BRW - BRW: Get Access To Hedge Funds And A Massive Yield

2023-10-02 06:56:45 ET

Summary

• Saba Capital Income & Opportunities Fund employs an unusual strategy to provide a high level of income to investors, with a current yield of 13.28%.
• The fund has outperformed the S&P 500 Index on a total return basis since July, partially due to its high distribution yield and investments that benefit from rising interest rates.
• The fund's portfolio includes investments in closed-end funds, special-purpose acquisition companies, and public and private debt instruments, offering access to assets typically only available to accredited investors.
• The fund actually managed to cover its massive distribution in the first half of its fiscal year, which may be rather surprising.
• The fund's shares are currently trading at a fairly attractive discount on net asset value.

The Saba Capital Income & Opportunities Fund (BRW) is a very interesting closed-end fund that employs a fairly unusual strategy in order to provide a very high level of income to its investors. Indeed, the fund's current 13.28% yield is a testament to its success in this area. Unfortunately, anytime a fund's yield reaches levels such as this, it is a sign that the market fears a near-term cut. This is something that we will naturally want to investigate before investing in this fund. However, in the case of this fund, I am somewhat optimistic that the fears may be unfounded, as Saba Capital has a reputation for taking over underperforming closed-end funds and redesigning them in order to generate substantially higher returns than they previously had. In the case of this fund, it was a floating-rate trust that obviously was not performing too well in the face of 0% interest rates over the past decade.

We last discussed this fund back in the middle of July. It has delivered a rather impressive performance since then, as it has completely dominated the S&P 500 Index ( SP500 ) on a total return basis:

With that said, a 0.73% total return over a two-month period is not necessarily the most impressive performance in the world, but it is far better than the loss that investors would have taken in the broader market index. This is partly due to the fund's high distribution yield, which partially offsets any decline in the shares. The fund's assets played a role too, as there are some securities in it that will benefit from rising interest rates.

About The Fund

According to the fund's webpage , the Saba Capital Income & Opportunities Fund has the primary objective of providing its investors with a high level of current income. This is the same objective that this fund had back when it was the Voya Prime Rate Trust, but its strategy to achieve its objectives is vastly different. From the webpage:

The Fund invests globally in debt and equity securities of public and private companies, which includes, among other things, investments in closed-end funds, special-purpose acquisition companies, and public and private debt instruments.

This is at least somewhat what we would expect from Saba Capital, particularly the investments in other closed-end funds. Saba Capital Management is, after all, the company that brought us the Saba Closed-End Funds ETF (CEFs), an actively managed exchange-traded fund that invests in undervalued closed-end funds. The basic goal of this fund's strategy with respect to these funds is to purchase a closed-end fund when it is trading at a large discount and profit from capital gains as the discount to net asset value narrows, in addition to receiving all of the distributions paid out by the fund in the interim. As everyone reading this is no doubt well aware, closed-end funds can frequently have higher yields than pretty much anything else in the market due to the fact that they pay out all of the capital gains and other investment returns earned by their portfolios to their shareholders, and employ leverage to boost their total returns.

As of the time of writing, closed-end funds comprise the largest single allocation in this fund's portfolio, at 33.02% of its net holdings:

This is very different from the last time that we discussed this fund. At that time, closed-end funds only accounted for 21.45% of the fund's portfolio. Its largest weighting at that time was corporate bonds, which we no longer see in the portfolio. This is probably not a bad thing though, as corporate bonds have not performed very well since mid-July. This chart shows the performance of American investment-grade corporate bonds ( LQD ) since the previous article on this fund:

U.S. Treasuries have not performed very well either, as the market optimism about near-term rate cuts has faded and interest rates have started rising. The Saba Capital Income & Opportunities Fund appears to be taking a very interesting position with respect to government bonds, however. The fund is actually shorting them and profiting from their decline. This is an advantage that closed-end funds have over exchange-traded funds, as most exchange-traded funds cannot opportunistically short securities to take advantage of trends such as these. The fund's short positions have almost certainly made it some money, though. The profits from the short positions can naturally ultimately be paid out to the fund's investors.

