FT - FT: 7.5% Yielding CEF With An Embedded Hedge

2023-08-24 12:40:49 ET

Summary

• FT is a fixed income closed end fund that seeks to provide high current income while also targeting capital preservation.
• The fund has a 60/40 fixed income/utilities equities allocation, which provides for an embedded hedge via the defensive nature of the utilities sleeve.
• The fund has a fully supported dividend yield, and its historical NAV performance attests to its capital preservation mandate.
• This CEF represents a good low beta allocation in the sector.

Thesis

Franklin Universal Trust ( FT ) is a fixed income closed-end fund. The vehicle seeks to provide a high level of current income while also targeting capital preservation. The fund has a really interesting build, with a 60/40 fixed income/energy equities allocation. This composition is quite attractive because it provides for an embedded hedge, and a structural way to reduce the standard deviation of the fund.

Utilities are a defensive asset class, and they have performed extremely robustly in the 2022 drawdown. We see many managers having the classic 60/40 build where treasuries are utilized as a hedge. That structure failed miserably in 2022 and in 2023, with yields relentlessly moving higher and the 'hedge' actually having a 1:1 correlation with the risky assets.

FT is a robust long-term performer, with an annualized 10-year total return exceeding 8%, all while the CEF has a below-average standard deviation of only 11.6% (measured on a 3-year look-back).

The CEF does not overdistribute, with its 7.5% yield fully covered from interest income, and the fund exhibiting an overall stable NAV through the past decade. We also like here the countercyclical nature of the fund's discount to NAV, which tends to narrow during market risk-off periods due to its utilities sleeve.

With rates close to historic highs presently, but yet an unclear picture on ultimate economic performance in the next 12 months, it makes sense to start dollar cost averaging into a fund like FT, which provides for a fully supported high dividend yield, and has a low volatility given its embedded portfolio hedge.

FT Analytics

• AUM: $0.17 billion.
• Sharpe Ratio: 0.23 (3Y).
• Std. Deviation: 11.6 (3Y).
• Yield: 7.5%.
• Premium/Discount to NAV: -7.36%.
• Z-Stat: 0.75.
• Leverage Ratio: 26%.
• Composition: Fixed Income - U.S. HY & Utilities.
• Duration: 3.2 years.
• Expense Ratio: 1.37%.

FT Holdings

The fund contains a 60/40 fixed income/utilities equities allocation:

On the fixed income side, the fund invests in U.S. high-yield debt predominantly:

Please note the above rating percentages are expressed as a ratio of the total fund, not of the fixed income sleeve solely. We can see the rating profile of the fund being equally weighted between 'BB' and 'B' names, with a fairly small 'CCC' bucket.

From a sectoral standpoint, the fund is overweight energy high-yield debt:

Energy constitutes over 15% of the holdings, followed by Finance and securitized products. An investor is mostly certainly taking energy risk here, the sector being double the size of the second ranking one, namely Finance.

On the equity side the composition is fairly granular, with no single name being more than 4% of the allocation:

It is important for a fund to have granularity because you do not want to run concentration risk as an investor. No matter how well-managed a fund is, you can always have outside events such as the one observed in Maui, where Hawaiian Electric is now almost wiped out on the equity side from potential civil liabilities after the devastating fires experienced on the island.

Granularity and diversification within an overarching theme are the cornerstone of positive long-term performance.

Premium/Discount to NAV

The CEF has historically traded with discounts to NAV of around -10%:

It is interesting to observe that the discount to NAV actually narrowed during the 2022 market moves. We attribute this to the defensive nature of the collateral build, and the fact that utilities were very well bid last year.

The moves in the discount to NAV here are countercyclical (i.e., the discount narrows in a risk-off scenario), which makes this fund an appealing one.

Performance

The CEF is a robust long-term performer:

On a 10-year time frame, the vehicle produced 8.8% annualized total returns, a very respectable figure for the fund's low standard deviation. Moreover, the CEF compares favorably with the widely bought and utilized DNP Select Income Fund ( DNP ). Indeed, DNP outperforms, but the correlation is quite high in total returns, and the net figures are not very far off.

FT shows off its intrinsic hedge by outperforming a pure HY fund, namely New America High Income Fund ( HYB ). The two vehicles had similar total returns up to the 2022 market sell-off, when FT outperformed due to its utilities sleeve.

Distribution Coverage

The fund seems to do a good job of only paying out what it makes, which is in line with the fund's objective of capital preservation:

San Mateo, CA., August 7, 2023. Franklin Universal Trust [NYSE: FT] today announced a monthly distribution from net investment income of $0.0425 per share, payable on August 31, 2023, to shareholders of record on August 17, 2023 (Ex-Dividend Date: August 16, 2023).

Source: Section 19a Notice .

We can see the same story being told via the fund's fairly stable NAV throughout time:

The fund has +/-10% fluctuations in NAV in the past decade, but the value is always mean reverting. This is what good funds look like. The NAV moves with market situations (recessions, bull markets), but it always reverts to a certain mean. Conversely, funds which overdistribute will have a downward sloping line over long periods of time. It is not the case here.

Conclusion

FT is a fixed income closed-end fund. The vehicle has an interesting build, with a 60/40 HY/utilities allocation. This structural feature provides for an embedded hedge, with utilities being a defensive asset class that outperformed the market in 2022. Other funds that used treasuries as a hedge saw that allocation profile backfire in 2022, when both treasuries and high yield experienced large drawdowns.

FT has a fully supported 7.5% yield, and has proven in the past decade that it takes capital preservation seriously, exhibiting a very stable NAV profile. The fund's performance benchmarks positively to much better-known names in the utilities sector and with good long-term HY CEFs.

FT has a smart, low beta allocation profile that should help it navigate the rest of 2023 and any significant market sell-off. Given the tremendous rise in rates it is a good time to start dollar cost averaging in a low-beta fund like FT that has an embedded portfolio hedge.

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