BMEZ - I'm Buying BMEZ As It Trades At 14% Discount To Its NAV

2023-07-14 13:25:20 ET

Summary

• BlackRock Health Sciences Term Trust is an actively managed fund specializing in healthcare and medicine, with a dividend yield of 10% largely due to its practice of selling covered calls.
• Despite the healthcare sector's underperformance this year, BMEZ has managed to stay up 12% year-to-date, largely due to its strategy of selling covered calls against individual stocks rather than indices.
• Currently trading at a -14% discount to its NAV, BMEZ could be a good addition to an income portfolio, despite underperforming since its inception in 2020.
• The fund was overweight in high P/E growth stocks in 2022 but shifted to investing more into large caps since then.

BlackRock Health Sciences Term Trust ( BMEZ ) is an actively managed fund by BlackRock that specializes in the fields of healthcare and medicine. The fund comes with a dividend yield of 10% most of which is due to the fund's practice of selling covered calls.

Before I talk more specifically about BMEZ, let me show you a chart showing the YTD performance of a variety of covered call funds this year. One thing you can't help but notice is the range of performances by different covered call funds, even though they all employ similar strategies with slight variations. You can see that YTD performance of covered call funds ranged from 2.49% to 27.42% which means not all covered call funds are the same. The top spot belongs to another BlackRock ( BST ) fund, followed by Nuveen's Nasdaq ( QQQX ) fund, which I covered in a past article . BMEZ which is the main focus of this article is on the lower end of performers by being up "only" 13%, but this doesn't surprise me since healthcare stocks aren't having their best year right now.

BMEZ is currently trading at a -14% discount to its NAV, which is the second-largest discount since the fund's inception if you don't count a brief period in March 2020 when the fund had a discount rate of almost -20% which only lasted a couple of weeks. In its entire history, the fund hasn't traded at a premium except for very brief periods here and there, and even those premiums were small (2-3%).

One reason this fund is trading at a discount is probably because of its specific sector. Below, you will see how certain sub-sectors of healthcare performed year-to-date compared to the overall market. While the overall market is up almost 18% YTD (and tech stocks are up almost 40%), biotech stocks are up only 2%, healthcare index is down -2%, and pharmaceuticals index is down -7% not to mention healthcare providers being down almost -8%. This didn't bode well for BMEZ, but it's still up 12% year-to-date (including reinvestment of dividends) which is actually quite impressive when you think about it.

A good chunk of this outperformance comes from selling covered calls. The fund has a low coverage rate of 26% which means it only writes covered calls against about one-fourth of its positions. This also allows the fund to enjoy upside potential on 3/4th of its portfolio while generating income in a targeted fashion.

This fund is similar to other BlackRock covered funds in using this strategy of writing calls against individual stocks instead of writing them against indices. The advantage of this approach is that individual stocks often have a higher implied volatility than indices, so you can generate a higher premium selling calls against individual stocks as compared to writing against indices.

The fund invests in more than 180 healthcare-related stocks. The fund is advertised as a global fund, but 78% of its holdings (by weight) are located in the US. Outside of the US, there are 4 countries that account for another 15% of the total weight, namely Switzerland, the UK, Germany, and China. The rest of the world accounts for another 7% of the fund's total weight, so while this is technically a "global" fund, an overwhelming majority of its holdings are centered around the US and a few other countries. Still, keep in mind that many American pharmaceutical companies operate globally, so investors still get global exposure one way or another.

The fund is headed by Dr. Erin Xie who has a PhD in biochemistry. In the fund, she partners with Dr. Xiang Liu who has a PhD in chemistry. Her team is responsible for following trends and making stock picks while BlackRock's Equity Derivatives Team handles writing covered calls and other financial details. This seems like a good arrangement and allows fund management to excel at where their domain expertise lays.

As with many BlackRock funds, BMEZ also invests in some companies that aren't exactly publicly traded. The fund invests in some pre-IPO companies, private companies, and other arrangements that aren't typically available to most retail investors. The advantage of this approach is that it allows the fund to have more diversification power, and the disadvantage of it is that you might get more risk and volatility with these types of companies.

The fund has a dividend yield of about 10% which has been pretty stable since the fund's inception a few years ago. Since the fund is writing calls against only 25% of its portfolio, it could easily sell more covered calls and increase its dividend, but I don't think this is part of the fund's strategy. The fund is keeping its distributions stable on purpose, which means no dividend cuts but not many hikes either. Since BMEZ is actively managed, and it trades in and out of positions frequently, it also posts capital gains which are usually reinvested into NAV once the 10% dividend is covered which also tells me that the management doesn't have any intention to increase dividends aggressively but to keep them stable.

One worrisome trend is the fact that the fund has been underperforming since its inception in 2020. Up until the fall of 2021, the fund was vastly outperforming its sector, being up almost 50% at one point because it was overweight hypergrowth stocks with high P/Es which outperformed during that period. From October 2021 to October 2022, the fund had a pretty terrible year for the exact same reason, it was overweight in high P/E growth stocks. Basically, it suffered the same fate that Cathie Wood's funds did. The fund's managers probably regret not selling more covered calls during that period, which would have softened this blow, especially considering the high VIX environment at the time.

Since then, the fund's management seems to have learned their lesson, and they are not overweight hypergrowth stocks anymore. Now close to 60% of the fund's portfolio consists of large-cap stocks and these tend to be less volatile.

All in all, BMEZ should be a decent addition to your income portfolio, especially now that it's trading at a -14% discount against its NAV. I don't like this fund as much as BlackRock's some other funds such as BST and BSTZ (BSTZ) but it's should still deliver decent results in the long run. For now, I am buying BMEZ but only in small amounts because I am cautiously optimistic.

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