DSU - DSU: This 10.85%-Yielding CEF Makes A Lot Of Sense For Income Investors Today

2023-08-10 14:26:38 ET

Summary

• The rising cost of living in the U.S. is a major problem, with inflation affecting food and energy prices.
• Investing in closed-end funds that specialize in generating income can help increase income to maintain your standard of living.
• The BlackRock Debt Strategies Fund Inc offers a high yield of 10.85% by investing in a portfolio of fixed-rate and floating-rate debt.
• The fund has the ability to alter its allocations to fixed-rate and floating-rate debt to profit in any interest-rate environment.
• The fund's distribution is fully covered by NII and BlackRock Debt Strategies Fund is trading at a discount.

There can be little doubt that one of the biggest problems facing the average American today is the rapidly rising cost of living that has made it ever more expensive to live our daily lives. This is evidenced by the consumer price index, which claims to measure the price of a basket of goods that is regularly purchased by an average person. This chart shows the year-over-year change of the consumer price index during each month over the past 25 years:

As we can clearly see, the rate of change of the index increased sharply beginning around the time that the economy reopened following the economic lockdowns that accompanied the COVID-19 pandemic. This was directly caused by the fact that the Federal Reserve and the Federal Government increased the money supply by 40% during the period, and once the economy reopened and people began spending all of that newly created money, it pushed prices up because the production of goods and services did not increase by nearly as much as the money supply.

This proved to be a particularly big problem for those of limited financial means because two of the areas that saw the greatest price increases were food and energy. These are both necessities, so a person cannot just avoid suffering the effects of the inflationary environment by eschewing luxuries. As wages did not increase by nearly as much as the cost of goods and services, the budgets of many households have gotten strained to the point where some people are forced to resort to desperate measures such as dumpster diving or pawning possessions simply to make ends meet. We have also seen an increase in the number of people taking on second jobs, which could be one of the reasons why the job numbers remain strong despite numerous other economic indicators pointing towards a recession.

As investors, we are certainly not immune to this inflation. After all, we have bills to pay, require food for sustenance, and need energy to heat our homes. We may also want to enjoy some luxuries from time to time. All of these things cost considerably more than they did only a few short years ago. Thus, we need to increase our incomes too in order to maintain our standard of living.

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 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 in order to make an informed investment decision. That is a shame because these funds offer some advantages over ordinary open-ended or exchange-traded funds. In particular, a closed-end fund is able to employ certain strategies that have the effect of boosting its yields well beyond that of any of the underlying assets.

In this article, we will discuss the BlackRock Debt Strategies Fund Inc ( DSU ), which boasts a 10.85% yield that will undoubtedly appeal to any income-seeking investor. I have discussed this fund before, but that was several months ago so naturally 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. Let us proceed onward and see if this fund could be a good addition to your portfolio today.

About The Fund

According to the fund's webpage , the BlackRock Debt Strategies Fund has the objective of providing its investors with a high level of current income. This is not especially surprising considering that the name of this fund implies that it will be investing in debt securities. The fund's description of its strategy largely confirms this:

"BlackRock Debt Strategies Fund, Inc.'s primary investment objective is to provide current income by investing primarily in a diversified portfolio of US companies' debt instruments, including corporate loans, which are rated in the lower rating categories of the established rating services (BBB or lower by S&P's or Baa or lower by Moody's) or unrated debt instruments, which are in the judgment of the investment advisor of equivalent quality. The fund's secondary objective is to provide capital appreciation. Corporate loans include senior and subordinated corporate loans, both secured and unsecured. The fund may invest directly in such securities or synthetically through the use of derivatives."

As of the time of writing, 99.47% of the fund is invested in bonds and other debt securities with only very small allocations to cash and preferred stocks:

As both the name of the fund and its description imply then, this is very much a bond fund. As such, the fund's objective makes a great deal of sense. After all, bonds are by their very nature an income vehicle. An investor purchases a fund at face value, receives a steady stream of coupon payments over the life of the bond, and receives face value back when the bond is redeemed at maturity. As such, the only return that the bond provides over its lifetime is the coupon payment made to the bondholder. There are no net capital gains due to the fact that bonds have no inherent link to the growth and prosperity of the issuing entity. A company certainly does not increase the payments that it makes to its creditors just because its profits go up and a government will not just pay its bondholders extra money because of an increase in tax revenue.

