BIT - BIT: Fantastic Fund Terrible Price

2023-10-08 23:37:31 ET

Summary

• BIT is a diversified bond CEF focusing on high-yield bonds.
• Although returns and distributions have both been quite strong in the recent past, the fund does not currently trade at an attractive price. Coverage is looking spotty.
• An overview of the fund follows.

I last covered the BlackRock Multi-Sector Income Trust (BIT), an actively managed diversified bond CEF, over one year ago. In that article, I argued that BIT's diversified holdings, strong distribution yield, good discount to NAV, low rate risk, and industry-beating returns, made the fund a well-rounded investment, and a buy. BIT has outperformed bond and equity benchmarks since and with most of the fund's peers posting sizable losses:

Since my last article, BIT's distribution yield has risen, but its coverage has decreased, and its discount has turned into a modest premium. Fund distributions seem unsustainable, as do prices and premiums. As such, I would not be investing in the fund at the present time.

BIT - Basics

• Investment Manager: BlackRock
• Expense Ratio: 1.70%
• Distribution Yield: 10.29%
• Premium to NAV: 3.44%
• Total Returns CAGR 10Y: 8.95%

BIT - Overview and Benefits

Diversified Bond Holdings

BIT is an actively managed bond CEF, investing in the most relevant bond sub-asset classes. BIT's portfolio includes high-yield bonds, senior loans, investment-grade bonds, mortgage-backed securities, treasuries, and others.

BIT invests in almost 1500 securities. Excluding agency mortgages, none of these accounts for even 1.0% of the fund's portfolio. This serves to minimize losses from the potential default of any individual issuer, reducing risk.

Credit quality is below average, with over 60% of the portfolio allocated to non-investment grade securities. The fund has an average credit rating of BB, mode of B.

BIT's diversification reduces portfolio risk and volatility. The fund remains on the riskier side for a bond fund, due to focusing on high-yield bonds.

Strong 10.3% Distribution Yield

BIT currently sports a 10.3% distribution yield. It is a strong yield on an absolute basis, and much higher than that of most bonds and bond sub-asset classes. This includes high-yield bonds and senior loans, the latter of which have seen very strong growth as the Fed hikes rates.

BIT's distributions are also incredibly stable, with the fund paying the same monthly distribution since mid-2019, and with no distribution cuts since inception in early 2013.

On a more negative note, BIT's distributions are a bit lower than those of the average CEF, as per the Invesco CEF Income Composite ETF ( PCEF ), a CEF index fund.

Distributions are also a bit lower than those of some niche income-producing asset classes, including mREITs, BDCs, and some of the riskier CLO tranches.

BIT's distributions are much higher than average, although some asset classes and funds do yield more.

Low Rate Risk

BIT focuses on high-yield corporate bonds, securities with relatively low maturities, duration, and rate risk. BIT's duration of 3.1 years is quite low and lower than those of most bonds and bond sub-asset classes. The fund's duration is a bit lower than expected for a fund with its asset mix, likely due to focusing on securities with particularly short maturities.

BIT's low duration reduces losses when interest rates rise, leading to outperformance during the same. The fund has outperformed most bonds and bond sub-asset classes since the Fed started to hike in early 2022, as expected.

BIT's low duration reduces portfolio risk, volatility, and losses when rates rise, all important benefits for the fund and its shareholders. On a more negative note, the fund's low duration should also lead to below-average gains and underperformance when rates decrease. Excluding the pandemic, the last time this happened was during 2019, during which the fund underperformed its peers, as expected.

Nevertheless, markets right now are pricing in an aggressive set of rate cuts starting in 2024 , so the fund should perform reasonably well as long as any cuts are within expectations. In other words, significant cuts would very likely lead to underperformance for the fund, but more moderate, methodical cuts would likely not.

Industry-Beating Returns

BIT's performance track record is quite strong, with the fund generally outperforming its peers and most CEFs, on both a price and NAV basis. The fund's price returns are, surprisingly, somewhat more consistent than its NAV performance. In most cases, it is the opposite, as changes in discounts and premiums lead to more volatile share prices and returns.

