META - BDJ: High Distribution Yield And Less Volatility Than Most Funds

2023-06-01 09:01:43 ET

Summary

• Investors today are desperately in need of income due to the rapidly rising cost of living in both the United States and many other nations.
• BDJ invests in a portfolio of high-yielding dividend stocks and then writes call options against individual stocks to synthetically boost their yields.
• The fund enjoys much less volatility than the market on average, which could be appealing to those investors concerned with principal protection.
• The fund failed to cover its distribution last year, but this may improve this year due to the strong market that we have seen year-to-date.
• The fund is currently trading at a larger-than-average discount to the net asset value.

Without a doubt, one of the biggest challenges facing the average American household today is the incredibly high inflation rate that is running rampant across the economy. This is illustrated by the consumer price index, which claims to measure the price of a basket of goods that is regularly purchased by the average person. As we can see here, there have only been two months over the past year in which the index went up by less than 6% on a year-over-year basis:

While it does appear that the index's growth has somewhat moderated in rent months, this is almost entirely due to lower energy prices. I discussed this in a recent blog post . Energy prices are somewhat volatile, so it is uncertain how long this improvement will last, especially considering that analysts are expecting a crude oil shortage later this year. The fact that prices are not increasing as rapidly as last year is also little comfort for many people whose wages have failed to keep up with the highest inflation that we have experienced in more than forty years. In short, many people are in desperate need of additional levels of income right now.

As investors, we are certainly not immune to the ravages of inflation. After all, we need food and energy just like anyone else. However, We have some options on how we can obtain extra income to cover rising costs. After all, we have the ability to put our money to work for us to earn an income. One of the best ways to accomplish this is to purchase shares of a closed-end fund that specializes in the production of income. These funds are unfortunately not very well followed by the financial media so it can be difficult to obtain the information that we would like to have to make an informed decision. This is unfortunate as these funds offer a number of advantages over open-ended and exchange-traded funds. In particular, a closed-end fund can employ certain strategies that boost its yield 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 BlackRock Enhanced Equity Dividend Trust ( BDJ ), which yields an impressive 8.32% at the current price. This is certainly a high enough yield to satisfy most investors that are seeking a high level of income from their portfolios. I have discussed this fund before, but that was several months ago so naturally numerous things have changed. In particular, the fund has released an updated financial report so we will want to analyze that as part of our investigation into this fund's suitability. Therefore, let us investigate and see if this fund could be a worthy addition to an income portfolio today.

About The Fund

According to the fund's webpage , the BlackRock Enhanced Equity Dividend Trust has the objective of providing its investors with a high level of current income and current gains. That is hardly surprising considering that the term "enhanced equity" usually means that a fund is investing in common equity and then employing a covered call strategy to generate synthetic dividends from its holdings. This one certainly appears to be doing that based on the fund's description of its strategy. From the webpage:

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.

A look at the portfolio composition does indeed reveal that the fund is investing primarily in common equity. In fact, its portfolio is currently 94.29% invested in common equity securities with the remainder mostly in cash:

The fund's investment objective makes a great deal of sense in this respect. After all, most people buy stocks both for the dividends that they pay out and the potential for capital gains as the issuing company grows and prospers. This fund does not place as much emphasis on long-term gains as it does on short-term gains though, which is almost certainly a side effect of the option-writing strategy.

The fact that this fund employs an options strategy is something that might concern some investors. After all, we have all heard about the risks inherent in options. However, this fund is only selling covered calls, which is by far the safest options strategy available. This is because the fund is selling options that it already owns the stock needed to satisfy the demand of the option buyer in a worst-case scenario. Basically, the worst-case scenario is that the option is exercised against the fund, in which case all the fund has to do is sell the stock that it already owns to the option buyer. The worst possible outcome here is that the fund does not realize as large a capital gain as it would have had the option not been exercised and the fund was allowed to keep the stock. This is not a dangerous options strategy as there is no risk of unlimited losses, as there would be if the fund was selling options against a stock that it does not own. Thus, risk-averse investors should still be able to enjoy a certain amount of comfort here.

As I have noted in articles about other closed-end funds that claim to be focused on earning dividend income from common stocks, the portfolios of these funds frequently make no sense as they are heavily invested in companies like Amazon ( AMZN ), Alphabet ( GOOG ), or Meta Platforms ( META ) that pay no dividends. This one is not like that, however. The fund's description claims that 80% of its assets will be invested in dividend-paying common stocks. The fund's largest positions appear to confirm that. Here they are:

While not all of these companies possess an enormous dividend yield, they do all pay a dividend:

As of the time of writing, the S&P 500 Index ( SPY ) yields 1.54%, so the majority of the companies that constitute this fund's largest positions yield above the market average. That is something that is certainly nice to see as it should allow the fund to earn a reasonable level of income simply from the common stock positions. The covered call income should provide an extra boost.

