2023-09-12 15:49:56 ET
Summary
- BANX experienced a significant drop in May, which continues to leave an opportunity for investors to buy at a deep discount as only a partial recovery took place.
- The fund's NAV has remained stable throughout the year, and its portfolio is exposed to floating-rate fixed-income securities.
- The fund's distribution yield is 10.83% after a recent raise and is fully covered by a significant margin, which should lead to a potential year-end special.
Written by Nick Ackerman, co-produced by Stanford Chemist.
When the banking fiasco hit the market, ArrowMark Financial Corp ( BANX ) dropped before recovering. Following this recovery in early May, BANX saw a deeper plunge, even larger than the March banking crisis plunge. This was on unusually high volume of nearly 18x the average daily volume.
Whether this was a margin call or some investor just trying to dump whatever they could is unclear; however, it created an opportunity for other investors to jump into this fund. The fund is also quite small, so volume is limited, which can cause some interesting volatility.
While there was a swift recovery following that significant drop, it hasn't quite got back to where it was trading previously. What is perhaps more unusual about all of this is that the NAV per share of this fund had hardly moved at all through this year - even during the months when we saw the large drops in the share price.
They report a monthly NAV, so it can make some investors a bit anxious between each update, but this year, it's been fairly steady. The fund has even been able to participate in rising interest rates due to most of its portfolio being exposed to floating-rate fixed-income securities. I believe that the fund's large discount still represents an opportunity for investors to gain exposure to this uniquely positioned fund.
The Basics
- 1-Year Z-score: -1.09.
- Discount: -22.65% (based on 7/31/2023 estimated NAV).
- Distribution Yield: 10.83%.
- Expense Ratio: 4.16%.
- Leverage: 24.20%.
- Managed Assets: $202 million.
- Structure: Perpetual.
BANX's primary investment objectives are "income generation, capital preservation, and providing total risk-adjusted returns."
To achieve these investment objectives, they will invest in "banking-related assets across the spectrum of community banks to global money center banks. The company invests across asset classes, including term loans, structured debt, regulatory capital relief securities and, to a lesser extent, equity. Under normal circumstances, we intend to invest at least 80% of the value of our net assets plus the amount of any borrowings for investment purposes in these assets."
The fund is leveraged, and that means any moves will be amplified in both up and down markets. That being said, we've seen the fund's NAV remain rather stable and even trending higher through this year. In the last two years, the fund has deleveraged from $60 million in borrowings at the end of 2021 to $55.6 million at the end of 2022. As of their last semi-annual report, total borrowings on their revolving credit agreement stood at $48.9 million. This wouldn't appear to be forced deleveraging but management taking down borrowings of their own volition.
Still, borrowing costs have been rising as their credit facility is based on SOFR plus 2.85%. When including borrowing costs, the fund's total expense ratio comes to a rather high 6.51%. The rate of their borrowings certainly doesn't help, but neither does the 1.75% advisory fee. Despite this, rising interest rates have helped boost the income generation of the fund, as we'll discuss more below. Additionally, it isn't that unusual to see higher expenses such as these when you get into the murky fringe areas of the investing world.
Performance - Deep And Attractive Discount
The last time we covered the fund, it just so happened to be on May 4, 2023. That was the day of the largest plunge, but the share price had been trending lower even prior to this. Given that, we've seen a really strong performance since our prior update.
BANX Performance Since Prior Update (Seeking Alpha)
Some of this was the discount shrinking but still remaining deep and attractive at this time. On that day, the discount touched nearly 30% based on its last estimated NAV. The last reported NAV at the end of July 2023 comes to $21.55, putting the estimated discount at nearly 23%.
Of course, as we can see from my prior update before the last one in January of this year, I also considered the fund a 'buy' when it was near a 15.50% discount. That proved to be a poor time to consider the fund as total returns would have resulted in a -4.13% decline. However, that would be entirely from the discount widening and not resulting from poor performance of the underlying portfolio.
YCharts
Historically speaking, this is an incredibly deep discount compared to what the fund is used to experiencing. Not only over the last year, as the average discount for this period comes to around 17.5%, but this fund had even regularly flirted with premiums in 2018 through 2022.
The fund is leveraged, and higher interest rates could be one of the reasons for investors wanting to discount the fund. However, in this case, most of their portfolio is based on floating rate investments - meaning they've benefited from seeing interest rates rise.
June's month-end estimated NAV was $21.29 , meaning we saw the NAV inch higher in the latest report. The NAV to start the year off was at $20.79 , meaning we've seen a trend of a rising NAV through 2023.
Distribution - Growing And Fully Covered
Shortly after writing this update, they announced an increase in their distribution to a quarterly payout of $0.45 from $0.39. This was good for an increase of 15.4%. The commentary has been updated to reflect the increase.
