WFC - BDJ: Deep Discount Creating A Long-Term Opportunity

2023-09-13 12:43:20 ET

Summary

• BlackRock Enhanced Equity Dividend Trust is a covered call-writing fund, which has now dropped to an attractive discount.
• BDJ has a simple approach, a low expense ratio, and a value-oriented portfolio.
• The fund has a steady and reasonable distribution rate, backed by the underlying dividend payers and capital gain potential.

Written by Nick Ackerman, co-produced by Stanford Chemist.

BlackRock Enhanced Equity Dividend Fund ( BDJ ) is one of my go-to covered call-writing funds. This is one of the largest positions in my own portfolio. It's currently representing an attractive opportunity for other investors to add as well, as the fund's discount has been widening out.

Since our last update , this fund, as well as the broader equity market, has trended lower. The S&P 500 isn't an appropriate benchmark in terms of a direct comparison for several reasons, but it does add some color to what the equity market is doing.

Our "buy target" for BDJ is at a -6% discount or wider. We've now achieved that and can upgrade the rating to a "Buy." In the prior update, it was right near that level but not quite there.

The Basics

• 1-Year Z-score: -2.50
• Discount: -11.37%
• Distribution Yield: 8.83%
• Expense Ratio: 0.85%
• Leverage: N/A
• Managed Assets: $1.623 billion
• Structure: Perpetual

BDJ's primary objective is to "provide current income and current gains." The fund intends to achieve this by "investing in common stocks that pay dividends and have the potential for capital appreciation." They concentrate on dividend-paying stocks with "80% of its total assets in dividend-paying equities."

One of the benefits of BDJ is that it's a fairly simple approach. They invest in dividend-paying equities and utilize a covered call strategy. They don't incorporate any leverage in terms of borrowings, so that's one less thing to worry about during this current interest rate environment. As other funds are having to grapple with higher borrowing costs, that's just not something BDJ has to be concerned about.

The fund's expense ratio is fairly low relative to other closed-end fund peers, coming in at 0.85%. This also has been a fairly consistent expense ratio over the last five years as well, fluctuating between as low as 0.85% and 0.87%.

Performance - Attractive Discount

As equities have been enjoying a mostly strong last decade-plus now, BDJ's results have been respectable, as expected.

BDJ is overwritten by 50.05%; this is actually above their 30% to 40% target range. Being overwritten by a larger amount could indicate that the management team is a bit more bearish looking forward. That wouldn't necessarily be a bad outlook either, given such strong results on a year-to-date basis with overall equities rising.

That being said, where a call writing fund can come in to give some limited upside potential is when the market is in a raging bull market. When a covered call trade is initiated, it essentially puts a ceiling on the amount of upside that a particular portfolio holding can experience because the position may be called away.

Alternatively, the management team can close or roll the position in order to participate in further upside, but that comes with its own drawbacks. Closing out the trade could mean that you experience a loss on the trade, meaning you'd need the position to rise even further to cover that loss now as you raise your breakeven.

If you roll a position out, you can likely cover the expense that comes with closing. However, you might just be delaying the inevitable or kicking the can down the road essentially. If the security continues to rise, you just put the ceiling somewhere else and could run into the same situation at a later day.

Fortunately, in the first half of the year , BDJ has been able to generate realized gains from options writing. Unfortunately, on the other hand, it was more than offset by the unrealized losses experienced from their option writing.

The main point of highlighting this is to explain why trying to compare to something like a straight equity index such as the S&P 500 Index tracked by an ETF like the S&P 500 SPDR ( SPY ) isn't necessarily appropriate.

On top of this, BDJ holds a more value-oriented portfolio with weightings favoring financials and healthcare, as well as energy, industrials and consumer staples over the information technology sector.

Instead, BDJ uses the Russell 1000 Value Index as a benchmark as well as the MSCI USA Value Call Overwrite Index to help measure against a more appropriate positioning. Against those benchmarks, BDJ has been able to exceed the overwrite index while putting up similar results to the Russell 1000 Value.

Overall, the most attractive feature of BDJ over any of these benchmarks or ETFs is the fund's discount. In that case, the fund is trading well below its longer-term average.

The current discount also represents a significant decline from the premiums the fund was flirting with. Which makes this latest drop seem that much more dramatic. However, that premium seemed unwarranted and was why I was in " Hold" mode consistently over the last several years.

Distribution - Looking Steady And Reliable

BDJ has been fairly consistent with its monthly distribution. They cut in the global financial crisis and did so on a couple of occasions even after that period. However, since then, the fund has seen a couple of small increases.

The current distribution rate on the NAV comes to 7.82%, which is a seemingly reasonable and realistic level where we shouldn't see a cut for the foreseeable future. Thanks to the large discount, the fund's distribution rate actually comes to 8.83% based on the market price.

As is the case with all equity funds, they will require capital gains to fund their payout. Thanks to the dividend-paying underlying portfolio, it still generates a fairly meaningful amount of net investment income too. NII can be more reliable than capital gains, which is why it's still an important factor to consider for equity funds. That said, covered calls also can be considered something that can be fairly reliable in terms of generating gains. However, as we noted above, this can fluctuate.

Looking at NII, it even ticked a touch higher with this last report, on a per-share basis, going from $0.16 to $0.09 or what would be annualized out to $0.18. Last year, the fund had paid out an additional $0.21762 year-end spillback distribution, which is why the total distribution paid out in fiscal 2022 was so significant.

BDJ's Portfolio

The latest turnover rate for the fund came to 24% for a six-month period. This puts it on a trajectory that is looking to be fairly consistent in terms of where the fund has historically been for turnover. 2022 was a bit of an anomaly, where the turnover was relatively higher at 81%.

Despite some meaningful turnover, the sector allocation of the fund has remained fairly consistent. They have overweighted financials and healthcare. They then have meaningful exposure to energy, consumer staples and industrials - all those sectors have larger allocations than information tech, which is what makes BDJ a bit more unique.

These sector weightings were fairly consistent with where they were two months ago when they reported these figures in our prior update. Given that being the case, it isn't too surprising to see that the largest holdings for the fund have also been fairly consistent. In fact, Wells Fargo's ( WFC ) 3.01% is exactly the same.

One new position in the top 10 is Shell plc ( OTCPK:RYDAF ), which has replaced First Citizens BancShares ( FCNCA ). During this period, FCNCA had outperformed RYDAF in the end - though it had been lower heading toward the end of June. This gives us an idea that they either reduced or sold out of their FCNCA position and possibly added to RYDAF.

RYDAF becoming a larger position also is reflected in the fund's semi-annual report, which is for the period ending June 30, 2023. At that time, we saw FCNCA's value at $31,966,889 with 24,907 shares. In that same report, we see that they held 1,263,772 shares of RYDAF valued at $37,700,422.

If we go back to the March 31, 2023 N-PORT , they held 30,717 shares of FCNCA at a value of $29,890,712. For RYDAF, we see a significant increase in their position as that showed only 510,170 shares being held with a value of 14,533,115.

They write covered calls on both of these positions, which could mean they saw some of their FCNCA positions called away.

Conclusion

BDJ is back at an interesting discount for income investors looking to generate attractive monthly cash flows. This discount comes after the fund has been trading at a historically rich premium or narrow discount for several years. The fund also is positioned a bit differently, which can add diversification with a low weighting to tech and instead take a value-oriented approach.

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