BKT - BKT: A Conservative Bond Fund For Income

2023-08-11 11:24:57 ET

Summary

• The average American is suffering from high inflation, causing strain on household budgets and the need for additional sources of income.
• Investors can earn income by purchasing shares of closed-end funds specializing in income generation, such as the BlackRock Income Trust.
• The BlackRock Income Trust invests in high-quality securities, primarily agency-backed residential mortgage-backed securities, and offers an impressive 8.95% yield.
• The BKT closed-end fund failed to cover its distributions last year, and it is uncertain whether or not it can sustain the current payout.
• The fund is trading at a reasonably attractive price, but it may be best to wait for the semi-annual report before purchasing its shares.

There can be little doubt that one of the biggest problems facing the average American today is the incredibly high level of inflation that has been persisting in the economy over the past two years or so. We can clearly see how high the current rate of inflation is 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 American. This chart shows the year-over-year rate of change in the index during every month of the past 25 years:

As we can clearly see, the consumer price index has been increasing much more rapidly than normal over most of the past two or three years. This is a direct result of the fact that the Federal government and the Federal Reserve increased the money supply by 40% in response to the economic lockdowns that accompanied the COVID-19 pandemic, which was far more than the increase in goods and services during that period. Once this newly created money entered the economy, it began to push up prices as a larger amount of money was attempting to purchase each unit of actual economic output. For most of the period in question, the prices of necessities such as food and energy were rising much more rapidly than wages, which has strained the budget of many households. This is the reason why we have been seeing an increase in the number of people engaging in things that were once thought unthinkable, such as dumpster diving and pawning their possessions, just to make ends meet. There has also been an uptick in the number of people working second jobs, which could be one reason why employment remains strong. In short, many people throughout the nation are desperately in need of additional sources of income.

As investors, we are certainly not immune to this phenomenon. After all, we require food for sustenance and energy to heat our homes and businesses just like anyone else. We probably also desire the occasional luxury. All of these things cost considerably more than they did a year ago, so we want more income to maintain our lifestyles. Fortunately, we do not have to resort to extreme measures to obtain this extra income. This is because we have the ability to put our money to work for us to earn an income.

One of the best ways to do this is to purchase shares of a closed-end fund aka CEF that specializes in the generation of income. These funds are unfortunately not very well followed by the financial media, and many investment advisors are unfamiliar with them. This is a shame, because these funds offer a number of advantages compared to open-ended and exchange-traded funds ("ETFs"). In particular, a closed-end fund is able to employ certain strategies that have the effect of boosting their yields well beyond that of the underlying assets or indeed pretty much anything else in the market.

In this article, we will discuss the BlackRock Income Trust ( BKT ), which is one fund that investors can use to earn an income today. This fund sports an impressive 8.95% yield at the current price, which is certainly enough to attract the attention of any income-seeking investor. I have discussed this fund before, but a few months have passed since that time so naturally quite a few things have changed. This article will therefore focus specifically on these changes as well as provide an updated analysis of the fund’s financial condition.

About The Fund

According to the fund’s webpage , the BlackRock Income Trust has the objective of providing its investors with a high level of income while still ensuring the preservation of capital. This is certainly not surprising since the fund’s description of its strategy implies that it is a fixed-income fund:

“BlackRock Income Trust, Inc.’s investment objective is to manage a portfolio of high-quality securities to achieve both preservation of capital and high monthly income. The trust seeks to achieve its investment objective by investing at least 65% of its assets in mortgage-backed securities. The trust invests at least 80% of its assets in securities that are (i) issued or guaranteed by the US government or one of its agencies or instrumentalities or (ii) rated at the time of investment either AAA by S&P or Aaa by Moody’s. The trust may invest in directly in such securities or synthetically through the use of derivatives.”

Obviously, based on this description, the BlackRock Income Trust is a fixed-income fund. A look at its portfolio confirms this as right now the fund is entirely invested in bonds:

We can see that the fund has a negative allocation to cash right now. This is possible because the fund employs leverage as a way to boost its returns, which we will discuss later in this article. It is not uncommon for a fixed-income fund to focus on earning a high level of current income for its shareholders while still preserving capital. In fact, a fixed-income investor is guaranteed not to lose money if they purchase a bond at face value and hold it until maturity, barring the default of the issuing entity. As this fund is investing mostly in U.S. government-backed securities (Treasuries, agency debt, and the like), the risk of default losses should be incredibly low. Indeed, I could argue that the nation has far bigger problems than a few investors losing money if these securities were to default.

