SPY - BIT: A Well-Managed 9.89%-Yielding Bond CEF But An Expensive One

2023-08-09 13:44:26 ET

Summary

• The high inflation rate in the U.S. has increased the cost of living, making it difficult for many people to make ends meet.
• The BlackRock Multi-Sector Income Trust offers a 9.89% yield, providing a potential source of extra income for investors.
• The fund primarily invests in debt securities, with a focus on high-yield bonds, and uses leverage to boost its returns.
• The fund actually managed to cover its distribution in the first half of the fiscal year, which is quite impressive.
• The fund trades at a premium to the net asset value, which is the only real black mark on an otherwise good fund.

There can be little doubt that one of the biggest problems affecting the average American today is the incredibly high inflation rate that pervades the economy. For the past two years or so, this high inflation rate has pushed up the price of nearly everything that we buy and so has rapidly increased the cost of living. We can see the extent of this problem by looking at the consumer price index, which claims to measure the price of a basket of goods that is regularly purchased by the average person. This chart shows the year-over-year change in the consumer price index for every month over the past 25 years:

As we can clearly see, the index began to increase at a much more rapid rate than usual beginning shortly after the COVID-19 pandemic caused governments throughout the United States and around the world to shut down their economies and provide unprecedented economic support to their citizens. This inflation is the direct response to all of this economic support, as it resulted in an enormous amount of money creation without the actual economic production to back this money. Two of the areas that have seen the steepest price increases are food and energy, which are necessities so purchasing them cannot be avoided simply by eschewing luxuries. This has had the effect of straining the budgets of many people, who in some cases have resorted to desperate measures such as dumpster diving and pawning possessions simply to make ends meet. In short, people desperately need extra sources of income.

As investors, we are certainly not immune to this. After all, we require food for sustenance and energy to heat our homes and businesses just like anyone else. We might also want to enjoy an occasional luxury. All of these things cost more money than they did a few short years ago. Fortunately, we do not need to resort to the same extreme measures that others have engaged in to obtain the extra money that is required to maintain a stable standard of living today. After all, we have the ability to put our money to work for us to earn income.

One of the best ways to do this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income. These funds are unfortunately not very well followed in the financial media and many investment advisors are unfamiliar with them. As such, it can be difficult to obtain the information that we would really like to have in order to make an informed investment decision. This is a shame because these funds offer a number of advantages over ordinary open-ended or exchange-traded funds. In particular, a closed-end fund is able to employ certain strategies that have the effect of boosting its yield well beyond that of any of the underlying assets or indeed pretty much anything else in the market.

In this article, we will discuss the BlackRock Multi-Sector Income Trust ( BIT ), which is one fund that can be used by investors seeking a high level of income. This is evident by looking at the fact that the fund has a 9.89% yield at the current price. That is quite a bit more than the S&P 500 Index (SP500) and it is certainly enough to turn the eye of any income-focused investor.

I have discussed this fund before, but a few months have passed since then so obviously several things have changed. This article will focus specifically on these changes as well as provide an updated analysis of the fund's financial performance.

About The Fund

According to the fund's webpage , the BlackRock Multi-Sector Income Trust has the stated objective of providing its investors with a high level of current income. This makes a great deal of sense, as the fund's name implies that it will devote much of its efforts toward the generation of income. Here is how the fund describes its objectives and strategy:

BlackRock Multi-Sector Income Trust's primary investment objective is to seek high current income, with a secondary objective of capital appreciation. The trust seeks to achieve its investment objectives by investing, under normal market conditions, at least 80% of its assets in loan and debt instruments with similar economic characteristics. The trust may invest directly in such securities or synthetically through the use of derivatives.

This description strongly suggests that this is a debt fund, which makes sense since debt securities are more commonly associated with income than common stock. Indeed, right now the overwhelming majority of the fund's assets are invested in bonds or other debt securities but the fund does have a small allocation to both preferred stock and common equity:

It is not surprising that a debt fund would be focused on the generation of income. After all, debt securities are income vehicles. They have no net capital gains over their lifetimes. An investor purchases a bond at face value, receives regular coupon payments from the bond, and then receives the face value back from it. Thus, there are no net capital gains over the bond's lifetime. This makes sense because a bond or other debt security has no inherent link to the growth and prosperity of the issuing entity. After all, a company will not increase the amount that it pays to its creditors just because its profits went up.