The fund did not have that large short position in government bonds the last time that we discussed it. It did have a short position in sovereign debt obligations, but it was only at 12.02% of net assets. Thus, the fund clearly increased it substantially as yields rose and bond prices fell. This, combined with the increased weighting to closed-end funds, and numerous other weighting changes that have occurred just in the past two months suggests that this fund is engaging in a great deal of trading activity, actively altering its positions to take advantage of market trends. This is certainly the case, as the fund's 99.00% annual turnover is substantially higher than most other closed-end funds. I explained why this is important in a recent article (paraphrased to be more applicable to this fund):

This could be important because it costs money to trade closed-end funds, bonds, and other assets. These costs are ultimately billed to the shareholders and create something of a challenge for management. After all, management needs to generate sufficient returns to both cover these added costs and still deliver a return that is comparable to a similar index fund. This is a task that very few management teams manage to achieve and as such most actively managed funds underperform their benchmark indices.

There is, obviously, no perfect index to compare this fund to as it uses a variety of different assets to achieve its investment goals. If we compare it against the S&P 500 Index and the Bloomberg U.S. Aggregate Bond Index ( AGG ), its performance over the past three years has been between the two of them on a total return basis:

However, this performance history is affected significantly by the fact that Saba Capital Management was not in control of this fund's assets prior to June 4, 2021. As mentioned in the introduction, one of the reasons why Saba took over management of the fund is that it was a perpetual underperformer. If we chart the fund's total performance from the date that the current fund manager took over responsibility for the fund's management, the Saba Capital Income & Opportunities Fund outperformed both the S&P 500 Index and the Bloomberg U.S. Aggregate Bond Index:

That certainly implies that the large degree of trading activity is not causing this fund too much trouble. While past performance is no guarantee of future results, the fund's performance over the past two years, which was probably the most challenging market that we have seen in a decade, speaks well to the quality of this fund's management.

As we saw earlier, the largest proportion of the Saba Capital Income & Opportunities Fund's assets are invested in other closed-end funds. However, curiously, we do not see these assets reflected among the fund's largest positions. Here are the top ten holdings in this fund:

While some of these are certainly funds, they are not closed-end funds. The largest position is actually a hedge fund managed by Stone Ridge. While it is difficult to find any information about this particular fund online, Stone Ridge itself focuses heavily on alternative capital funds and similar things. The fund's semi-annual report states that this fund invests in catastrophe bonds and similar assets that reinsurance companies use to ensure that they are not completely wiped out in the event of a severe disaster. These things represent a class of assets that can be very hard to get access to, particularly for non-accredited investors. As such, this fund represents one of the few ways for non-accredited investors to get access to hedge funds, private equity, and similar funds. These things can provide very good returns, but they can also result in enormous losses. The fact that this fund is holding this position through another fund helps to limit its exposure and achieve diversification. Probably the biggest problem with this position is that it is illiquid so the fund cannot sell out of this position very easily. Fortunately, we can always just sell the shares of the closed-end fund in order to achieve liquidity if necessary.

Leverage

As is usually the case with closed-end funds, the Saba Capital Income & Opportunities Fund employs the use of leverage as a means of boosting the effective total return of its portfolio. I explained how this works in my previous article on this fund:

In short, the fund borrows money and uses that borrowed money to purchase closed-end funds, bonds, or other income-producing assets. As long as the purchased assets deliver a higher total return 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. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, this will usually be the case.

With that said, this strategy is not as effective today with rates at 6% as it was two years ago when rates were at 0%. We have already seen other funds run into trouble because of the rising expenses related to their leverage.

The use of debt in this fashion is a double-edged sword because leverage increases both gains and losses. As such, we want to ensure that the fund is not using too much leverage because that would expose us to too much risk. I generally do not like a fund's leverage to exceed a third as a percentage of assets for this reason.

