BIT - BIT: High Exposure To CCC Or Lower Credits
Summary
- The BIT fund provides high income from a portfolio of fixed income securities.
- I am concerned about BIT as the fund has over 20% of managed assets rated CCC or lower heading into a potentially weakening economy in 2023.
- The fund pays an attractive 10.0% of NAV distribution that appears too high relative to historical returns.
The BlackRock Multi-Sector Income Trust (BIT) is a closed-end fund offering high current income from a portfolio of fixed income securities. BIT performed relatively well in 2022 as it had a low portfolio duration during an interest rate rising cycle. However, as the risks to the economy rises in 2023 due to the Fed's 'higher for longer' monetary policy, I think we may see deterioration in credit spreads. This could hit BIT particularly hard as it has over 20% of managed assets rated CCC or lower.
I am also concerned that the fund may be paying an unsustainable distribution yield of 10.0% of NAV vs. the fund earning 2.9% 5Yr average annual returns.
Fund Overview
The BlackRock Multi-Sector Income Trust is a closed-end fund ("CEF") that provides high current income from a portfolio of fixed income instruments. The BIT fund invests across multiple sectors of the fixed income market with the goal of delivering superior risk adjusted returns.
The BIT fund has $832 million in managed asset and $557 million in net assets for 33% effective leverage (Figure 1). The BIT fund charged 1.99% of net assets in fiscal 2022.
Portfolio Holdings
BIT's portfolio contains over 1,500 securities and has an effective duration of 1.4 years (Figure 2). The portfolio has a yield of 9.1% against the fund's 9.8% distribution rate.
Sector-wise, the BIT fund has 42.5% of managed assets invested in high yield ("junk"), 24.0% invested in securitized products, 17.6% in agency mortgages, 14.2% in investment grade ("IG") credit, and 10.8% in non-US developed bonds (Figure 3).
Figure 4 shows BIT's credit quality allocation. The fund has 27.3% of managed assets invested in AAA-rated securities out of 49.4% invested in investment grade credits (BBB and above). 74.8% of managed assets are rated below investment grade, with over 15.3% rated below CCC and 5.4% not rated.
Returns
Figure 5 shows BIT's historical returns. The BIT fund has delivered modest historical returns, with 3/5/10Yr average annual total returns of 4.5%/2.9%/5.9% to February 28, 2023.
While 2022 was a bad year for fixed income funds in general, it was not particularly bad for BIT as the declines in fixed income were primarily driven by rises in long-term interest rates and BIT's portfolio has low duration (Figure 6).
However, with a portfolio duration of only 1.4 years, BIT's 2022 decline of -8.9% appears to be a little high, as the 2Yr treasury yield only increased by 3.68%, so ~5% of BIT's 2022 losses can be attributed to interest rate increases (Figure 7). This suggests BIT also suffered from negative security selection, i.e. bad bets on certain sectors and asset classes.
Figure 7 - 2Yr treasury yields increased 368 bps in 2022 (St. Louis Fed)
Distribution & Yield
The BIT fund pays a monthly distribution of $0.1237, which annualizes to a 9.8% yield. On NAV, the fund is yielding 10.0%.
Investors should note that a significant portion of BIT's distribution in the past few years have been funded out of return of capital ("ROC") (Figure 8).
Figure 8 - BIT uses significant amounts of ROC to fund distributions (BIT 2022 annual report)
Comparing between BIT's historical average annual returns of 3-6% vs. the distribution rate of 10.0% of NAV, I have concerns that the fund may not be earning its distribution, and instead, has been periodically liquidating NAV to pay its distribution.
While there is little risk to the distribution in the short-term, in the long-run, a fund that constantly has to liquidate NAV to fund a too-high distribution rate will deplete income earning assets, making future distributions even harder to fund.
Watch Out For High Yield Spreads
Another concern regarding the BIT fund is that with 75% of managed assets rated below investment grade, the BIT fund is very sensitive to movements in high yield credit spreads. While high yield credit spreads, as modelled by the ICE BofA High Yield Index OAS Spread, is currently benign at just 422 bps, there is significant risk of credit spreads widening if the economy deteriorates due to the Fed's relentless 'higher for longer' interest rate policy.
Figure 9 - HY credit spreads currently benign (St. Louis Fed)
This is especially true for BIT as more than 20% of its managed assets are rated CCC or below. From figure 10 below, we can see that while high yield spreads in general are benign, that is not the case for those rated CCC, which have widened by more than 400 bps from 2021 levels. CCC-rated securities are considered speculative and "vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments" by S&P .
Figure 10 - CCC spreads have widened considerably (koyfin.com)
Conclusion
The BIT fund offers high current income from a portfolio of fixed income securities. Historically, the fund generates a modest return, with 5Yr average annual returns of 2.9% to February 28, 2023. However, it is paying a 10.0% of NAV distribution, which appears too high relative to the fund's earnings power. I am also concerned that the BIT fund has large exposures to very speculative fixed income securities rated CCC or below.
For further details see:
BIT: High Exposure To CCC Or Lower Credits