With that said, it is possible to get some capital gains from bonds by trading them prior to maturity. This is because bond prices tend to fluctuate over time due to changes in interest rates. It is an inverse correlation, so when interest rates go up, bond prices decline. As everyone reading this is certainly well aware, this has been the case recently as the Federal Reserve has been aggressively raising interest rates in the United States since March 2022 in an effort to combat high inflation. As we can see here, the effective federal funds rate stood at 0.08% in February 2022 but today it stands at 5.12%:

The United States has not been the only country in which interest rates have gone up over the past year or two. In fact, every country in the G20 except for Japan and China has increased its benchmark interest rate since January 2022. The United States has been one of the more aggressive, however. The BlackRock Multi-Sector Income Trust is primarily invested in securities issued by entities in the United States though, so that is the most relevant nation for our analysis today:

This rising interest rate environment has had a devastating effect on the bond markets and on bond funds. This is due to the fact that it has driven down the price of most bonds. It makes a lot of sense that this would be the case, as brand-new bonds are issued with a coupon rate that corresponds to the benchmark interest rate of the economy. As such, a brand-new bond issued today will have a higher coupon interest rate than a bond issued last year. Indeed, it will have a higher rate than any bond issued since 2007, which means that nearly every bond in the market has a coupon rate that is less than the current market interest rate. Nobody would purchase such a bond when they could buy a brand-new one with identical characteristics and a higher yield. As such, the price of the existing bonds needs to decline in order to offer a similar yield-to-maturity as identical brand-new bonds to entice buyers.

We can see the extent of the carnage by looking at the Bloomberg U.S. Aggregate Bond Index ( AGG ), which purports to track the entire American intermediate-term bond market. As we can see here, the index is down 6.06% over the past twelve months:

The carnage over the past year has been so intense that it has resulted in the index falling 8.75% over the past five years with nearly all of the decline occurring since the start of 2022:

The BlackRock Multi-Sector Income Trust has not been spared from the challenging market conditions either. Over the past year, the fund's share price has declined 7.06% and it is down a whopping 14.03% over the trailing five-year period:

With that said the BlackRock Multi-Sector Income Trust has a substantially higher yield than the aggregate bond index. That has proven to be a boon to investors in the fund. The fund's five-year total return is actually a quite reasonable 34.84%, which substantially beats the broad market bond index:

That certainly speaks well to the quality of this fund's management team. While past performance is no guarantee of future results, the fund's historical performance does still make a very good argument in its favor.

As might be expected, the BlackRock Multi-Sector Income Trust has somewhat different assets than the broad-market bond index. As I have pointed out before, closed-end bond funds have a tendency to allocate a significant proportion of their total assets to high-yield bonds ("junk" bonds). This one is no exception to the rule as junk bonds currently account for the largest individual weighting in the fund's portfolio at 47.02%:

This is something that may prove concerning for conservative investors, such as most retirees. After all, we have all heard about the high risk of default possessed by junk bonds. Indeed, this risk is why they have a higher yield than investment-grade corporates. As bonds are purchased for face value at issuance and redeemed for face value at maturity, the only way that an investor will lose money on bond investments is if the bond issuer defaults. Therefore the fear that risk-averse investors have here is justified.

Fortunately, we can assuage that fear somewhat by looking at the credit ratings that have been assigned to the bonds in the fund's portfolio. Here is a high-level summary:

An investment-grade bond is anything rated BBB or higher. As we can clearly see, that accounts for 46.66% of the portfolio's assets. The remainder of the securities are junk debt securities. However, we can see that 59.18% of the fund's assets are invested in securities that carry either a BB or a B rating. These are the two highest possible ratings for junk debt. According to the official bond rating scale , entities whose securities carry these ratings have sufficient financial strength to honor and carry their debt through a short-term economic shock. While they are not quite as strong as an issuer with an investment-grade rating, the risk of default is quite low. As the overwhelming majority of the portfolio consists of securities with either a B rating or better, we should not need to worry too much about losing money due to default here. When we combine this with the fact that the fund's portfolio contains 1,466 different securities, which ensures that any single issuer only accounts for a relatively small proportion of the fund's total assets, we can see that the risk of suffering any noticeable loss due to default is quite remote.

Leverage

As stated in the introduction, one of the characteristics of closed-end funds like the BlackRock Multi-Sector Income Trust is that they have the ability to employ certain strategies that can boost their yields beyond that of any of the underlying assets. One of these strategies is the use of leverage. In short, the fund is borrowing money and using that borrowed money to purchase bonds and other debt securities. This is the reason why the above charts of the fund's assets show them totaling more than 100% of net assets. As long as the purchased assets have a higher yield than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective return of the portfolio. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, so this will usually be the case. It should be mentioned though that this strategy is not as effective today with borrowing rates at 6% as it was eighteen months ago when borrowing rates were effectively nothing. This is because the difference between the rate that the fund borrows at and the rate that it receives from the purchased assets is much less than it used to be.