The fund’s description of its strategy states that at least 65% of its assets will be invested in mortgage-backed securities. In fact, the figure right now is much higher. In fact, the fund is almost entirely invested in mortgage-backed securities:

That is something that may be concerning to some investors. After all, the commercial real estate space is experiencing severe problems right now. This is mostly due to the trend toward remote work that started with the pandemic. Several companies decided that remote work was preferable to leasing office space, so they have decided not to renew their commercial leases. As a result, we are seeing vacancy rates go up. For example, the office vacancy rate in San Francisco is very close to 30% according to CBRE . Admittedly, San Francisco might be worse than other cities, but for the most part, office vacancy rates have been reaching very high levels in many American cities. This has caused the cash flows generated by these properties to decline, which naturally has made it very difficult for the property owners to cover the mortgages.

Thus, some commercial mortgages have been defaulting, which would naturally have an impact on commercial mortgage-backed securities. However, these are not the securities that are held by this fund. As we can see, the fund is primarily invested in agency mortgages. These are residential mortgage-backed securities packaged and insured by Fannie Mae, Freddie Mac, and Ginnie Mae. While many of these may not be explicitly guaranteed by the United States government, we saw back in 2008 that the government will step in to ensure that these entities remain solvent. Thus, for all practical purposes, these securities are as safe as U.S. Treasuries. We should not have to worry about default risk with this fund, as it is unaffected by the problems in the commercial real estate space.

Naturally, that does not prevent the fund from being affected by bond price changes. While there is basically no risk to the fund of losing money through defaults, it can still see the value of its assets decline. This comes from the fact that bond prices vary with interest rates. It is an inverse correlation, so when interest rates go up, bond prices decline and vice versa. As everyone reading this is no doubt well aware, the Federal Reserve has been aggressively raising interest rates in an effort to combat the incredibly high inflation in the economy. As we can see here, the effective federal funds rate has gone from 0.08% in February 2022 to 5.08% today:

This is the reason why the bond market delivered a disappointing performance last year. The Bloomberg U.S. Aggregate Bond Index ( AGG ) delivered a –13.01% total return in 2022, which was its worst performance in years. The BlackRock Income Trust was certainly not spared from this carnage. The fund’s portfolio delivered a –16.67% total return. This was disappointing, but the fund’s shares did even worse in the market, delivering a –21.50% total return in 2022:

It is not unusual for a closed-end fund’s shares to deliver a worse return than the underlying portfolio actually delivered during a given period. In fact, many bond funds handed their investors a worse market return than the portfolio itself actually delivered. This can sometimes result in an opportunity to acquire the assets of a fund for less than they are actually worth. We will discuss that in more detail later in this article.

The bond market has generally delivered a strong performance this year despite the fact that the Federal Reserve continued to raise rates. The iShares Core U.S. Aggregate Bond ETF has actually delivered a positive total return year-to-date. This is certainly not true for the BlackRock Income Trust, however. In fact, the closed-end fund has delivered a negative total return over the same period:

It is somewhat difficult to understand why this would be the case, especially considering that the closed-end fund is actually invested in safer securities than the broad-market index. It gets even more confusing when we consider that residential mortgage-backed securities have actually done pretty well this year. The FTSE NAREIT All-Mortgage Capped Index ( REM ), which tracks residential mortgage-backed securities, has actually beaten both the aggregate bond index and the BlackRock Income Trust year-to-date:

It is possible that the market is confused about this fund and thinks that it includes commercial mortgage-backed securities for some reason. As we saw earlier though, the fund is almost entirely agency mortgages, and the U.S. government does not back mortgages on office buildings. With that said, the fund’s portfolio actually delivered a 1.48% total return during the first six months of this year, so it is pretty obvious that the market is underappreciating this fund. That could create an opportunity for investors.

Leverage

In the introduction to this article, I stated that closed-end funds have the ability to employ certain strategies that can boost the effective yield of their portfolios. One of these strategies is the use of leverage. In short, the fund borrows money and then uses that borrowed money to purchase agency-backed residential mortgage-backed securities. As long as the purchased securities 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 yield 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. Unfortunately, this strategy is less effective today with borrowing rates at 6% than it was a year ago when borrowing rates were close to 0%. This is because the difference between the interest rate that the fund has to pay and the yield on the purchased securities is much narrower than it once was.

