market as a whole. That is, in fact, the case as this fund's net asset value held up better than the S&P 500 Index in 2022:

It has also been much more stable than the S&P 500 Index over the past ten years:

The fund has obviously underperformed the broader market index during what amounted to the most powerful bull market in history, but we can still see that the fund's net asset value has overall been far more stable than the broader market index. This is something that may appeal to income-focused investors.

It is also important to keep in mind that the above chart shows the fund's net asset value per share compared to the S&P 500 Index. It does not show the total return, so investors in the fund actually did much better than the 38.19% gain that the chart shows because they also received distributions over the period. The fund's shares had a total return of 116.0% over the ten-year period. That fits pretty well with our assumption that this fund should underperform the index during bull markets but will be less volatile and so should make it easier for risk-averse investors to sleep at night.

Distribution Analysis

As mentioned earlier in the article, the primary objective of the BlackRock Enhanced Equity Dividend Trust is to provide its investors with a high level of current gains and current income. In order to achieve this objective, the fund invests in a portfolio of dividend-paying stocks and naturally collects the money that these stocks pay out as dividends. The fund also writes call options against the stocks in its portfolio. The basic goal here is for the option to expire worthless, which allows the fund to keep the premium and then write another option to repeat the process. These option premiums are added to the dividends that the fund receives and then paid out to the shareholders. As we have already seen, most of the common stocks in this fund are paying very respectable dividend yields, and with the addition of the option premiums, which act as synthetic dividends, the fund should be receiving a pretty high effective yield from its portfolio. As such, we can assume that this fund boasts a very high yield itself.

That is certainly the case, as the BlackRock Enhanced Equity Dividend Trust pays a monthly distribution of $0.0562 per share ($0.6744 per share annually), which gives it an 8.92% yield at the current share price. As we have already seen, this yield compares fairly well to similar assets in the market. This fund has actually been pretty consistent with respect to its distribution over the years, although it was cutting the payout during the first few years of the recovery from the Great Recession:

We can see though that this fund has been very slowly increasing its distribution over most of the past decade. It has not reduced the distribution in recent years, but as stated its long-term history is not perfect here. This fund's overall distribution history is still likely to appeal to most investors who are seeking a safe and secure source of income to use to pay their bills or finance their lifestyles.

As is always the case, it is important that we have a look at the fund's finances to ensure that it can actually afford the distribution that it pays out. After all, we do not want to be the victims of a distribution cut that reduces our incomes and almost certainly causes the fund's share price to collapse.

Fortunately, we have a relatively recent document that we can consult for the purpose of our analysis. As of the time of writing, the fund's most recent financial report corresponds to the six-month period that ended on June 30, 2023. This is a more recent report than the one that we had available to us the last time that we discussed this fund. That is something that is very nice to see since it will give us a much better idea of how well the fund performed during the first half of this year. That was a pretty good period for the market overall, as investors widely anticipated that the Federal Reserve would soon reverse course on interest rates and kick off another stock market bubble. The stock market performed very well, however nearly all of the positive performance came from the Magnificent 7 companies that this fund does not invest in. However, this fund might have still had some potential to earn some capital gains and this report will tell us just how well it managed to perform.

During the six-month period, the BlackRock Enhanced Equity Dividend Trust received $23,885,282 in dividends from the investments in its portfolio. The fund had no interest income, although it did have a small amount of money come in from securities lending activities. We add that income into the total and subtract the money that the fund had to pay in foreign withholding taxes. Overall, the BlackRock Enhanced Equity Dividend Trust reported a total investment income of $23,388,136 during the period. The fund paid its expenses out of this amount, which left it with $16,506,586 available for shareholders. This was, unfortunately, not nearly enough to cover the $62,879,687 that the fund paid out in distributions during the period. At first glance, this is something that may be concerning as the fund's net investment income was not nearly enough to cover the distributions that it paid out.

However, it is common for equity closed-end funds to be unable to cover their distributions out of net investment income. This is attributable to the low dividend yields paid by most common stocks. As such, funds like this tend to rely on paying out realized capital gains, which are not included in net investment income. This fund also writes options and collects premiums, which are also not included in net investment income. Fortunately, this fund did have a great deal of success in this area over the six-month period. The BlackRock Enhanced Equity Dividend Trust reported net realized gains of $54,811,311 and had another $7,971,973 in net unrealized capital gains. Overall, the fund's net assets went up by $17,112,969 after accounting for all inflows and outflows during the period. Thus, this fund did actually manage to cover its distributions during the period, which is a much better performance than the $273,196,549 net asset decline that it experienced during the full-year period ending on December 31, 2023. As such, this fund's distribution is probably fine at the current level.

With that said, the fund's net asset value has decreased so far in the second half of this year:

As we can see, the fund's net asset value is down by 3.95% since July 1, 2023. This is a sign that the fund may be paying out more than it is earning so far in the second half of this year. That could be concerning, although it does have some funds left over from its strong performance during the first half of the year so it might be okay, especially if the market continues to be reasonably strong.

Valuation

As of November 16, 2023 (the most recent date for which data is currently available), the BlackRock Enhanced Equity Dividend Trust has a net asset value of $8.46 per share but the shares only trade for $7.54 each. This gives the fund's shares a 10.87% discount on net asset value at the current price. That is not nearly as attractive as the 12.71% discount that the shares have had on average over the past month. As such, it might be possible to obtain a better price by waiting a bit and buying on any market correction. However, a double-digit discount is generally a reasonable price to pay for any fund, so the current entry point is probably fine if you want to add the shares to your portfolio.

Conclusion

In conclusion, the BlackRock Enhanced Equity Dividend Trust appears to be a very reasonable way to obtain a very high level of income from the assets in your portfolio with a lower volatility than a straight common equity investment. The fund's covered call-writing strategy helps to reduce the fund's overall volatility relative to the market, as well as providing a synthetic dividend from many of the common stocks held in the fund's portfolio. The fund managed to cover its distribution during the first half of the year, which is quite nice. Its net asset value did decline so far in the second half of the year though so it is uncertain whether or not it will end up fully covering its distribution for this year. The fund's valuation is reasonably attractive though, so it might be worth purchasing today.

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