BTZ - BTZ: Buy If You Think Yields Will Go Lower
Summary
- BTZ provides high current income from a portfolio of credit instruments.
- It has a relatively high duration of 6.4 years, which caused 2022's poor performance.
- If you believe the Fed will be able to engineer a soft landing with moderating interest rates in the coming months, then BTZ could be a solid turnaround candidate.
The BlackRock Credit Allocation Income Trust ( BTZ ) is a closed-end fund that generates high income from a portfolio of credit instruments. The fund suffered steep losses in 2022 due to its high duration. If the Fed can engineer a soft landing without a recession and interest rates can fall in the coming months, then BTZ could be an interesting turnaround candidate, as historically, the fund was able to fund its generous 9.2% forward yield from net investment income.
Fund Overview
The BlackRock Credit Allocation Income Trust is a closed-end fund ("CEF") that aims to provide high current income and total returns to investors. The BTZ fund primarily invests in credit-related securities including investment grade ("IG") bonds, high yield ("junk") bonds, senior loans, preferred securities, convertible bonds, and derivatives that provide similar economic characteristics.
The BTZ fund is fairly popular with investors, with $1.65 billion in managed assets and $1.08 billion in net assets for 35.8% effective leverage (Figure 1). BTZ charges a 1.12% gross expense ratio.
Portfolio Holdings
The BTZ fund has almost 1,600 holdings and a portfolio effective duration of 6.4 years. Figure 2 shows BTZ's portfolio allocation by asset class as of January 31, 2023. The fund has 39.8% allocated to IG bonds, 30.2% in junk bonds, 17.2% allocated to non-US developed bonds, and 9.8% in securitized products.
In terms of credit allocation, BTZ has 66.2% allocated to investment grade credits, and 43.8% allocated to non-investment grade.
Investors should note that BTZ's credit allocation can shift from time to time. For example, as of June 30, 2022, the fund's portfolio was riskier, with 57.9% investment-grade and virtually nil in ultra-safe AAA credits vs. 9.7% as of January 31, 2023.
Figure 3 - BTZ's allocations can shift from time to time (BTZ 2022 semi-annual report)
Returns
The BTZ fund has produced modest long-term average annual returns, with 3/5/10Yr average annual returns of -1.2%/2.3%/4.0% to January 31, 2023 (Figure 4).
Compared to the Multisector Bond category on Morningstar, BTZ has generally produced higher volatility and lower returns on a 3/5/10Yr time frame (Figure 5).
Figure 5 - BTZ has generated lower returns and higher volatility than peers (morningstar.com)
Distribution & Yield
The BTZ fund pays a monthly distribution of $0.0839 or 9.2% forward yield on current market price.
Historically, the BTZ fund has been able to fund its distribution mostly out of net investment income ("NII"), as the use of return of capital ("ROC") has been minimal (Figure 6).
Figure 6 - BTZ has funded distribution from NII (BTZ 2022 semi-annual report)
Investors need to be aware that with modest 5Yr average annual total returns of only 2.3%, the BTZ fund may have a (earnings - distribution) shortfall. A large earnings shortfall can be indicative of a 'return of principal' fund where the fund cannot earn its distribution and must resort to liquidating its NAV.
However, a check on BTZ's long-term NAV chart do not show the typical 'return of principal' characteristic of long-term NAV declines (Figure 7). Instead, BTZ's NAV has been fairly stable in the past decade, indicating that the fund was able to earn its monthly distribution prior to 2022, if not much more.
Figure 7 - BTZ's NAV was stable in the past decade prior to 2022 (morningstar.com)
Buy BTZ If You Think Yields Will Decline
If interest rates decline (due to a 'Fed Pivot') and there are no deteriorations in credit (no recession), then BTZ could be a good recovery vehicle, as its portfolio took a heavy beating in 2022 from its duration exposure.
The key question is how likely is the above scenario?
Unfortunately, I do not believe the above scenario is very likely. If we take a step back and look at long-term interest rates, we can see that the past decade saw ultra-low interest rates, which were caused by the Fed's endless rounds of QE, especially following the COVID-19 pandemic (Figure 8). This boosted the valuation on high-duration bonds like those held in BTZ's portfolio.
Figure 8 - Treasury yields were unusually low prior to 2022 (Author created with price chart from stockcharts.com and inflation data from St. Louis Fed)
However, given the current sticky inflation situation (January's headline CPI came in at 6.4% YoY vs. economist estimates of 6.2%), the Fed may have to honour its pledge to keep interest rates 'higher for longer'. This will provide upward pressure on interest rates. I discussed more about my inflation and interest rate expectations in a recent article on the Vanguard Long-Term Bond ETF ( BLV ) that may be of interest to readers.
Conclusion
The BTZ fund generates high income from a portfolio of credit sensitive securities. The fund suffered a steep loss in 2022 due to the high duration of its portfolio and the Fed's interest rate increases. If investors believe interest rates will decline in the coming months without a U.S. recession, then BTZ could be an interesting buy, as historically, the fund was able to fund its generous 9.2% forward yield out of NII. However, that is not my base case, as I believe interest rates are set to go 'higher for longer' due to sticky inflation.
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BTZ: Buy If You Think Yields Will Go Lower