FT - FT: Solid Combo Of Junk Bonds And Utilities
2023-04-18 14:55:46 ET
Summary
- The FT fund aims to provide high current income from a portfolio of high yield bonds and utility stocks.
- The fund is currently yielding an attractive 7.3%.
- Although I like the fund's long-term return profile, I worry about a pending recession.
The Franklin Universal Trust ( FT ) aims to provide high current income from a portfolio of high yield corporate bonds and utility stocks. The fund delivers sold 5-6% p.a. returns that funds a generous distribution currently yielding 7.3%.
Although I like the steady long-term returns of this fund, I am currently on the sidelines as I worry about a pending recession. Given the fund's high exposure to high yield corporate bonds, I believe there may be significant price declines in the fund if credit spreads widen as they typically do during recessions.
Fund Overview
The Franklin Universal Trust is a closed-end fund ("CEF") that aims to provide high current income to unitholders through a portfolio of high yield corporate bonds and utility stocks.
The FT fund may use leverage to enhance returns and as of March 31, 2023, the fund had $257 million in total assets and $192 million in net assets for a 25.3% effective leverage. The FT fund charged a 2.57% net expense ratio in fiscal 2022.
Portfolio Holdings
The FT fund has 327 holdings with a portfolio effective duration of 3.4 years and an 8.2% yield to maturity (Figure 1).
Figure 1 - FT portfolio characteristics (franklintempleton.com)
As of December 31, 2022, the FT fund had 58.9% of assets invested in high yield corporate bonds, 36.9% invested in equities, and 4.2% held in cash (Figure 2).
Figure 2 - FT asset allocation (FT December 2022 factsheet)
Figure 3 shows the sector allocation of the fund's fixed-income portfolio as well as the credit quality allocation of the portfolio. The fund's largest sector weights are Energy (14.4%), Asset backed securities (12.0%), and Finance (6.5%).
Figure 3 - FT sector and credit quality allocation (FT December 2022 factsheet)
The fund's high yield bonds are predominantly non-investment grade, with investment grade BBB bonds only accounting for 3.6% of the portfolio. 20.0% of the portfolio is rated BB, 18.2% is rated B, and the rest is rated CCC or below.
Returns
Figure 4 shows the historical performance of the FT fund. The fund has generated modest 3/5/10Yr average annual returns of 8.4%/5.1%/5.3% respectively to March 31, 2023.
With sizeable exposure to low-duration high yield bonds, the FT fund has low portfolio volatility, with a 3Yr standard deviation of returns of 12.3%. Compared to peers within the Morningstar category Tactical Allocation , the FT fund has slightly lower returns, but significantly lower volatility, which results in a better Sharpe Ratio (Figure 5).
Distribution & Yield
The FT fund pays an attractive monthly distribution currently set at $0.0425 or a forward yield of 7.3%. On NAV, the FT fund is yielding 6.6%.
Historically, the FT fund's distribution is funded mostly through net investment income ("NII"), with a small portion from realized gains (Figure 6).
Figure 6 - FT has funded distribution from NII and realized gains (FT 2022 annual report)
With 5 and 10Yr average annual return of 5.1% and 5.3% respectively vs. the current distribution rate of 6.6% of NAV, the FT fund has a slight gap between historical total returns and distribution rate. However, FT's gap does not appear serious enough to consider the fund as an amortizing 'return of principal' fund. 'Return of principal' funds refer to investment funds that do not earn sufficient returns and must rely on liquidating NAV to fund their distributions. These funds are characterized by long-term amortizing NAV like the Eaton Vance Short Duration Diversified Income Fund ( EVG ) shown in Figure 7.
Figure 7 - EVG is a classic example of return of principal fund (morningstar.com)
In comparison, the FT fund's long-term NAV does not have an unhealthy amortizing pattern (Figure 8).
Figure 8 - FT does not have an amortizing pattern (morningstar.com)
FT Susceptible To Economic Cycles
In normal economic times, the FT fund is a very steady performer, delivering modest total returns and an attractive distribution yield. However, one thing investors in the FT fund need to watch out for is economic cycles, particularly as the FT fund has a large allocation to high yield corporate bonds. When economic fundamentals deteriorate, credit spreads widen and high yield bond prices fall. This will negatively impact the FT fund.
For example, if we overlay the historical NAV and market price history of the FT fund against recessions and high yield corporate spreads, we see that the FT fund performs poorly when high yield corporate spreads widen and or recessions occur (Figure 9).
Figure 9 - FT has historically performed poorly in recessions (Author created with price chart from Morningstar and economic data from St. Louis Fed)
Given a high probability of a pending recession, investors considering the FT fund need to be mindful of potential price declines with the fund (Figure 10).
Figure 10 - High probability of an impending recession (Conference Board)
Conclusion
The Franklin Universal Trust is a long-serving closed-end fund that aims to provide high current income from a portfolio of high yield corporate bonds and utility stocks. Historically, the fund has delivered solid, if unspectacular long-term returns that average 5-6% p.a. This is then paid out to unitholders through a generous monthly distribution that currently yields 7.3%.
Although I like the long-term returns profile of this fund, I am currently on the sidelines as I believe a recession is imminent. Given the fund's high exposure to high yield corporate bonds, I believe there may be significant price declines in the fund in the coming months. However, for those with a more sanguine view, I can see the merits of this 7.3% yielding fund.
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FT: Solid Combo Of Junk Bonds And Utilities