2023-10-23 11:33:29 ET
Summary
- BlackRock Limited Duration Income Trust has significantly outperformed bond and high-yield bond benchmarks.
- BLW has a strong distribution yield of 10.4% and a moderate discount to NAV of 5.7%.
- The fund has low interest rate risk and remains a strong investment opportunity.
I last covered the BlackRock Limited Duration Income Trust ( BLW ), an actively-managed, low duration, leveraged corporate bond CEF of limited duration, over one year ago. In that article, I argued that BLW's strong distributions, moderate discount to NAV, and low rate risk, made the fund a buy. The fund has significantly outperformed bond and high-yield bond benchmarks since, as expected.
Since then, BLW's distributions have grown, with yields rising to 10.4%. Discounts have slightly narrowed, but remain reasonably good at 5.7%. Interest rate risk remains as low as ever, which might positively impact the fund if rates remain higher for longer . BLW's overall value proposition remains strong, and so the fund remains a strong investment opportunity.
BLW - Overview and Analysis
Holdings
BLW is an actively-managed, low duration, leveraged corporate bond CEF.
BLW invests in most relevant bond sub-asset classes, including treasuries, investment-grade bonds, mortgage-backed securities, and similar. At the same time, the fund strongly focuses on non-investment grade bonds and loans. The fund currently holds almost 1,600 securities. Diversification seems adequate, but lower than the average bond index fund. Asset allocations are as follows.
BLW is a leveraged fund, with the fund financing 34.5% of its assets with debt.
I find it more intuitive to say that the fund has a leverage ratio of 1.52x. So, for every $1.00 in equity, the fund has $1.52 in assets (and $0.52 in debt). Meaning, for every $1.00 (in equity) that investors place in the fund, they receive income, gains and losses from $1.52 (in assets).
Leverage means outsized distributions and returns from comparatively small investments, but potential losses are quite high too, and interest expenses are a constant drag on performance. The net long-term effect is generally positive on a total-return basis, but more risk-averse investors might be unwilling to stomach the risk and volatility of leveraged funds.
Credit Quality
BLW focuses on non-investment grade bonds and loans, with an average credit rating of B. Credit ratings are as follows.
Securities with these ratings are generally issued by companies with comparatively weak financials and balance sheets. Default rates tend to be higher than average, but not excessively high, in the 2.4% - 3.8% range these past few months.
Companies with credit ratings of B can generally meet their financial obligations right now , but might have issues if economic or industry conditions deteriorate. Higher interest rates are making it more difficult, and more expensive, for some companies to issue new bonds or roll-over their debt right now. Default rates have risen, but remain low on absolute and historical levels.
As BLW's underlying holdings are riskier than average, the fund tends to experience above-average losses during downturns and recessions. These are further boosted by the fund's use of leverage. As an example, the fund was down 16.1% during 1Q2020, the onset of the coronavirus pandemic. Losses outpaced those of most bonds and bond sub-asset classes, but were marginally lower than those of equities.
BLW's weak credit quality and above-average losses during downturns and recessions is a significant negative for the fund and its shareholders. Although I don't think these risks or losses are excessive, more risk-averse, conservative investors might disagree.
Interest Rate Risk
BLW focuses on term loans and high-yield corporate bonds, two sub-asset classes with comparatively little duration or rate risk. Some context first.
Most bonds have fixed rates, and so see lower prices when the Federal Reserve hikes rates. As an example, 10Y treasuries currently yield 4.8%. If the Fed were to hike rates to 10.0%, existing 10Y treasuries would maintain their 4.8% rates until maturity. Investors would almost certainly react to such scenario by selling their low-yielding treasuries to buy newer, higher-yielding securities, especially t-bills.
High-yield corporate bonds have low rate risk, as these securities generally have short maturities, and so investors are only stuck with low rates for a relatively short amount of time. Investors in longer-term securities must wait longer, increasing selling pressure.
Term loans have extremely low rate risk, as these are variable rate securities, and so see higher coupon rates when the Federal Reserve hikes rates. In most cases, investors only have to wait one quarter for their coupons to reset after a Fed hike. Investors in longer-term securities must wait much longer, increasing selling pressure.
BLW itself sports a duration of 3.8 years, quite low on an absolute basis, and much lower than average.
BLW's low rate risk benefits investors in two ways.
First, it allows the fund to outperform when rates rise, as has been the case since early 2020.
Second, it means significant, swift income growth when rates rise. Distributions should grow too, but as CEFs have managed distribution policies, this might not necessarily be the case. BLW's distributions have grown 10.0% since early 2020.
Growth was much lower than expected, probably because the fund chose to prioritize higher distribution coverage ratios / retaining capital over distribution growth. Do remember, higher income benefits investors even if it does not result in distribution growth (the extra income does not disappear).
As a final point, although further significant rate hikes are unlikely, the Fed might decide to keep higher rates for longer, which should have a broadly similar effect to hiking rates.
Distribution Analysis
BLW's underlying holdings generate significant, above-average income, for two reasons.
First, the fund focuses on non-investment grade bonds and loans, which tend to sport above-average yields.
Second, the fund's term loans have seen very significant, swift increases to their coupon rates due to Federal Reserve hikes.
BLW's significant generation of income is partly reflected in the fund's strong 10.4% distribution yield. For reference, the average bond yields 4.3%, while the average high-yield corporate bond yields 6.0%.
BLW's significant generation of income is partly reflected in the fund's high 94.7% distribution coverage ratio. Several CEFs, including most BlackRock income CEFs, have seen their distribution coverage ratios decrease as bond prices / NAVs plummet. BLW has seen higher income, and higher coverage ratios instead.
BLW's strong, growing, covered 10.4% distribution yield is a significant benefit for the fund and its shareholders, and core to its investment thesis.
As an aside, do remember that CEF distributions are sometimes unsustainable, so looking at their coverage ratios, underlying generation of income, market and industry conditions is of utmost importance. Knowing how Fed hikes impact BLW's term loans is probably more important than knowing its distribution yield, as the latter ultimately depends on the former.
Performance Track-Record
BLW's performance track-record is quite good, at least on a relative basis. The fund consistently outperforms most bonds and bond sub-asset classes on both a NAV and price basis, generally by healthy margins.
Returns for the past year have been quite strong, as interest rates stabilized, and due to prior Fed hikes. Prospective returns are quite strong too, assuming no significant rate cuts or deterioration in economic conditions.
Long-term returns were much lower, as rates were much lower in the past. Economic conditions are much different now, so I don't believe these figures to be all that relevant for investors moving forward.
Medium-term returns are quite mediocre, as rates were at zero from 2020 to 2021, and bond prices collapsed in 2022. It has been a tough couple of years for bonds, and fund returns reflect that.
In my opinion, BLW's overall performance track-record is reasonably good. At the same time, the fund's shorter-term returns are more reflective of the returns that investors should expect moving forward. Much will depend on future Fed policy, however.
Discount Analysis
As a final point, the fund currently trades with a 5.7% discount to NAV, about average for the fund.
Conclusion
BLW's strong distributions, moderate discount to NAV, and low rate risk, make the fund a buy.
For further details see:
BLW: Leveraged High-Yield Bond CEF, Strong 10.4% Yield And Performance