However, 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 because that would expose us to an excessive amount of risk. I generally do not like a fund’s leverage to exceed a third as a percentage of its assets for that reason. Fortunately, this fund satisfies that requirement as its levered assets only comprise 30.11% of the total portfolio. Thus, it appears that the fund is striking an acceptable balance between risk and reward right now.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the BlackRock Income Trust is to provide its investors with a high level of current income while still preserving capital. In order to accomplish this, the fund purchases agency-insured mortgage-backed securities and applies a layer of leverage to boost its effective yield. As such, we can assume that the fund will boast a fairly high yield itself. This is certainly the case as it currently pays a monthly distribution of $0.0882 per share ($1.0584 per share annually), which gives it an 8.95% yield at the current price. Unfortunately, the fund’s distribution has not been particularly consistent over its history:

As we can see, the fund’s distribution has varied quite a bit with the passage of time. This may be a turn-off to those investors that are seeking a safe and secure source of income to use to pay their bills or finance their lifestyles. However, it is not unexpected, especially for a bond fund. After all, the income of the fund is heavily dependent on interest rates, which are always changing depending on the policies of the Federal Reserve and the supply and demand for money in the economy.

As I have pointed out before, the fund’s history is not necessarily the most important thing for new investors. After all, anyone purchasing the fund today will receive the current distribution at the current yield. Such a person will not be affected by any events that occurred in the past. The most important thing for a new investor today is how well the fund can sustain its current distribution. Let us investigate this.

Unfortunately, we do not have an especially recent document that we can consult for this purpose. 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. As such, it will not include any information regarding the fund’s performance so far this year. That is a shame because this year has generally been a better one for bonds than last year so the fund may have had some opportunities to make a profit. With that said, we can still see how well the fund navigated the challenging conditions that existed last year and sometimes that can be more valuable than seeing how well the fund performed during a strong market. After all, anyone can make money during a bull market.

During the full-year period, the BlackRock Income Trust received $130,377 in dividends and $14,199,208 in interest from the assets in its portfolio. This gives the fund a total investment income of $14,329,585 during the period. It paid its expenses out of this amount, which left it with $9,190,557 available to shareholders. Obviously, this was nowhere near enough to cover the $21,947,669 that the fund actually paid out during the period. This is certainly concerning, as we generally like a fixed-income fund to be able to cover its distributions entirely out of net investment income.

However, the fund does have other methods through which it can obtain the money that it needs to cover its distributions. For example, it might have been able to earn some capital gains through bond trading that can be paid out to the shareholders. As might be expected given the weak market last year, the fund failed miserably at that task. It reported net realized losses of $2,021,958 and had another $67,003,293 net unrealized losses during the period.

Overall, the fund’s net assets declined by $81,717,403 after accounting for all inflows and outflows during the period. This is quite concerning as the fund clearly failed to cover its distributions. Curiously, it did not cut the payout in response to this poor performance, but as mentioned it may have been able to deliver a better performance so far this year. We will need to wait for the semi-annual report to be released to know for certain. That should happen within the next few weeks.

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 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 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. That is, fortunately, the case with this fund today.

As of August 9, 2023 (the most recent date for which data is available as of the time of writing), the BlackRock Income Trust has a net asset value of $12.61 but the shares currently trade for $11.85 per share. This gives the shares a discount of 6.03% on the net asset value at the current price. That is quite a bit better than the 4.04% discount that the fund’s shares have averaged over the past month. Thus, the current price appears to be quite reasonable.

Conclusion

In conclusion, the rapidly rising cost of living has forced investors to seek out options to earn extra income in order to maintain their desired lifestyle. The BlackRock Income Trust offers a very good way to accomplish this and get a degree of safety due to the fact that the fund’s portfolio is invested in securities issued by the U.S. government and its agencies. The fund’s portfolio has generally been outperforming its shares in the market over the past several months, which is presenting a good entry point. The biggest concern here is that the fund’s distribution may not be sustainable unless if manages to undo all of the losses that it took last year. It may be best to wait until the BlackRock Income Trust releases its semi-annual report before buying in to ensure safety.

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