As of the time of writing, the Saba Capital Income & Opportunities Fund has levered assets comprising 16.07% of its total portfolio. This is, admittedly, higher than the last time that we discussed this fund, but it is still a very reasonable level of leverage. Overall, the balance between risk and reward is probably acceptable here. However, it is important to keep in mind that the closed-end funds that this fund invests in also use leverage, so there is effectively layer upon layer of leverage here and that could significantly increase the fund's volatility. We may want to keep an eye on this fund's leverage more than other funds for that reason, especially since interest rates continue to rise, which will undoubtedly put some pressure on the fund's finances.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the Saba Capital Income & Opportunities Fund is to provide its investors with a very high level of current income. In pursuance of this objective, the fund invests in a portfolio of closed-end funds, bonds, alternative capital securities, and similar things that can have very high yields. It also employs strategies such as leverage and short selling to generate investment profits in excess of what the underlying securities actually produce. All of these strategies can certainly generate large yields or capital gains, which the fund collects and pays out to its shareholders net of the fund's own expenses. We can expect that this would result in the fund boasting a very high yield itself.

This is certainly the case, as the Saba Capital Income & Opportunities Fund pays a monthly distribution of $0.0850 per share ($1.02 per share annually), which gives it a whopping 13.28% yield at the current price. Unfortunately, the fund is certainly not stable with respect to its distribution. In fact, the distribution tends to vary from month to month:

The fund has raised or lowered its distribution seven times in the past twelve months:

We can therefore clearly see that it is probably not going to be very attractive to anyone who is seeking a safe and secure source of income to use to pay their bills or finance their lifestyles. However, the fact that the yield is so high might provide a certain amount of appeal to such a person who maybe does not need all of the distribution. An investor whose needs could be met with say an 8% or a 9% yield would probably still get sufficient income from this fund while the excess can be used as bonus income to be reinvested or for an occasional treat. Of course, this all depends on whether or not this distribution is sustainable, so let us investigate that.

Fortunately, we do have a relatively recent document that we can consult for the purpose of our analysis. As of the time of writing, the fund's most recent financial report is the semi-annual report that corresponds to the six-month period that ended on April 30, 2023. This report was linked to earlier in this article. The relative recency of this report is nice because it should give us a good idea of how well the fund was able to take advantage of the market's overall optimism during the first half of the year. With that said, in some ways, this fund is an absolute return fund so it should be able to perform reasonably well in a pessimistic market as well. We can see that in the fact that it has a large short position to government bonds right now.

During the six-month period, the Saba Capital Income & Opportunities Fund received $5,914,201 in income along with $3,313,032 in dividends from the assets in its portfolio. This gives the fund a total investment income of $9,227,233 during the period. It paid its expenses out of this amount, which left it with $2,715,989 available for shareholders. This was, unfortunately, nowhere close to enough to cover the $22,327,984 that the fund actually paid out during the period. At first glance, this is likely to be somewhat concerning as the fund's net investment income is obviously nowhere near sufficient to cover its distributions.

However, the fund does have other methods through which it can obtain the money that it needs to cover the distribution. For example, it could have capital gains. While the fund claims a current income objective, its portfolio is more opportunistic and targets short-term capital gains. It, fortunately, did have a great deal of success at this task during the period. It reported net realized gains of $14,935,014 and had another $7,881,123 net unrealized gains. Overall, this fund's net assets went up by $3,204,142 after accounting for all gains and losses during the period. Thus, it did, surprisingly, manage to cover its distribution during the period. It remains to be seen if it can continue to accomplish this task going forward as it did fail to completely cover it during the preceding full-year period. Overall, though, there is less reason to worry about this fund than most funds that manage to achieve a double-digit distribution yield.

Valuation

As of September 28, 2023 (the most recent date for which data is currently available), the Saba Capital Income & Opportunities Fund has a net asset value of $8.35 per share but the shares currently trade for $7.68 each. This gives the fund's shares an 8.02% discount on net asset value at today's price. This is a very reasonable discount that is in line with the 8.46% discount that the shares have averaged over the past month. Thus, the current price appears to be a reasonable place to get in.

Conclusion

In conclusion, the Saba Capital Income & Opportunities Fund is a rather unique fund that allows an easy way to add assets beyond the traditional stock and bond holdings that most people focus on. The fund invests in other closed-end funds, alternative capital, special-purpose acquisition companies, and other things that are frequently only available to accredited investors. These assets can deliver very high returns, as evidenced by the fact that this fund currently is covering its massive 13.28% yield. There are definitely some risks here, but overall this fund appears to be a good way to add some diversification to a traditional portfolio and earn a high level of income at the same time.

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