Summary
- FGB has become an interesting fund to trade on occasion when larger-than-usual discounts open up.
- Recently, we've seen that discount open up once again to over 13%.
- The fund could also continue to benefit from rising interest rates due to the underlying portfolio being heavily invested in BDCs.
- That being said, an anticipated recession later this year could present a significant risk going forward.
Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on February 20th, 2023.
For most of my portfolio, I hold positions that I feel I can hold for years at a time. However, I view a select few funds as more trading candidates. One of those names is the First Trust Specialty Finance & Financial Opportunities Fund ( FGB ).
This fund has offered opportunities for investors to pick it up at cheap discounts and sell it at reduced discounts. My most recent trip with FGB was buying on July 7th, 2022, at $3.25. I then unloaded it on November 22nd, 2022, at $3.40. While that wasn't necessarily a large play on its own, there were also two distributions of $0.0825 picked up during that time. The discount when I bought it was nearly 14%, and when I sold was the day after the discount touched 4.51%. However, it moved quickly that next day, and I couldn't offload it at that discount—still, not a terrible result for four months.
These trading opportunities began happening after the 2020 collapse. What makes FGB more of a trading CEF rather than a longer-term hold is how precarious things can get during market collapses and bear markets.
Now that shares are trading over a 13% discount once again, it's on my watchlist. They hold a portfolio of business development companies, which should continue to benefit from rising interest rates. However, I believe we are nearing the end of interest rate hikes. If we get the anticipated recession later this year, that could even cause rate cuts. So that will be a risk in the future, depending on the holding time frame.
The Basics
- 1-Year Z-score: -0.93
- Discount: 13.18%
- Distribution Yield: 9.82%
- Expense Ratio: 1.53%
- Leverage: 13.40%
- Managed Assets: $64.187 million
- Structure: Perpetual
FGB has an investment objective to "seek a high level of current income. As a secondary objective, the fund seeks an attractive total return." To achieve this, the fund will "invest, under normal market conditions, at least 80% of its managed assets in a portfolio of securities of specialty finance and other financial companies that the Fund's sub-advisor believes offer attractive opportunities for income and capital appreciation."
A risk to note here is the fund's incredibly small size. That generally leads to a lack of trading volume. That would essentially leave larger retail investors out if they wanted to use it as a trading vehicle, which is what this fund is more appropriate for, in my opinion.
The fund carries a moderate amount of leverage, but the underlying BDCs being leveraged should also be factored in. The fund's expense ratio moves up to 2.02% when factoring in the leverage expenses. BDCs play a role in the fund's expenses but aren't visible.
This is because, like traditional CEFs, BDCs have their own expense ratios too. These are often higher, between 5% and 10%. Unlike the VanEck Vectors BDC Income ETF ( BIZD ), FGB doesn't have to include "acquired funds fees and expenses." However, we can see that the net expense ratio for BIZD comes to 10.92%. So that can give us some color on the expenses of the BDCs.
Now, just like traditional CEFs, it's important to remember that leverage costs are a huge factor in these monster expense ratios. As long as they earn above the leverage costs, it is beneficial for investors and essentially pays for itself.
Besides amplifying results to the upside and the downside, leverage comes with a cost. Their borrowings are based on a floating rate, which averaged 2.30% in the last fiscal year. To truly understand the change that rates have had though, the borrowing costs finished with a 4.76% rate. Since interest rates have increased since their fiscal year-end, November 30th, 2022, we know that borrowings have also increased.
Fortunately, that's where BDC's own underlying holdings can be beneficial. BDCs often invest in floating-rate senior loans and borrow at fixed rates. This means they can benefit from increased interest rates without experiencing the full brunt of higher interest rates in their leverage costs.
Performance - Wild Ride
Part of the reason for FGB being such a volatile fund is because of the leverage-on-leverage aspect. They invest primarily in BDCs, which are highly leveraged on their own. Then despite the fairly moderate leverage put on top of FGB, it still makes the fund highly susceptible to large drops.
During GFC, right after it launched, was, in particular, telling of the problems. Had you bought at inception, at this point, you still wouldn't have made a positive return despite all the distributions along the way.
Deleveraging out of these market crashes also means that any rebounding would be more difficult. In 2020, they went from $25 million in borrowings down to $6.5 million.
The fund's discount/premium only exaggerates these drastic moves during market panics and crashes. Until the fund cut its distribution in 2020, it enjoyed trading at a premium.
Once again, this is where the underlying holdings also come into the picture. BDCs trade at their own discount/premiums to their net asset values. During market panics, we generally see discounts widen out in CEFs and BDCs. Thus, a fund like FGB can also get hit with the advantage of discounts on discounts.
The deeper discount for FGB seems here to stay now but also shows us that it's near the bottom of its newer range—at least the bottom of times when we aren't in market panic mode.
BIZD Comparison
One way to avoid the added leverage and discount/premium volatility goes back to BIZD. This is a non-leveraged (on the portfolio level) passively managed ETF. Due to their creation and redemption mechanism, ETFs rarely trade at discounts/premiums. If they do, it's generally at shallow levels or for short periods. Over longer periods of time, the benefit can certainly be seen if one is looking to hold a basket of BDC exposure passively.