With that said, it is possible to earn some capital gains by trading bonds prior to maturity. This is because bond prices move in conjunction with interest rates in the broader economy. It is an inverse relationship, so when interest rates go up, bond prices decline and vice versa. As everyone reading this is certainly well aware, the Federal Reserve has been very aggressively raising interest rates in the United States in an attempt to combat the high inflation that we have already discussed. As we can see here, the effective federal funds rate (the rate at which banks lend money to each other on an overnight basis) has gone from 0.08% to 5.08% since the start of 2022:

This was the biggest cause of the turbulence in both the bond and stock markets last year. Prior to the rate hikes, interest rates were so low that investors were putting all of their money into anything that could possibly yield a positive return. After all, the yield of safe assets was basically nothing. That has since changed, increasing the appeal of holding safe assets like money market instruments. When we consider that the money supply has also been declining, there is less money available to drive up the price of highly speculative assets to the obscene levels that we saw back in 2021.

As just stated, bond prices declined in response to the rate hikes. During 2022, the Bloomberg U.S. Aggregate Bond Index ( AGG ) delivered a -13.01% total return. The index is still down today, having declined 6.02% over the past twelve months:

As expected, the BlackRock Debt Strategies Fund also suffered from the carnage in the bond market. The fund's portfolio delivered a -2.97% total return in 2022, but it actually managed to deliver a positive 15.12% over the past twelve months. The fund's share price has not delivered this strength, however. The share price has only delivered an 11.12% total return over the past year:

Please note that this is the return that you would have received had you bought the fund and reinvested all of its distributions. It is probably fair to assume that most people buying an income-focused fund like this will not be reinvesting all the distributions so their realized total return would be somewhat lower. The fund's share price is up 1.00% over the past twelve months though, so at least there would have been some positive return even if you spent all the distributions that you received.

One of the reasons why this fund was able to perform so much better than the bond index is that it is able to invest some of its assets into bank loans. These are what are sometimes called leveraged loans, which are securities backed by bank loans made to companies that already have a significant amount of debt. As we can see, these securities currently account for 84.64% of the fund's portfolio:

These are floating-rate loans, which gives them a distinct advantage over traditional fixed-rate bonds in a rising interest-rate environment. As mentioned earlier in this article, bond prices decline when interest rates go up. This is because bonds are issued with a coupon rate that corresponds to the prevailing interest rate in the market at the time of issuance. Thus, during a rising rate environment, a brand-new bond will have a much higher coupon rate than an otherwise identical existing bond. It makes no sense for any investor to purchase an existing bond at face value when they could buy a brand-new bond with a higher interest rate, so the price of the existing bond has to decline until it delivers a yield-to-maturity that is competitive with brand-new bonds that possess identical characteristics. A floating-rate loan will not have this problem, since its coupon rate actually increases when market rates go up. As such, it will always provide a yield that is competitive with brand-new similar securities.

These securities thus tend to hold their value. In fact, as I pointed out in a recent article , the Bloomberg Floating Rate Note Index ( FLOT ), which tracks the value of intermediate-term floating-rate debt securities, has been almost perfectly flat over the past five years.

The fact that the BlackRock Debt Strategies Fund can invest in these securities gives it a notable advantage over the traditional bond indices or other bond funds that do not have this ability. It is important to note though that the fund's description says nothing about what percentage of its assets will be allocated to floating-rate securities as opposed to traditional fixed-rate securities. The prospectus simply states that the fund can invest in either fixed-rate or floating-rate debt securities in whatever proportion management deems appropriate.

Thus, it is fair to assume that the fund could begin to rotate into fixed-rate debt if rates begin to fall. Those securities will usually outperform floating-rate ones in such an environment. The market is currently anticipating that interest rates will drop next year, but I find that rather unlikely. As I pointed out in a blog post earlier this year, most of the progress against inflation that policymakers have been claiming credit for is caused by energy prices being lower in 2023 than during most of the first half of 2022. We have recently started to see energy prices tick up as the OPEC production cuts are weighing on supply and the government can no longer use the Strategic Petroleum Reserve as a way to keep supply high in the market.

This points to a very real possibility that headline inflation will start to tick higher, and that could prompt the Federal Reserve to raise rates further. This would be devastating for traditional bonds that are pricing in rate cuts, but this fund should be able to avoid the worst of that event. This actually positions the fund fairly well to be a permanent holding as it can adjust its portfolio to handle any rate environment.

Leverage

In the introduction to this article, I stated that closed-end funds like the BlackRock Debt Strategies Fund have the ability to employ certain strategies that can boost the effective yields of their portfolios well beyond that of any of the underlying assets. One of these strategies is the use of leverage. In short, the fund borrows money and then uses that borrowed money to buy various debt securities. As long as the yield that the fund receives from the purchased securities is higher than the interest rate that it pays 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. However, this strategy does not work as well today with borrowing rates at 6% as when rates were basically 0% eighteen months ago. This is because the difference between the interest rate that the fund pays on the borrowed money and the yield that it receives from the purchased securities is much smaller than it once was.