Heading into 2022, the fund had raised its distribution to investors, with another distribution up to $0.45 recently taking place. A large leap and one that looked like it was necessary. The fund also has paid out year-end specials fairly regularly.
I fully expected another special this year, as they are exceeding their distribution in terms of net investment income versus their payout. However, with an increase in the regular, as large of a special may not be expected anymore. They are a regulated investment company, meaning they have to pay out most of the income and gains that the portfolio takes in.
The latest semi-annual report shows us that NII per share came to $1.23, and as a reminder, this is for a six-month period only. Their whole fiscal 2022 saw NII come in at $1.84, which was itself a meaningful bump from the $1.60 seen in fiscal 2021.
Given that the fund had paid out $0.78 in the first half of the year, we are looking at distribution coverage of 158%. If we annualize out the first six months to the full year, we'd see NII come in around $2.46 compared to the old annualized regular distribution of $1.56. This reflects that the growing NII due to floating rate securities has been enough to offset the growing costs of borrowing by a wide margin.
That's why I was confident we would either see the regular bump - which, admittedly, I'm surprised they hadn't done even sooner- or a larger year-end special relative to the last couple of years. In each of the last two years, the fund paid a special of $0.10.
Even with the larger distribution, that would be annualized out to $1.80 or distribution coverage of 137%. Therefore, there is a good chance that a year-end will still be in play.
If the fund doesn't pay out a larger special, it could be looking at some potential meaningful excise tax that it would have to pay. They already paid an excise tax last year of $246,963 . Against the total shares outstanding, that works out to around $0.035 per share. This is not the end of the world, but something that could have been avoided had they paid a larger special.
In defense of funds that have paid excise taxes before, there can sometimes be a good reason to pay those excise taxes to retain more assets. That can make sense if the fund managers believe that they can earn more than they'd have to pay in taxes for shareholders.
The tax classifications for this fund due to investing in fixed-income type assets are regularly going to be classified as ordinary income. That has been the case for the last two years, where the entire distribution paid by the fund was considered ordinary income. That would make this fund more appropriate for a tax-sheltered account.
For the year ended December 31, 2022, the tax character of distributions paid by the Company was $11,702,625 of ordinary income dividends. For the year ended December 31, 2021, the tax character of distributions paid by the Company was $10,502,305 of ordinary income dividends. Distributions from net investment income and short-term capital gains are treated as ordinary income for federal tax purposes
BANX's Portfolio
We've touched on this in the past, but it's always worth mentioning again for investors who may be new to this fund. This fund was taken over by ArrowMark partners in 2020, and they renamed the fund last year to reflect this.
In addition to this takeover and renaming, the fund's investment focus has changed significantly. It was previously a fund that was invested in debt issued by banking institutions, such as their bonds or preferreds; additionally, the fund carried a sizeable collateralized loan obligation investment.
For the most part, BANX's portfolio turnover rate isn't too elevated. In 2020, when they started to transition the fund, it came to a rather high 60%, but it has since moderated to 20% in 2021 and 29% in 2022. In the first six months of 2023, the turnover rate came to 11%.
Today, the overwhelming majority of the portfolio is regulatory capital relief securities.
BANX Portfolio Allocation (ArrowMark Financial)
These securities are pretty much what their name would imply. They are securities issued to provide relief to regulatory capital for banks. That is, banks issue these securities to help "optimize capital levels, reduce balance sheet concentrations, manage lending capacity, and respond to regulatory and/or accounting changes." They are issued by banks, and they retain exposure to these loans but these securities offset some risks by sharing in the losses if the borrowers don't repay their loans.
Most of these will also be floating-rate coupons, which translates into BANX being around 86% invested in floating-rate securities. Unfortunately, BANX doesn't provide too many specifics on its own portfolio. This could be where some of the skepticism comes from and where a large discount could be appropriate. Level 3 securities were around 45% of the portfolio, so about half the fund's value is an estimate. This is either by an "independent third party valuation firm" or "in good faith by the Board of Directors, in accordance with procedures established by the Board..."
However, their quarterly presentations always include much more details on regulatory capital relief securities in general. On one note, they provide that the credit quality is generally "investment-grade/near investment-grade weighted average." They also mention that no security would be issued below B-, but it could slip lower after being issued.
Conclusion
BANX is a unique fund that provides investors with exposure to an asset that most investors wouldn't otherwise have exposure to. The fund has historically shown that it has been able to buck the trend and be a diversifier. On a total NAV return basis, 2022 saw positive results when most other equity and fixed-income assets saw declines. This year, the fund is performing well, too, but the opaqueness of their portfolio could be keeping investors away. Given the large discount of the fund relative to its historical level, I believe this is an interesting fund to consider at this time despite its drawbacks.
For further details see:
BANX: Deep Discount Persists After Drop Earlier This Year