2023-12-07 06:37:09 ET
Summary
- Ares Dynamic Credit Allocation Fund is a flexible, diversified fixed-income fund managed by Ares Management.
- The fund has strong distribution coverage and has increased its distribution several times, with the potential for another increase.
- ARDC is trading at a historically attractive discount, making it an opportunity in the current environment.
Written by Nick Ackerman, co-produced by Stanford Chemist.
Ares Dynamic Credit Allocation Fund ( ARDC ) is run by one of the top alternative asset managers in the world, Ares Management ( ARES ). This fund takes a "dynamic" approach by investing in a diversified fixed-income portfolio that includes various types of debt securities. That can include collateralized loan obligations ("CLOs"), both the equity and debt tranches of those, as well as investing directly into senior loans and also includes a large sleeve of bond investments.
The portfolio is generally tilted toward the below-investment-grade, as is often the case with these types of funds. However, the fund has been delivering solid results with several distribution increases. Of course, this is owed to the fund's floating rate exposure, which would be those CLO and loan investments. While Fed rate cuts would be a headwind for this fund, most believe that rates won't go back to zero.
Given the fund's strong distribution coverage and even another interest rate hike since their last available report, it suggests there is some cushion there before a distribution cut is in the cards. In fact, we could even be in for a holiday present when they announce their next distribution, which wouldn't surprise me if we received another distribution increase.
On top of this, the deep discount makes this fund remain a 'buy' in this current environment.
The Basics
- 1-Year Z-score: 1.04
- Discount: -9.36%
- Distribution Yield: 10.95%
- Expense Ratio: 2.46%
- Leverage: 36.91%
- Managed Assets: $519.3 million
- Structure: Perpetual
ARDC's investment objective is "to provide an attractive level of total return, primarily through current income and, secondarily, through capital appreciation."
In an attempt to achieve these objectives, the fund takes a pretty flexible approach - as its name would suggest. Specifically, they state that:
The Fund invests primarily in a broad, dynamically managed portfolio of (i) senior secured loans (“Senior Loans”) made primarily to companies whose debt is rated below investment grade; (ii) corporate bonds (“Corporate Bonds”) that are primarily high yield issues rated below investment grade; (iii) other fixed-income instruments of a similar nature that may be represented by derivatives; and (iv) securities of collateralized loan obligations (“CLOs”).
This flexible approach allows them to tilt their portfolio toward a more fixed approach when needed or a floating rate approach when interest rates are higher. An illustration they provide gives an example of what they are looking to achieve in each of the interest rate cycles.
The fund employs a high amount of leverage, and they also charge like they are running one of their private funds. When including the fund's leverage expenses, the fund's total expense ratio climbs to 4.85%. That is certainly on the higher end for a traditional closed-end fund but comes more in line with similar peers when looking at more comparable funds.
Additionally, while the fund is highly leveraged - and that is certainly always a risk that adds to more volatility for the fund - they take a hybrid approach in their leverage as well. That is, they incorporate both a credit facility and fixed-rate Mandatory Redeemable Preferred Shares.
They locked these rates in prior to the increased interest rates from the Fed and received envious financing terms. For Series A and B, they pay a dividend rate of 2.58%, and for Series C, they pay 3.03%. The weighted average dividend rate for these comes to 2.81%. They also don't mature for several years out.
T he redemption dates for the Series A MRP Shares, Series B MRP Shares and Series C MRP Shares are July 15, 2026, September 15, 2026 and September 15, 2028, respectively .
That means they pay a low cost for borrowings, and it also means they haven't had to pay as much for these borrowings as other CEFs that employ a credit facility only. It's definitely a great position to be in for a fund.
Performance - Fixed-Income Down
Despite even having floating rate exposure for a sizeable portion of their portfolio, fixed-income investments still faced pressure in terms of prices being pushed lower for their underlying portfolios. That causes their yields to rise to make them more competitive. Higher rates also mean that the Fed is pushing for more companies to fail and defaults to rise, which increases credit risks, and those need to be factored in as well for fixed-income investors.
That being said, after a rough 2022 for the fixed-income market, we are seeing significant rebounds this year. ARDC is one of those funds that is performing quite well. When looking at the last year relative to some of its peers, we can see that it hasn't performed quite as strongly as its more CLO-focused XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ).
However, it has topped its "newly minted" Nuveen Credit Strategies Income Fund ( JQC ). As a reminder, JQC has only more recently become a hybrid fund to join the likes of peers ARDC and XFLT.
Therefore, the performance comparison historically might not be overly relevant for JQC. However, looking back over the longer term, ARDC has been the victor. Historical performance comparison here is limited to XFLT's launch in 2017.
Admittedly, trying to find an exact peer here is difficult - for most CEFs, it's actually difficult - when you start to get really into these dynamic approaches that are so flexible. So, an argument could really be made for any of these funds being worthy at this time, in my opinion. Additionally, since most of this time period was when rates were at zero, most of the floating rate exposure within these funds was probably only yielding the "floor rate." That is the bare minimum that a floating-rate debt instrument pays. With a higher rate environment, returns going forward could have more potential.
With all that being said, despite the positive trend for ARDC, the fund is trading right near its historically wide discount. They don't seem to get any lift from the Ares Management name in this case. This would seem to be an appropriate discount for investors who believe a zero-rate environment could be coming back. However, in the current environment, a narrower discount would seem to make sense and I don't believe we are necessarily going back all the way to zero - at least probably not for over a decade period as we last experienced.
