BGT - BGT: Amortizing 'Return Of Principal' Loan Fund

2023-07-10 02:42:34 ET

Summary

• BGT generates a high distribution yield from a portfolio of junk loans.
• BlackRock Floating Rate Income Trust pays an attractive 11.8% forward distribution yield.
• However, I recommend investors avoid BGT as there is a mismatch between the fund's long-term returns of 5.4% over 15 years and the double-digit distribution yield paid.

While looking for high yielding investments, I came across the BlackRock Floating Rate Income Trust ( BGT ). The BGT fund is currently paying an attractive 11.8% forward distribution yield that has been increasing in the past year due to the increase in short-term interest rates.

While the forward distribution yield is attractive, I have reservations about the fund. Simply put, I believe the BGT fund is paying more than earns, as the long-term average annual return of the BGT fund is only 5.4% over 15 years yet it is paying a 11.8% distribution yield.

Even though BGT's distribution may be 'covered' by its net investment income, I urge investors to consider the fact that over the past 6 fiscal years, the fund has lost a cumulative $1.70 / share in realized and unrealized losses. Since the fund primarily invests in floating rate loans, these are 'credit losses' and suggest the fund may be 'stretching' in terms of credit quality to generate high yields.

While investors in the BGT fund may think they are earning a double digit annual return because of the high distribution yield, after subtracting credit losses, total returns may be much more modest at ~5% per year.

Fund Overview

The BlackRock Floating Rate Income Trust is a closed-end fund ("CEF") that aims to provide a high level of current income. The BGT fund primarily invests in floating rate instruments of both US and non-US issuers. Under normal market conditions, the average duration of the BGT fund will be no longer than 1.5 years.

The BGT fund may use leverage to enhance returns. As of May 31, 2023, the BGT fund has 25% leverage. The BGT fund has $286 million in net assets and charges a 2.2% gross expense ratio on net assets (Figure 1).

Portfolio Holdings

As of May 31, 2023, the BGT fund has an effective duration of 0.2 years and portfolio yield to worst of 14.0% (Figure 2).

Figure 3 shows the asset class allocation of the BGT fund. The BGT fund is 95% invested in term loans, with a small handful of high yield bonds and other securities.

Figure 4 shows the fund's sector allocation. The fund's largest sector allocation is Consumer Cyclicals (20.1%), followed by Technology (18.6%), Capital Goods (13.8%), Consumer Non-Cyclicals (12.8%), and Communications (11.4%).

Figure 5 shows the portfolio's credit quality allocation. 22.2% of the BGT fund is invested in BB-rated securities while 62.6% is B-rated and 8.8% is CCC-rated. The BGT fund also has a handful of unrated securities.

Returns

Figure 6 shows the historical returns of the BGT fund. The BGT fund has delivered modest total returns over the long run, with 3/5/10/15Yr average annual returns on NAV of 7.4%/4.3%/4.7%/5.4% respectively to June 30, 2023.

Since the BGT fund primarily invests in floating rate term loans, investors should think of BGT's historical returns as that of non-investment grade credit spreads. Over the long-run, high yield credit spreads have averaged 5.4%, with periods of calm punctuated with occasional panics when credit spreads spike higher (Figure 7).

Therefore, over a cycle, investors should expect to generate average annual returns of 5-6% by investing in the BGT fund, adjusted higher for leverage but lower for fund expenses. This is confirmed by the fund's long-term average annual returns of ~5%.

Distribution & Yield

The BGT fund pays an attractive monthly distribution, currently set at $0.1136 or an annualized yield of 11.8% (Figure 8).

BGT's distribution has been steadily increasing in the past year with the Fed's increase to short-term interest rates (Figure 9).

BGT's distribution is funded primarily from net investment income ("NII") with occasional contribution from return of capital ("ROC") (Figure 10).

With the fund only earning long-term average annual returns of ~5% but paying a 11.8% forward yield, I have concerns that the BGT fund shows characteristics of being an amortizing 'return of principal' fund.

This concern is confirmed by an analysis of the BGT fund's long-term NAV performance, which shows the classic amortizing NAV pattern of 'return of principal' funds (Figure 11).

'Return of principal' funds are problematic because in the long-run, these funds end up with shrinking NAV and market prices, and eventually, shrinking distributions as there are not enough assets to fund their distributions. Although the BGT fund is generally able to fund its distribution from NII, there are other sneaky ways investors can lose.

For example, notice that in the past 6 fiscal years, the BGT fund has lost a cumulative $1.70 / share in realized and unrealized losses. Since the fund invests in floating rate loans, these losses are probably 'credit losses' from investing in 'junk' investments as the BGT fund chases high yields.

Conclusion

The BGT fund provides high current income from a portfolio of non-investment grade term loans and other floating rate investments. While the BGT fund pays an attractive 11.8% forward distribution yield, I would personally avoid the fund as it shows the classic traits of being an amortizing 'return of principal' fund.

The problem is not with the fund's portfolio or historical returns. In fact, the BGT fund has generated modest ~5% long-term average annual return on NAV that places it in the 1st or 2nd quartile when compared to peer 'Bank Loan' funds in Morningstar's database.

Instead, my concern is the mismatch between the fund's modest returns over a cycle and the double digit distribution yield paid by the fund. Over the long-run, investors in amortizing 'return of principal' funds like the BGT fund end up realizing total returns far lower than the attractive distribution yield.

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