BRW - BRW: Unique Assets Variable Distribution And Selling At A Discount

2023-07-19 19:27:57 ET

Summary

• Investors today are desperate for additional sources of income to maintain their lifestyles in the current inflationary environment.
• Saba Capital Income & Opportunities Fund invests in a unique portfolio of CEFs, SPACs, and traditional stocks and bonds to provide a high level of current income.
• The BRW closed-end fund yields a whopping 13.08% annually, but its distribution varies from month to month.
• It appears that the fund is varying its distribution based on the performance of its portfolio, which is likely to be a turnoff for people that need stable income.
• The fund is currently trading at a reasonable discount to the net asset value.

There can be little doubt that one of the biggest problems facing the average American investor today is the rapidly-rising cost of living. Ever since the pandemic, the costs of most necessities have increased much more rapidly than wages, straining the budget of the average person. This is clearly evidenced by the consumer price index, which claims to measure the cost of a basket of goods that is regularly purchased by the average person. As we can clearly see here, this index has been increasing by more than the 2% year-over-year rate that is considered healthy during each of the past twelve months:

There may be some people that point to the fact that the year-over-year rate of increase has been slowing down. However, this has not reduced the pressure on the average person due to the fact that inflation compounds just like assets in our investment portfolios. The 3% year-over-year increase that we saw in June came on top of a 9.1% increase in June 2022, which actually works out to a 12.373% increase over two years. In addition, the improvements that we see are being caused by the fact that fuel prices are cheaper than at this time last year. This is evidenced by the fact that the core consumer price index, which excludes food and energy, is showing much stronger year-over-year growth:

This has caused real wage growth to be down for 26 straight months and many consumers to resort to desperate measures to survive. For example, there has been an apparent increase in dumpster diving for food as well as pawning possessions. I discussed this in a recent blog post . In short, the average person is under considerable financial stress and is struggling to survive in the current economy.

As investors, we are certainly not immune to this. After all, we have bills to pay and require money to feed ourselves too. In addition, many of us might want to enjoy an occasional luxury or two, which have also gotten much more expensive over the past few years. Fortunately, we do not have to resort to extreme measures to obtain the extra income that we require for these things. After all, 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, or CEF, that specializes in income generation. Unfortunately, these funds are not very well followed in the financial media, and many investment advisors are not familiar with them. As such, it can be difficult to obtain the information that we would really like to have to make an informed investment decision. That is a real shame because these funds have a number of advantages over exchange-traded or open-ended funds. In particular, a closed-end fund has the ability to employ certain strategies that can boost its effective yield well beyond that of any of the underlying assets or indeed just about anything else in the market.

In this article, we will discuss the Saba Capital Income & Opportunities Fund ( BRW ). This fund yields an impressive 13.08% at the current share price, which is clearly higher than just about anything else in the market. Unfortunately, anytime a fund's yield gets to this level, it is a sign that the market expects that the distribution will soon be cut. Thus, we will need to investigate that possibility. We have discussed this fund before, but that was a few months ago so naturally several things have changed. This article will therefore focus specifically on those changes as well as provide an updated analysis of the fund's financial condition. Let us investigate and see if this fund could be a good addition to an income-seeking investor's portfolio today.

About The Fund

According to the fund's webpage, the Saba Capital Income & Opportunities Fund has the objective of providing its investors with a high level of current income. This is not surprising considering that the name of the fund implies that it will be investing in debt securities. The fund's fact sheet confirms this, as it states the following:

The fund will invest globally in debt and equity securities of public and private companies, which includes, among other things, investing in registered closed-end funds, special purpose acquisition companies, and public and private debt instruments.

This is perhaps a little more than we expected based on the fund's name and history. Prior to 2021, this fund was the Voya Prime Rate Trust, which was a floating-rate debt securities fund. The fund's new strategy still allows it to invest in these securities but also includes other things such as closed-end funds and special-purpose acquisition companies. In fact, we can clearly see that the fund has taken advantage of its newfound freedom, as currently the majority of the fund's assets are invested in common equity instead of debt:

There could be some overlap here though, as some of the fund's equity exposure could actually be the common equity of a fixed-income fund. It is questionable whether such a position would qualify as equity or fixed-income since the actual exposure would be to the bond market as opposed to the stock market. Ultimately though, this is a blended fund that puts its assets into whatever things it can find that will deliver a high level of income, without exposing the fund to more downside risk than management is comfortable with.