Unfortunately, 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 want a fund's leverage to be under a third as a percentage of its assets for this reason.

As of the time of writing, the BlackRock Debt Strategies Fund has levered assets comprising 24.61% of its portfolio so it appears to be satisfying this requirement. It appears that this fund is striking a reasonably good balance between risk and reward. There does not appear to be anything that we need to worry about here.

Distribution Analysis

As mentioned earlier in the article, the primary objective of the BlackRock Debt Strategies Fund is to provide its shareholders with a very high level of current income. In pursuit of this strategy, the fund purchases corporate bonds, loans, and other debt securities that deliver the bulk of their investment returns through direct payments to the investors. It then applies a layer of leverage to boost the effective yield of its portfolio well beyond that of any of its underlying assets. The fund then pays out its investment profits to the shareholders. As such, we can probably assume that the fund will have a very high yield itself.

That is certainly the case, as this fund pays a monthly distribution of $0.0911 per share ($1.0932 per share annually), which gives it a 10.85% yield at the current price. Unfortunately, the fund has not been particularly consistent with its distribution over the years, although it has raised it three times in the past twelve months. Its long-term track record is much less encouraging, however:

As we can clearly see, the fund's distributions have varied considerably with the passage of time. This is almost certain to be a turn-off for any investor that is seeking a stable and secure source of income to pay their bills and finance their lifestyles. However, it is quite understandable for a debt fund to have such a track record. After all, the fund's returns are significantly impacted by changes in interest rates. In particular, it will generally receive more income during periods of high rates. Despite the fact that people are calling today's rates high, they are very low. In fact, one of the factors blamed for the housing boom and bust that took place in the early 2000s was "low interest rates," despite the fact that rates then were comparable to what we have today.

The recent increases in interest rates are apparently benefiting the fund, though, as the floating-rate securities are delivering more income to the fund than they once did. This is being passed through to the shareholders via the distribution increases that the fund has implemented over the past year.

As is always the case though, we want to ensure that the fund can actually afford the distributions that it pays out. After all, we do not want to be the victims of a distribution cut since such an event would reduce our incomes and almost certainly cause the fund's share price to decline.

Unfortunately, we do not have an especially recent document to consult for the purposes of our analysis. 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 about the fund's performance during the past eight months. This is quite disappointing, as the market has generally been much stronger this year than it was over the course of the year. This strong market may have allowed the fund to capitalize on bond price swings and make some capital gains. It will also provide us with very little insight into the fund's income, which we want to have to examine how sustainable its recent distribution increases are likely to be.

With that said, the document should still give us a good idea of how well the fund navigated the challenging market conditions of last year, and sometimes a fund's ability to handle challenging conditions speaks more about the quality of its management than its performance during a strong market. After all, anyone can make money when the market is going up.

During the full-year period, the BlackRock Debt Strategies Fund received $78,358 in dividends and $42,508,039 in interest from the assets in its portfolio. When combined with a small amount of income from other sources, the fund reported a total income of $43,085,781 during the period. It paid its expenses out of this amount, which left it with $33,524,702 available for shareholders. That was sufficient to cover the $32,417,479 that the fund paid out in distributions during the period.

This speaks well for the sustainability of the fund's distribution, since it appears that all the fund is doing is paying out its net investment income. Assuming that it continues to just do that, then the distribution increases that the shareholders received over the past year will also be sustainable as long as interest rates remain at today's levels. As we discussed earlier, that could very easily be the case for quite a while.

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 BlackRock Debt Strategies 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 market value of all the fund's assets minus any outstanding debt. This 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 closed-end 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 purchasing a 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 Debt Strategies Fund had a net asset value of $10.79 per share but the shares currently trade for $10.07 each.

This gives the fund's shares a 6.67% discount on net asset value at the current price. This is relatively in line with the 6.31% discount that the shares have had on average over the past month. As such, the current price looks quite reasonable.

Conclusion

In conclusion, the BlackRock Debt Strategies Fund appears to be one of the better debt funds available in the market. The fund has delivered very reasonable returns relative to both the bond and floating-rate securities indices and boasts a much higher yield than either of them. It also has the flexibility to adjust its portfolio to any interest-rate environment, allowing it to have certain "buy and forget" qualities. The fact that the fund's distribution is fully covered by net investment income is also nice as it should ensure long-term sustainability unless interest rates decline from today's levels. The valuation is also quite reasonable. This fund could certainly make a great deal of sense for any income-focused investor today.

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