Unfortunately, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not employing too much leverage since that would expose us to an excessive amount of risk. I generally like to see a fund's leverage remain under a third as a percentage of its assets for this reason. The BlackRock Multi-Sector Income Trust mostly satisfies that requirement. As of the time of writing, the fund's levered assets comprise 33.70% of the portfolio, so it is slightly over that one-third limit but not by very much. First the most part, this fund appears to be striking a reasonable balance between risk and reward. This is especially so when we consider that its assets are debt securities that historically do not fluctuate in price nearly as much as common equity or similar securities. We should not have to worry too much about this fund's debt load.

Distribution Analysis

As mentioned earlier in the article, the BlackRock Multi-Sector Income Trust has the objective of providing its investors with a very high level of current income. In order to accomplish that objective, it purchases bonds, collateralized debt obligations, and similar securities that provide the majority of their investment returns through direct payments made to investors. The fund focuses heavily on speculative-grade securities that have a much higher yield than investment-grade bonds and applies a layer of leverage to boost its effective portfolio return.

As such, we can assume that this fund will almost certainly boast a very high yield itself. That is indeed the case as the fund pays a monthly distribution of $0.1237 per share ($1.4844 per share annually), which gives it a 9.89% yield at the current price. This is obviously quite a bit better than the 1.45% yield of the S&P 500 Index or even the 2.93% yield of the Bloomberg U.S. Aggregate Bond Index. In addition to an attractive yield, the fund has a history of consistency with its distribution:

As we can see, the BlackRock Multi-Sector Income Trust has never cut its distribution. That makes this one of the only debt funds on the market to have done so, as nearly all of them were forced to cut their distributions in response to interest rate increases in both 2018 and 2022 which caused substantial bond price declines. The fact that this one was not forced to cut indicates that we should investigate it as that could be a sign that it is distributing more than it is financially able to. The overall consistency will certainly appeal to any investor that is seeking a safe and secure source of income to use to pay their bills or finance their expenses, though. Let us investigate how sustainable the distribution is likely to be since we do not want to be the victims of a future distribution cut.

Fortunately, we do have a fairly recent document that we can consult for the purposes of our analysis. The fund's most recent financial report corresponds to the full-year period that ended on April 30, 2022. The bond market was fairly strong during the first few months of this year following a disastrous December due to investor optimism surrounding financial loosening by the Federal Reserve. While that optimism has since proven to be unfounded, it still could have allowed the fund to earn some trading profits. This report is also newer than the one that we had available to us the last time that we discussed this fund so it will prove quite useful as an update.

During the six-month period, the BlackRock Multi-Sector Income Trust received $437,924 in dividends and $26,203,882 in interest from the assets in its portfolio. When combined with a small amount of income from other sources, the fund achieved a total investment income of $26,647,407 during the period. It paid its expenses out of this amount, which left it with $16,532,975 available for shareholders. As might be expected, this was nowhere close to enough to cover the $27,982,395 that the fund paid out in distributions over the period. At first glance, this is quite concerning as we usually like debt funds to be able to cover all of their distributions with net investment income.

Fortunately, the fund does have other methods that can be employed to obtain the money that it needs to cover its distributions. For example, it might have been able to take advantage of price changes in the securities in its portfolio and earn some capital gains that can be paid out. It did manage to have some success at this as the fund reported net realized losses of $9,751,641 but these were more than offset by net unrealized gains of $23,481,492 in the period.

Overall, the fund's net assets increased by $2,898,459 after accounting for all inflows and outflows over the period. Thus, the fund did manage to cover its distribution, although its net assets are still down substantially from November 2021. As long as it can continue to deliver performance as we saw in the first half of the fund's 2023 fiscal year though, the distribution should be fine.

Valuation

It is always critical that we do not overpay for any assets 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 Multi-Sector Income 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 all of the fund's assets minus any outstanding debt. It 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 obtain them at a price that is less than the net asset value. This is because such a scenario implies that we are acquiring the fund's assets for less than they are actually worth. This is, unfortunately, not the case with this fund today. As of August 8, 2023 (the most recent date for which data is available as of the time of writing), the BlackRock Multi-Sector Income Trust had a net asset value of $14.51 per share but the shares currently trade for $15.05 per share. This gives the fund's shares a 3.72% premium to net asset value at the current price. That is quite a bit above the 2.75% premium that the fund's shares have averaged over the past month and frankly, it is quite a lot to pay for any fund. It may be best to wait for the fund's price to come down a bit before purchasing its shares.

Conclusion

In conclusion, the BlackRock Multi-Sector Income Trust appears to be a very reasonable way for an investor to earn a 9.89% yield today. That is quite useful given that we all need more income in order to sustain our standard of living in today's inflationary environment. The fund appears to be well managed and is quite well diversified, but that, unfortunately, comes at a price as the shares look expensive today. The fund would make a lot of sense if it can be acquired at a discount, however.

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