FRA - FRA: Earn A High Yield And Reduce Your Interest Rate Risk

2023-05-09 16:52:27 ET

Summary

• Investors are in desperate need of additional sources of income since the rapidly rising cost of living has strained many budgets.
• BlackRock Floating Rate Income Strategies Fund Inc invests in a portfolio of floating-rate debt securities that offer a great deal of interest rate protection compared to ordinary bonds.
• The FRA closed-end fund is mostly invested in speculative-grade securities, but it should still be reasonably safe from default risk.
• The 11.41% yield is covered solely by net investment income.
• The FRA CEF is trading at a reasonably attractive discount to its net asset value.

There can be little doubt that one of the biggest challenges facing Americans today is the incredibly high inflation rate that continues to dominate the economy. Over the past twelve months, the consumer price index has increased by at least six percent year-over-year eleven times:

Although inflation has come down a bit during the most recent months, the nation has still experienced negative real wage growth for 24 straight months. This has forced consumers to take actions such as drawing down their savings or borrowing money against their credit cards just to make ends meet. I showed this in detail in a blog post recently. The problem seems to be getting worse as consumer debt spiked to a record level in March 2023 (the most recent date for which data is currently available). In short, the average American is desperately in need of new sources of income just to make ends meet.

As investors, we are certainly not immune to this. After all, we need to purchase food, gasoline, and many other goods and services in our daily lives too. We do, however, have other means that we can employ to obtain this income. After all, we have the ability to put our money to work earning an income. One of the best ways to do this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income. These funds are unfortunately not very well-followed in the investment media and most financial planners are not familiar with them, so it can be difficult to obtain the information that we would like in order to make an investment decision regarding these funds. That is a shame because closed-end funds offer some advantages over their open-ended or exchange-traded fund cousins. In particular, closed-end funds are able to use certain strategies that boost their yields far beyond what other funds are able to offer.

In this article, we will discuss the BlackRock Floating Rate Income Strategies Fund Inc ( FRA ), which currently boasts a very attractive 11.41% yield. This is clearly a large enough yield to produce a sizable income from a portfolio, and the fact that the fund has been increasing its distribution over the past year only adds to its appeal. The fund is also trading for a very attractive price today, so it is certainly worth investigating further. Therefore, let us investigate 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 Floating Rate Income Strategies Fund has the stated objective of providing its investors with a high level of current income while still preserving capital. This is a fairly standard investment objective for a fixed-income fund such as this one. In fact, as we can see here, the fund is entirely invested in debt securities:

However, these are not the traditional bonds that most other fixed-income funds purchase. As the name of this fund implies, the BlackRock Floating Rate Income Strategies Fund primarily invests in floating-rate securities. The fund's webpage explicitly states this:

"BlackRock Floating Rate Income Strategies Fund, Inc.'s investment objective is to provide shareholders with a high current income and such preservation of capital as is consistent with investment in a diversified, leveraged portfolio consisting primarily of floating rate debt securities and instruments. The fund seeks to achieve its investment objective by investing, under normal market conditions, at least 80% of its assets in floating rate debt securities."

A floating rate debt security is a bit different from an ordinary coupon bond. Typically, a bond is issued with a set coupon that simply pays out a specific amount twice per year so as to give a specified yield to an investor that purchased the bond at its face value when it was first issued. The debt securities that this fund invests in are different because the coupon payments actually change based on some interest rate benchmark, such as LIBOR. This is something that is very important today because interest rates all over the world have been rising over the past year. This is immediately apparent by looking at the federal funds rate, which is the rate at which American commercial banks lend money to each other on an overnight basis. As we can see here, the effective federal funds rate has gone from 0.33% a year ago to 4.83% today:

This is a more rapid increase in interest rates than we have seen in most developed economies, but Japan and China are the only nations in the G20 that have not seen rising interest rates over the past two years. The reason that this is important for debt investors is because bond prices are inversely correlated to interest rates. In short, when interest rates increase, bond prices decrease. This is because newly issued bonds will have a yield that is based on the market interest rate at the time that the bond is issued. In a rising rate environment, brand-new bonds will therefore have a higher yield than existing bonds so nobody will pay full price for an existing bond when an otherwise identical new one will have a higher yield. Thus, the price of existing bonds needs to decline so that they offer the same effective yield-to-maturity as a brand-new bond with otherwise identical characteristics.

While this has no impact on an investor that buys a bond at issuance and simply waits until maturity, funds trade based on the current market value of their assets so naturally the share price of bond funds will decline in a rising rate environment. This is what we have seen over the past year as the Bloomberg US Aggregate Bond Index ( AGG ) is down over the past twelve months, but it has rebounded year-to-date due to expectations of a near-term interest rate cut:

As I have pointed out in various previous articles though, it is somewhat unlikely that the Federal Reserve will pivot and cut the federal funds rate this year. The strength of the most recent jobs report adds to that conviction and macro hedge funds are now shorting expectations of a near-term pivot. In short, it appears unlikely that the Federal Reserve will cut interest rates this year, so the recent gains in some bonds will likely be short-lived.

However, the floating-rate bonds that are held by the BlackRock Floating Rate Income Strategies Fund are very different because the payments made from the borrowing entities to investors actually increase alongside interest rates. This should allow those bonds to hold a reasonably steady value regardless of interest rates because these bonds will always be delivering a rate that is competitive with newly issued bonds. We can see this in the fact that the iShares Floating Rate Bond ETF ( FLOT ) has been almost perfectly flat over the past year:

The BlackRock Fund itself has indeed held up pretty well in the rising rate environment, exactly as we would expect. As of the time of writing, the fund is down 2.18% over the past twelve months:

When we combine this with the fund's relatively high yield, it has delivered a positive total return to its investors over the period. Indeed, over the twelve-month period that ended on March 31, 2023, the BlackRock Floating Rate Income Strategies Fund delivered a 3.11% total return to its investors:

We can see that the fund's performance when measured by its market price was negative over that period, but the performance of the portfolio is more important. Unlike open-ended funds or exchange-traded funds, closed-end funds do not always trade in sync with the value of their assets. This can sometimes create opportunities in which investors can purchase the fund's assets for less than they are actually worth. We will discuss this later in this article.