Distribution - Fully Covered Double-Digit Yield
Like most funds that have some or all floating rate exposure, ARDC has been raising its payout to investors over the last couple of years. They've done so on four occasions. Their last cut was in 2020, during Covid, which is probably for fairly obvious reasons.
On an NAV basis, the distribution rate comes to 9.92%, just barely over the double-digit level. However, thanks to the fund's discount, investors get 10.95% instead of buying today.
Perhaps even better is this fund fully earning its distribution based on its last report. Historically speaking, the fund has generally been covering its distribution to investors; that isn't necessarily new information or a change for the fund, but some of their peers don't always focus on covering their payout through net investment income. They currently pay $1.41 annually based on the last amount declared and earn $1.44 annually based on their last semi-annual report . That was a nearly 10% increase over the 2022 level they earned and over 14% from year-end 2021.
That being said, this report was for the six months ended June 30, 2023. In July, the Fed bumped up their target rate another 25 basis points to the range of 525 to 550 basis points. All else being equal, that should mean that ARDC also would have seen another bump up in their income generation.
At this point, the Fed isn't expected to raise anymore and even potentially cut next year. However, depending on ARDC's confidence, I believe that there is room for another increase when they announce in December, and I wouldn't be surprised if they did so. Even if they don't announce an increase and keep it at the current level, I don't think there would be room to complain, either.
For tax purposes, the prior two years had listed the entire distribution as ordinary income. This is to be expected as a fixed-income-oriented fund.
ARDC's Portfolio
The dynamic approach affords the fund greater flexibility to invest when and where it sees fit, depending on the interest rate environment. Most of the time, since this fund launched, was in a period of zero rates, meaning we haven't really seen the ability of this fund shine just yet. We only now have seen it with a materially higher rate environment. As of their last fact sheet , nearly 61% of the fund was invested in floating rates.
The largest allocation here is to bonds and then that is followed by senior loans. From there, they also hold a sleeve of CLO debt. Then, finally, they carry a smaller but still somewhat meaningful sleeve of the riskier parts of the CLO structure, the equity tranches. There, the yields are eye-popping, but so are the potential for losses.
That broader allocation overall was up from the ~53.5% floating rate exposure the fund listed at the end of 2021 .
Going back even further to pre-Covid times as of October 31, 2019 , the fund held even less in floating rate exposure. Although, I wouldn't say it was particularly significantly less.
Naturally, if rates are going to be cut soon, or if management believes they'll be cut soon, they could start shifting their portfolio toward more high-yield fixed-rate investments. Thus 'locking in' these higher yields and providing the fund to retain some of the higher income generation that they've been able to flip to while rates were rising.
That said, from the above, we can see that the fund doesn't go particularly hard one way or another, and while they have the flexibility to incorporate a dynamic approach, they don't do so in an aggressive and erratic way. That could be a positive as you will mostly know how the fund is positioned, but it also could be argued as a negative because they aren't going as dynamically as some might want.
When looking at the credit rating breakdown, the investment grade is just under a 10% allocation. Clearly, this fund is invested heavily toward below-investment-grade or junk-rated debt, as would be expected.
Naturally, the lower the debt, the higher the frequency of defaults . Here's a breakdown of defaults by credit rating category of bonds over the last 15 years (as of June 13, 2023.)
Even in bankruptcy, bonds and loans typically see recoveries, and that means it isn't a complete write-off. So, even as defaults are also on the rise, it isn't all a loss. Loans being higher in the capital stack over bonds means they would be ahead of the line, seeing a higher recovery rate.
According to S&P Global , data from 1987 through 2022 shows first-lien loans have a mean recovery of 71.1% and a median of 80.5%. That drops considerably when you get to the second-lien, with an average recovery of 44% and a median of 30.6%. When it comes to bonds, there is a wide range between senior secured bonds and subordinated bonds. That being said, overall, they list an average of 47.3% for bond and note recoveries.
Like any well-managed portfolio, carrying exposure across a diversified pool helps limit risks. With ARDC, an investor is looking at a total of 218 issuers across 267 different instruments. They listed that at the end of October 2023, the average position size of these holdings would, therefore, come to 0.37%. Of course, that's only the average, and toward the top ten holdings, we'll see heavier weights.
Still, no single position is overly large to where it could take the fund down with them in the case of default or bankruptcy. While recoveries vary wildly, most of the time, there is some recovery in debt instruments. Of course, one has to account for ARDC's leverage and know that those losses are still going to be amplified.
Conclusion
ARDC has benefited from higher rates by having a dynamic allocation that puts a heavier emphasis on floating rate exposure. However, they don't look to be making significant moves in terms of being aggressively tilted toward one way or another. That could be a benefit to some investors, as they'll generally have an idea that ARDC will always remain quite split between fixed and floating instruments. On the other hand, some might not think they are going far enough in their allocations to take advantage of current higher interest rate levels.
In the end, while we had seen the Fed raising rates aggressively, this still remains a relatively young fund in the grand scheme of things. Throughout most of its existence, rates were at or quite near zero. It'll be interesting to see how they employ their flexible approach going forward when we go through the full rate cycle. Naturally, with rates expected to be cut into next year, we should start to see a higher allocation go back toward fixed-rate debt instruments to start 'locking in' these higher rates.
Given the Ares name, they certainly have a strong and capable management team backing them, but that hasn't seemed to have benefited the fund. It is still trading at a deep and attractive discount, which provides potential advantages for investors putting capital to work today.
For further details see:
ARDC: Providing A Solid ~11% Yield