BIT's strong performance track record is an important benefit for the fund and its shareholders. Combined with the fund's diversified holdings, low rate risk, and high 10.3% distribution yield, I almost want to buy the fund. Almost.

BIT - Risks and Downsides

Modest Premium to NAV

BIT currently trades with a 3.4% premium to NAV. Although it is a modest premium on an absolute basis, it is somewhat higher than the fund's short-term average and much higher than the fund's long-term average. In fact, the fund generally traded with a double-digit discount prior to 2021.

To further reinforce the point, BIT's Z-scores are quite high.

BIT's modest premium to NAV harms investors in two key ways.

First, higher premiums are equivalent to higher share prices, which means lower distribution yields and total returns. BIT might be a buy with a double-digit discount and +12.0% distribution yield, not so with a modest premium and a 10.3% yield. Importantly, this will almost certainly negatively impact shareholders regardless of what the market thinks or does.

Second, premiums expose investors to the possibility of losses due to widening/normalizing discounts. If the market decides that BIT should trade with a double-digit discount again, investors would see double-digit capital losses. This is obviously far from certain, but the risks are high, as are the potential losses.

In my opinion, although BIT's premium is quite modest, it exposes investors to excessive risks. The fund generally trades with a reasonably hefty discount, and I feel that its current premium will prove unsustainable in the long term.

Low Distribution Coverage Ratio

BIT's distribution coverage ratio has materially worsened since early 2022, decreasing to 64.6% from 79.6%.

Such a significant drop in the fund's distribution coverage ratio is somewhat at odds with recent Fed hikes. In my opinion, the fund's coverage ratio has declined for two main reasons.

First, the fund's NAV has declined, and moderately more than average.

Lower NAVs mean lower assets, and hence lower income. NAVs themselves have declined mostly due to Fed hikes and widening credit spreads. NAVs have declined more than average , due to leverage and (partially) unfunded distributions. Lower NAVs should result in lower income and distributions moving forward.

Second reason behind the fund's lower distribution coverage ratio is an inverted yield curve. This reduces the effectiveness or profitability of leveraged funds, as these tend to borrow short-term and lend long-term. Income should rise as the yield curve normalizes. This should happen in the medium term, although much will depend on future Fed policy/market movements.

BIT's low distribution coverage ratio should result in either distribution cuts or destructive return of capital distributions moving forward. Distribution cuts would very likely result in a much-reduced discount to NAV, taking into consideration the fund's current premium. Destructive return of capital distributions would, by definition, lead to lower NAVs moving forward, all else equal. A combination of even greater cuts or capital losses would very likely follow.

I would personally be much more willing to stomach the fund's low coverage if it traded with a reasonably large discount. Under current conditions, a low coverage ratio acts as a potential catalyst for an increase in its discount, exposing investors to significant losses (and lower distributions to boot). If the fund traded with a double-digit discount, the impact from a distribution could very likely be much lower- A premium and unsustainable distribution simply seems excessively risky to me.

High Credit Risk

As mentioned previously BIT invests in a diversified set of bonds, but focuses on non-investment grade securities, with these encompassing around 60% of its portfolio. The fund has an average credit rating of BB, mode of B.

BIT's credit risk is solidly above-average, leading to above-average losses during downturns and recessions. The fund significantly underperformed during 1Q2020, the onset of the coronavirus pandemic, as expected. In my opinion, losses were somewhat higher than expected for a fund with BIT's asset mix, but these did not last very long. Liquidity issues might have impacted the fund, as was quite common at the time.

In my opinion, BIT's credit risk is neither excessive nor a deal-breaker. The fund's premium to NAV and unsustainable distributions are deal-breakers though, and sufficiently risky and harmful to make a bullish rating impossible.

Conclusion - Not A Buy Right Now

BIT is a diversified bond CEF with a strong 10.3% distribution yield, low rate risk, and a proven track record of outperformance. The fund also trades with a modest premium to NAV and a low distribution coverage ratio. In my opinion, the fund's negatives outweigh its positives. As such, I would not be investing in the fund at the present time.

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