However, coming out of those market panics, we can see the benefits of being brave enough to take a plunge. This results from the performance between the funds from the March 23rd, 2020, low to three months later.
You'd have to be fairly lucky to see an opportunity like that. However, going back to my real-life example above also shows how it can be exploited during short periods too. FGB mildly underperformed BIZD during the time I held, but thanks to discount contraction, the actual share price performance during that time was our opportunity.
(Author Note: As I said above, I couldn't get the position offloaded at the high price during that time, my returns were 9.70% - not the nearly 12% listed above.)
Trading instead of investing does involve a little bit of luck and timing. This is difficult to do regularly, so I concede that it comes with a lot greater risks. During the October market lows, the actual result was inferior to holding BIZD. Had we dived further into bear market territory instead of bouncing since then, the results could be disastrous, as history has shown us.
Distribution - Fairly Safe
Since I view this one as more of a trading fund, the distribution discussion isn't nearly as important. I wouldn't plan for holding years at a time, so coverage in the payout isn't too concerning.
That being said, the fund's distribution rate comes to 9.82%; on a NAV basis, this works out to 8.53%. They pay quarterly, which some investors don't find appealing.
When looking at the distribution coverage in the fund's last report, it should seem fairly safe at this point. We aren't seeing 100% of the fund covered through net investment income, so some capital gains would be required to fund the distribution fully. NII coverage in the prior fiscal year came to almost 80%.
I believe it's fairly safe at this point because many BDCs have been raising their own distributions as they benefit from these interest rate increases. Even if the costs of FGB's leverage are rising, it's been mostly offset by these increases.
If you hold FGB over longer periods where the distributions make up a meaningful amount, then the tax classifications are important to consider. In the last two years, the majority of the distribution was classified as ordinary income.
This will be the case because BDCs invest in loans that pay interest, which gets taxed at ordinary income rates. Those then get passed onto FGB and out to its own shareholders. Thus, in most years, the fund should be distributing distributions taxed at ordinary income rates.
FGB's Portfolio
The overall BDC space isn't excessively large. BDC Council mentions 57 publicly traded BDCs in existence. FGB isn't barred from investing in other financial exposure, such as mortgage REITs or diversified financial services. However, as long as I've followed the fund, most of the portfolio was tied to BDCs.
By the fund investing in mostly BDCs, they become fairly limited in terms of options they can invest in. According to CEFConnect, they listed 30 total holdings. Most of the portfolio is invested in their top ten holdings alone at over 63%.
However, since these underlying BDCs also contain their own portfolios, each contains dozens or even a hundred of their own underlying exposures.
Ares Capital Corp ( ARCC ) is the largest BDC by assets and the largest exposure for FGB. Often considered a top-tier BDC along with Main Street Capital ( MAIN ), which also makes its way into the top holdings list for FGB. MAIN is the seventh-largest BDC by asset size
MAIN is a name that regularly trades at a premium; it only becomes larger and larger through accretive at-the-market offerings and secondary share offerings. Although, to be fair, ARCC has kept right up on its heels despite not trading at nearly the same elevated premium.
ARCC and MAIN are probably what you think about when you think of a traditional BDC. However, Hercules Capital ( HTGC ) is another name that's quite popular, at least anecdotally from what I've picked up through Seeking Alpha comments.
This BDC is a bit different, focusing on venture lending and working with "innovative entrepreneurs and their venture capital partners." This can make it a bit more volatile but potentially offer greater rewards. 2020 through 2021 saw this play out as venture capital was all the rage.
However, that performance came crashing down in 2022. We can see how this played out for HTGC compared to ARCC and MAIN over the last decade. Certainly, still an impressive result, and more recently, HTGC has been pulling away significantly again.
HTGC has a track record of trading at some impressive premiums as well. In fact, more recently, it appears to have been surging higher. That is the sort of surge that gets reflected in the above total return results we saw when comparing the three names.
While you're not getting discounts on discounts for FGB, you are getting a discount on the FGB level for exposure to these higher-quality BDCs. Still, they also hold some of what could be considered lower quality too. That's always the trade-off for investing in CEFs/ETFs or any fund. One gets diversification, but it also means you get some of the good with the bad.
ARCC, MAIN and HTGC are all examples of BDCs raising their dividends. Their also examples of paying out specials or supplementals quite regularly too. However, they aren't alone, as most BDCs have been doing the same, including all of FGB's top ten holdings. Of course, this is the normal operating procedure for MAIN, which has never cut its distribution and has only increased. ARCC is close, but they cut after the GFC, which I don't think detracts from their otherwise sterling track record.
Conclusion
While I tend to gravitate towards designing my portfolio around holdings I can hold for years, several funds can offer opportunities for trading. They require more timing and luck, which can mean more risk. I believe FGB is such a fund, and the current discount could present such an opportunity. Interest rates are expected to continue to rise, at least a bit further from here. Thus, the underlying BDCs should continue to perform well in this environment. The main risk comes from the leverage on leverage and the potential depth of a recession should it rear its ugly head later this year.
For further details see:
FGB: Back In Deep Discount Territory