One of the characteristics of floating-rate debt securities is that they are frequently issued by companies that have strained balance sheets with a significant amount of other debt. This is because firms with very strong balance sheets will generally prefer to issue fixed-rate debt because it is more certain how much the debt will cost and allows for easier budgeting. We can simply look at how many regular consumers have been devastated by adjustable-rate mortgages and similar products to see that this is the case. The fact that the fund is going to be heavily invested in debt issued by companies like this is a risk that could concern more risk-averse investors since companies with strained balance sheets have a higher risk of default during challenging economic times. As such, it is a good idea to look at the credit ratings of the securities in the portfolio as part of our risk analysis. Here is a summary:

An investment-grade debt security is anything rated BBB or above. As we can see, that is only 2.67% of the portfolio, so this is very much a junk bond fund. However, we can also see that 86.24% of the securities held by the fund are rated BB or B. According to the official bond rating scale , companies whose securities are issued these ratings have sufficient financial capacity to handle their current debt obligations even in the event of a short-term economic shock. Thus, the default risk on these securities is going to be relatively low. The fund also has 430 current positions, so any default will likely not have a noticeable impact on the overall portfolio. Thus, risk-averse investors should still be able to sleep well at night with this fund as the risk of severe losses is very slim.

Leverage

As mentioned in the introduction, closed-end funds like the BlackRock Floating Rate Income Strategies Fund have the ability to employ certain strategies that boost their yields well beyond that of anything else in the market. In some cases, these funds can actually earn an effective yield that is above that of the assets in the portfolio. One strategy that the fund uses to accomplish this is the use of leverage. In short, the fund borrows money and then uses that borrowed money to purchase floating-rate debt securities. As long as the yield on the purchased assets is higher than the interest rate that the fund needs to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, so this will usually be the case.

However, 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 using too much debt since this would expose us to too much risk. I do not usually like to see a fund's leverage exceed a third as a percentage of its assets for this reason. As of the time of writing, the BlackRock Floating Rate Income Strategies Fund has levered assets comprising 24.25% of its portfolio, so it appears to be satisfying this requirement. Overall, this fund appears to be striking a reasonable balance between risk and reward.

Distribution Analysis

As stated earlier in this article, the BlackRock Floating Rate Income Strategies Fund has the stated objective of providing its investors with a high level of current income. In order to accomplish this task, it invests in floating-rate debt securities that primarily provide their investment return through direct payments to investors. The fund then applies a layer of leverage to boost its effective portfolio yield beyond that of any of the assets in the portfolio. As such, we might assume that the fund would have a very high yield itself. This is indeed the case, as the fund pays a monthly distribution of $0.1116 per share ($1.3392 per share annually), which gives it an 11.41% yield at the current price. The fund's distribution has varied considerably over the years, although as stated in the introduction, it has been increasing over the past year:

This overall variability may be a bit of a turn-off for those investors that are looking for a stable and secure source of income to use to pay their bills or finance their lifestyles. However, it is quite understandable considering the fund's exposure to interest rates. After all, the fund's income from a portfolio of floating-rate securities will vary directly with interest rates. There have been numerous changes in interest rates over the past twenty years, so naturally the fund's income will fluctuate. The fund should generally not pay out more than it collects, so the distribution will vary. However, anyone buying the fund today will receive the current distribution at the current yield and so does not really need to worry about the fund's past distribution performance. The most important thing today is how well the fund can maintain its current distribution. So let us investigate that.

Fortunately, we do have a recent document that we can 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 over the past few months, but it will still give us a good idea of how well the fund navigated the market environment in 2022, which was the time period that included most of the central bank's rate hiking cycle. During the full-year period, the fund received $75,134 in dividends and $38,919,929 in interest from the assets in its portfolio. When we combine this with a small amount of income from other sources, we see that the fund had a total investment income of $39,520,644 during the period. It paid its expenses out of this amount, which left it with $29,462,918 available for shareholders. This was sufficient to cover the $27,297,906 that the fund paid out to its shareholders in distributions. This is something that should prove comforting as it appears that the fund is just paying out its net investment income. This is something that we like to see in the case of debt closed-end funds like this one.

Valuation

It is always important 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 Floating Rate Income 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 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 acquiring the fund's assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of May 8, 2023 (the most recent date for which data is available as of the time of writing), the BlackRock Floating Rate Income Strategies Fund has a net asset value of $13.03 per share but the shares currently trade for $11.66 each. This gives the fund's shares a 10.51% discount to net asset value at the current price. That is a reasonably attractive discount that is quite a bit better than the 9.11% discount that the shares have traded at on average over the past month. As such, the price certainly appears acceptable today.

Conclusion

In conclusion, the BlackRock Floating Rate Income Strategies Fund offers investors an excellent way to boost their incomes today. Unlike most debt funds, the securities in this fund should prove relatively stable in all market environments, which may be important as there are some predictions that the Federal Reserve will increase interest rates further. The fund's current distribution is easily one of the highest available in the market, but it does appear to be sustainable so investors should not have to worry about a near-term cut. The BlackRock Floating Rate Income Strategies Fund Inc is also trading at a very attractive valuation, so it may make sense to pick up some shares today.

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