The fact that this fund is buying other closed-end funds is interesting as these assets offer some of the highest yields in the market. This is due both to the fact that they use leverage to boost returns and pay out the majority of their income and capital gains to their shareholders in the form of distributions. These entities tend to be very well-liked among income-focused investors for that reason.

Special-purpose acquisition companies are a different animal though, as these are essentially designed as a way to take a private company public without needing to go through the expense of an initial public offering. These companies are simply a publicly-traded pool of capital that has the sole purpose of merging with or buying a private company. These entities dominated financial headlines back in 2021 but they have become somewhat less popular recently due to financial conditions no longer being as loose as they were in the pre-pandemic world. They do have the potential to deliver large returns if they purchase the right company at a reasonable price, but unfortunately, most of them significantly underperform the market. According to Goldman Sachs ,

Since its February peak, an ETF of SPACs across stages of the lifecycle ( SPAK ) has returned -35% vs. 14% for the S&P 500. Meanwhile, other high-growth and interest-rate sensitive pockets of the market like long duration stocks and non-profitable tech stocks have fared better but also declined.

The article notes that many SPACs outperform the Russell 3000 Index from the date of their initial public offering to the announcement of their deal, and then significantly underperform. There are some cases when a special-purpose acquisition company does manage to acquire the right target and perform well but for the most part, these are highly speculative investments. I will admit that I would prefer not to see them included in a fund like this one, as this fund is targeted specifically at income-focused investors. Most investors in this category tend to be fairly risk-averse individuals that want to generate a livable level of income from their portfolio and basically avoid too much in the way of risks. The other assets in this fund do generally suit that purpose, however.

As might be expected based on the fund's strategy, the largest positions in the portfolio are very different than we see in most other funds. Here they are:

We do see a mix of closed-end funds, bonds, and even cryptocurrencies here. Perhaps surprisingly, there are no special-purpose acquisition companies among the largest positions in the fund. That particular type of entity is 24.46% of the fund's holdings though, so these firms are certainly represented in the overall portfolio.

This is certainly a diverse portfolio, as many of these assets should have little correlation to one another. With that said, one thing that we have seen a few times recently is that an increase in interest rates causes the prices of everything else to decline. This was not the case twenty years ago when rising interest rates generally correlated with a strong economy, which resulted in stocks and interest rates rising together. Today though, what we frequently see is that everything declines when interest rates rise due to the fact that an increase in the risk-free rate makes holding cash more attractive. The reverse is true. As such, the diversification benefits that we get from a fund like this that has both stock and fixed-income investments are not as great as they would have been back in the 1990s.

One thing that we do see here is that the fund's allocation to special-purpose acquisition companies has come down significantly since the start of the year. The last time that we discussed this fund, it had 40.75% of its assets invested in these entities compared to 24.46% today. The fund increased its allocation to corporate bonds during the period, which could be a sign that its management believes that interest rates have peaked or are close to peaking. This is the prevailing view of the market as well, with bonds currently being priced as though the Federal Reserve will only raise rates once or twice more this year and then start cutting over the course of 2024. I have my doubts about whether or not this will happen, due to the simple fact that an increase in energy prices could quickly reignite inflation and undo all the progress that has been made in the fight against it.

However, bonds are still a much safer investment than special-purpose acquisition companies in most cases so risk-averse investors should generally like this change in the fund's allocation. If it does appear that the market is wrong on the trajectory of interest rates next year, this fund could also unload its bond position and move into something else. That is a flexibility that a pure bond fund does not possess.

Leverage

In the introduction to this article, I stated that closed-end funds like the Saba Capital Income & Opportunities Fund have the ability to employ certain strategies that can boost their effective yields above that of any of the underlying assets. One of these strategies is the use of leverage. 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 5% as it was two years ago when rates were at 0%. We have already seen other closed-end funds run into trouble because of the rising expenses related to their leverage (see here ).

