BTZ - BTZ: This CEF Remains Attractively Valued

2023-08-07 16:02:01 ET

Summary

• BlackRock Credit Allocation Income Trust provides diversified exposure to fixed-income securities with a multi-sector approach.
• BTZ remains attractively valued despite a bit of a narrowing discount, but distribution coverage has worsened.
• The fund utilizes derivatives with its highly flexible investment strategy, which could potentially provide for capital gains to fund the payout.

Written by Nick Ackerman, co-produced by Stanford Chemist.

BlackRock Credit Allocation Income Trust ( BTZ ) provides fixed-income exposure to investors. With its multi-sector approach and flexibility, an investor is getting a diversified basket of many different types of debt instruments.

The fund remains attractively valued, even with a little bit of discount narrowing since our prior update . BTZ has mostly performed flat at this time on a total share price return basis.

Unfortunately, distribution coverage has not improved during this time but has become a bit worse. So while the fund remains attractively valued in terms of its discount, investors should consider the weak and trending weaker distribution coverage.

The Basics

• 1-Year Z-score: -0.52.
• Discount: -9.24%.
• Distribution Yield: 9.95%.
• Expense Ratio: 0.94%.
• Leverage: 37.02%.
• Managed Assets: $1.055 billion.
• Structure: Perpetual.

BTZ invests with an objective to "provide current income, current gains, and capital appreciation." They intend to achieve this through investing "…under normal market conditions, at least 80% of its assets in credit-related securities, including, but not limited to, investment-grade corporate bonds, high yield bonds, bank loans, preferred securities or convertible bonds or derivatives with economic characteristics similar to these credit-related securities."

The fund is quite large, which isn't too surprising for a BlackRock fund. This can help with having a relatively lower expense ratio in the CEF space. However, the total expense ratio comes to 1.79% when including interest expenses for their leverage. Rising costs of leverage have impacted this fund. BTZ utilizes reverse repurchase agreements to gain its leverage, with its last report showing interest rate costs were around 4.50%. As the Fed has raised its benchmark interest rates several times since its last report, we know the cost of this debt has risen similarly.

However, there is good news. BTZ also incorporates positioning to help hedge itself too. In this case, it is primarily in shorting Treasury futures contracts and interest rate swaps. Derivatives are very much a part of their strategy in operating BTZ. We noted this in our last update, but instead of receiving the floating rate for their interest rate swaps, instead, they positioned themselves to become the payer of the floating and receive the fixed as of their last report.

Performance - Attractive Discount

Through 2020 and into 2021, investors bid up this fund and pushed it to trade at a premium. Other than at its inception, the fund had never traded at a premium, so this was rather unusual. A fall from that level seemed inevitable, and today the fund is trading near its longer-term discount average, which can make it an appealing time to consider starting a position. Of course, the wider the discount, the better margin of safety, all else being equal.

The historical performance of the fund hasn't been anything too appealing, but that's mostly because fixed-income investments haven't been too appealing. A large driving factor for this was 2022 itself seeing bond prices collapse as the Fed pushed up interest rates. Then putting leverage on top of that in the case of BTZ meant an even further relative drop.

Below is a comparison over the last decade of performance between BTZ and the iShares iBoxx High Yield Corporate Bond ETF ( HYG ) and iShares iBoxx Investment Grade Corporate Bond ETF ( LQD ) to give us some context on fixed-income returns. BTZ is primarily invested in investment-grade and high-yield fixed-income positions, so this can give us a fairly good amount of similar context.

BTZ did relatively well against these non-leveraged, passively managed ETFs, but this really highlights how much returns were pushed lower just with last year's moves.

Distribution Coverage Slips Further

Due to the rising costs of leverage, the distribution coverage would be presumed to continue to get pressured. With the latest UNII report from the fund, that's exactly what we see as well, with coverage at around 60.2%. That was a decline from the January 2023 report when it came in at 64%.

The silver lining here is that with BTZ's utilization of derivatives, despite being a fixed-income oriented fund, they have a chance of producing capital gains fairly regularly - at least, if management is successful in their calls.

In the prior year, we can see that they had some mixed results. Though the derivatives portion of their portfolio generated a net realized gain, it was actually fairly minimal. Against the $86.3 million the fund paid out in distributions last year, we can get a sense of how fairly immaterial these gains were as far as providing 'coverage' for the distribution.

Historically, the fund has made adjustments to its distribution, but they seem more hesitant to do so at this time as coverage remains under pressure.

Given this information, I would continue to be cautious about the distribution remaining at the current level. However, the nearly 10% distribution rate is certainly attractive, and the discount works in favor of investors to receive a higher relative payout compared to the NAV rate of around 9%. 9% isn't too unreasonable of a level for distribution, but given the fund's positioning, it can make more sense.

BTZ's Portfolio

The fund's effective duration comes to 6.14 years. Part of the reason for this longer duration in this fund is due to the fund's tilt toward a higher-quality portfolio. Given this higher quality tilt, relatively lower yields come with these debt offerings. That's why it can be a bit of a reach for BTZ to hit its current distribution level, especially on the back of rising borrowing costs.

The majority of the portfolio is tilted in favor of BBB rated debt or higher, making up nearly 70% of the fund.

Higher-rated debt can often come with generally longer maturities, which is one of the key factors in the duration calculation. In terms of maturity breakdown for the fund, the largest allocation is to the 3-5 year maturities, which isn't too long. However, right behind that is the 20+ year maturities that represent just over a quarter of the fund, which would really do a lot in pushing up the average maturity for the fund.

This was all fairly consistent with what we saw for positioning in BTZ earlier in the year. This is also consistent with what we see for some of the top holdings; Verizon ( VZ ), Wells Fargo ( WFC ), TransDigm ( TDG ), Citigroup ( C ), Altria ( MO ) and Bank of America ( BAC ) were all listed as top ten exposures in our previous update as well. That's even with a portfolio turnover last year of 42%, though that was one of its more active years in terms of turnover.

Conclusion

BTZ remains at an attractive valuation in terms of the fund's discount historically, and even despite narrowing a bit since our last update. However, the distribution coverage has also slipped even further too, which remains an area of caution for the fund. CEFs can be great for providing steady monthly distributions, but it would be more comforting if they were paying out something that was more sustainable.

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