There have been quite a few changes since we last looked at the fund. In particular, General Motors ( GM ), Cisco Systems ( CSCO ), and JPMorgan Chase ( JPM ) were all removed and replaced with Kraft Heinz, Baxter International, and Laboratory Corporation of America. In addition to this, the weightings of several positions changed significantly, but that could be explained by one stock outperforming another in the market. The fact that nearly a third of the fund's ten largest positions were swapped within a few months might still lead one to expect that this fund has a fairly high turnover, however. This is certainly the case, as the BlackRock Enhanced Equity Dividend Trust had an 81.00% annual turnover in 2022. That is higher than many other equity closed-end funds. The reason that this is important is that it costs money to trade stocks or other assets, and these expenses are billed directly to the fund's shareholders. That causes a drag on the fund's performance and makes management's job more difficult. After all, the fund's managers will need to generate sufficient returns to cover these added expenses and still provide a return that is acceptable to the fund's shareholders. There are very few management teams that manage to accomplish this on a consistent basis, which is one reason why most actively-managed funds fail to match the performance of a comparable index fund. For its part though, the BlackRock Enhanced Equity Dividend Trust has managed to deliver a pretty solid performance in past periods:

This fund actually beat the S&P 500 Index over the trailing one-year period, although the market index beat the closed-end fund during all of the remaining periods. Here are the comparable figures for the iShares Core S&P 500 ETF ( IVV ) to prove the point:

This is exactly what we would expect for a fund that employs covered calls as a part of its strategy. The premiums received from the option sales will offset some of the losses in a declining market. However, during a raging bull market, the options strategy caps the fund's potential gains. The only year over the past ten in which the S&P 500 Index was not a raging bull market was the one-year period reflected in the chart above, so this is pretty much what we see. With that said though, the S&P 500 Index is not a perfect comparison for this fund because the index has significant weightings to numerous companies that do not pay dividends. Either way, we can see that the BlackRock Enhanced Equity Dividend Trust still manages to deliver an acceptable total return during most years that is much less volatile than the S&P 500 Index. That may be appealing to investors that are most concerned with preserving the money that they already have and earning a high level of income.

Distribution Analysis

As mentioned earlier in this article, one of the primary objectives of the BlackRock Enhanced Equity Dividend Trust is to provide its investors with a high level of current income. In order to achieve this objective, it invests in a portfolio of dividend-paying stocks that seem to have higher yields than the market on average. The fund then writes call options against the stocks in its portfolio in order to obtain some extra income. We can therefore assume that the fund itself will boast a respectably high yield. This is certainly the case as the fund pays a monthly distribution of $0.0562 per share ($0.6744 per share annually), which gives the fund an 8.32% yield at the current price. Unfortunately, the fund has not always been consistent with respect to its distribution, but it has done very well since 2015:

This is a better track record than most closed-end funds have managed to achieve as most exhibit much more volatility and changing distributions over time. With that said, the options strategy employed by this fund does a pretty good job of reducing portfolio volatility. We discussed this earlier in this article. The fact that the fund has managed to maintain a very consistent and growing distribution over most of the past decade will likely appeal to those investors that are seeking a safe and secure source of income to use to pay their bills and finance their investors. As is always the case though, we want to be sure that the fund 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 most likely causes the fund's share price to decline.

Fortunately, we do have a relatively recent document that we can consult for the purposes of our analysis. As of the time of writing, the fund's most recent financial report corresponds to the full-year period that ended on December 31, 2022. Although this report will not include any information about the fund's performance over the past few months, it is a much more recent report than we had available the last time that we discussed this fund. It will also give us a very good idea of how well the fund navigated the very challenging market conditions that characterized 2022. During the full-year period, the BlackRock Enhanced Equity Dividend Trust received $45,768,320 in dividends and surprisingly nothing in interest. After we add in a small amount of income from other sources and net out foreign withholding taxes, the fund reported a total investment income of $44,888,544 over the period. It paid its expenses out of this amount, which left it with $30,038,016 available for shareholders. This was nowhere close to enough to cover the $204,152,869 that the fund paid out in distributions during the period, however. This is something that is likely to be concerning at first glance as the fund did not have nearly enough net investment income to cover its distributions.

However, the fund has other methods that it can employ to obtain the money that it needs to cover the distribution. For example, it might have capital gains that could be distributed. These capital gains could also include income from the options writing strategy as this money could be considered capital gains or a return of capital depending on the situation. Perhaps surprisingly, the fund did have some success here over the course of the year. It reported net realized gains of $147,475,079 over the period, but this was offset by $250,207,024 net unrealized losses. Overall, the fund's assets declined by $273,196,549 over the period after accounting for all inflows and outflows. Overall, the fund failed to completely cover its distributions. However, its net investment income plus net realized gains totaled $177,513,095, which was fairly close to the amount that was actually distributed. Thus, the weakness here was mostly the net unrealized gains. If the fund has fewer losses in 2023 then it can probably sustain its distribution. The market is off to a good start year-to-date so we will want to continue to watch its performance over the next several months.

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 surefire way to earn a suboptimal return on that asset. In the case of a closed-end fund like the BlackRock Enhanced Equity Dividend Trust, 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 the fund's assets minus any outstanding debt. This 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 acquire 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 May 30, 2023 (the most recent date for which data is available as of the time of writing), the BlackRock Enhanced Equity Dividend Trust had a net asset value of $8.51 per share but the shares currently trade for $8.06 each. That represents a 5.29% discount on the net asset value at the current price. This is a much larger discount than the 3.29% that the shares have averaged over the past month. Thus, the price appears to be reasonable today.

Conclusion

In conclusion, the BlackRock Enhanced Equity Dividend Trust appears to be a reasonable way to obtain income today. The fund invests in a portfolio of high-yielding common stocks and then writes call options against the individual stocks in its portfolio. This gives it both income and capital gains that can be paid out to the investors. The fund did unfortunately overdistribute last year, which is a valid threat to the distribution but the market appears stronger year-to-date so hopefully this situation has improved. The fund is also trading at a reasonably attractive valuation today, so it may be worth considering for a portfolio.

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