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 its assets for this reason. Fortunately, this fund satisfies this requirement. As of today, the Saba Capital Income & Opportunities Fund has levered assets comprising 15.74% of its total portfolio.

This is a fairly reasonable balance between risk and reward. As such, investors probably do not need to worry too much about the fund's use of leverage.

Distribution Analysis

As mentioned earlier in this article, the primary investment objective of the Saba Capital Income & Opportunities Fund is to provide its investors with a high level of current income. In order to achieve this objective, the fund invests in a portfolio of closed-end funds, debt securities, preferred stock, and other things that boast fairly high yields or total returns. The fund then applies a layer of leverage to boost its returns beyond what any of the assets deliver on their own. As such, we can assume that this fund will have a remarkably high distribution yield.

This is certainly the case here, 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 13.08% yield at the current price. Unfortunately, this fund has not been particularly consistent with its distribution over time. In fact, it was been all over the place over its lifetime:

The fund has changed its distribution in ten of the past twelve months. This clearly makes it a fund that is unlikely to appeal to anyone that is seeking a stable and secure source of income to use to pay their bills or finance their lifestyles. With that said, this is probably an indication that the fund is simply paying out its investment returns each month. That is something that we can appreciate as investors, even though it makes it very difficult for us to budget our recurring expenses against the fund's distributions. Let us investigate the fund's finances though and see exactly what it is doing.

Fortunately, we do have a very recent document that we can consult for the purposes of our analysis. The fund's most current financial report corresponds to the six-month period that ended on April 30, 2023. This is one of the most recently released financial reports that we currently have available to us from any closed-end fund, which is very nice in this case. The end of last year was challenging for most sectors of the market but we saw a strong rebound in the first few months of 2023. These events will be reflected in this report, so we can see how the fund navigated both of them.

During the six-month period, the Saba Capital Income & Opportunities Fund received $5,914,201 in interest and $3,313,032 in dividends from the investments in its portfolio. This gives the fund a total investment income of $9,227,233 over the period. It paid its expenses out of this amount, which left it with $2,715,989 available for shareholders. As might be expected, this was nowhere close to enough to cover the $22,327,984 that the fund actually paid out in distributions over the period. At first glance, this is likely to be concerning as the fund clearly failed to cover its distributions out of net investment income.

However, there are other ways that the fund can obtain the money that it needs to cover its distributions. For example, it might be able to earn capital gains that can be paid out to the shareholders. The fund was quite successful at this during the period, as it achieved net realized gains of $14,935,014 and net unrealized gains of $7,881,123 over the period. Overall, the fund managed to increase its net assets by $3,204,142 over the six-month period after accounting for all inflows and outflows. It, therefore, does appear that the fund is basically paying out its investment profits each month. That is definitely sustainable over the long term, but it will result in the situation that we see in which the distribution varies each month.

Valuation

It is always critical that we do not overpay for any asset 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 Saba Capital Income & Opportunities Fund, 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 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 acquire them at a price that is less than the net asset value. This is because such a scenario implies that we are buying the fund's assets for less than they are actually worth. That is fortunately the case with this fund today. As of July 18, 2023 (the most recent data for which data is available as of the time of writing), the Saba Capital Income & Opportunities Fund has a net asset value of $8.56 per share but the shares trade for $7.79 each.

This gives the fund's shares a 9.00% discount to the net asset value at the current price. This is relatively in line with the 9.20% discount that the shares have averaged over the past month. Thus, the current price appears to be quite reasonable.

Conclusion

In conclusion, this is one of the more unique closed-end funds in the market with respect to what it invests in. Saba Capital Income & Opportunities Fund invests in special-purpose acquisition companies, closed-end funds, and other things that are not traditional stock and bond assets. This could give the fund a different return profile than other things in a portfolio and thus provide some diversification benefits. However, nowadays just about everything tends to inversely correlate with interest rates so the benefit is not as great as it once was.

This fund does still provide a high level of income, although it varies from month to month. The fund also trades at a reasonable discount to the intrinsic value of the shares. It might be worth buying some Saba Capital Income & Opportunities Fund shares today for that reason, just keep the variable distribution in mind.

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