2023-07-16 10:25:59 ET
Summary
- The First Trust Specialty Finance & Financial Opportunities Fund has 93% of its fund invested in BDCs, which have been benefiting from rising interest rates.
- FGB offers a potential opportunity with its own double-digit discount, with its largest holdings invested in top-tier BDCs like Hercules Capital and Main Street Capital.
- FGB should be starting to see the benefit from the underlying BDCs as they ramp up their own dividends to investors, which should improve distribution coverage for FGB's payout.
Written by Nick Ackerman, co-produced by Stanford Chemist.
Business development companies ("BDCs") have been enjoying strong and growing investment income as rates have risen higher. The traditional BDC, in general, carries a portfolio of loans that are primarily based on floating rates. At the same time, they leverage up their exposure through preferred offerings and baby bonds at fixed rates. This allows their portfolio to benefit from the interest rate increase while their debt costs remain relatively steady.
One way to gain that exposure is through First Trust Specialty Finance & Financial Opportunities Fund ( FGB ). While the name doesn't explicitly imply, it's a portfolio dedicated to BDCs, ~93% of the fund is invested in this area. The negligible remainder of the portfolio is allocated to mortgage real estate investment trusts, financial services, banks and insurance companies. All of those categories make up the roughly 7% allocation after BDCs.
One of the main benefits of choosing FGB over investing directly into the BDCs is the discount that the fund is trading at, presenting a potential opportunity with its own double-digit discount that has remained since our last update . In fact, the discount has widened out just a touch since. While BDCs can carry their own discounts, several of FGB's largest holdings are actually invested in top-tier BDCs that command regular premiums, such as Hercules Capital ( HTGC ) and Main Street Capital ( MAIN ).
The Basics
- 1-Year Z-score: -0.76
- Discount: 14.51%
- Distribution Yield: 10%
- Expense Ratio: 1.53%
- Leverage: 13.44%
- 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."
The fund's small size continues to be a risk for larger investors to consider. This is because it generally leads to fairly limited trading volume, making it difficult to accumulate a sizeable position and subsequently would limit the ability to sell off a large position in a hurry.
The fund's own leverage is fairly moderate, but it is important to consider that this is leverage on top of leveraged instruments themselves. Besides potential discount on discount investment opportunities, the other downside here would be the expenses on expenses. BDCs carry their own expense ratios and can often be 3 to 10% or even higher.
Unlike the fixed rates that BDCs generally carry for their leverage, FGB's borrowings are based on floating rates. That's why they've seen their total expense ratio climb from 1.78% to 2.02% in the last fiscal year . This is set to go higher with their next report. They pay a rate of 1-month LIBOR plus 85 basis points. This resulted in the interest rate for these borrowings climbing to 4.76% near the end of the last fiscal year from 0.95% earlier before the Fed began raising rates.
Performance - Attractive Discount Remains
There is a point where higher rates can become damaging, which is, after all, what the Fed wants to do to slow down the economy. This is something to consider. However, we don't appear to be at that level yet, as the economy continues to remain resilient even with these higher rates. The result has been rather strong results through the first half of the year for the fund. As long as the economy remains resilient, the underlying BDCs should continue to provide an attractive place to put capital to work.
The fund's discount has come off some of the lowest levels it touched most recently, but it remains well below its historical level.
Ycharts
Discount widening across the board has taken place with closed-end funds in general. This could be because retail investors continue to remain cautious and remain weary of the leverage they employ in this uncertain market. 2020 is still fresh enough in most investors' minds that FGB was one of the funds that had it particularly rough and was a fund that had to deleverage. They took borrowings down from $25 million to $6.5 million. They have since bumped it back up to $8.6 million.
Deleveraging in times of panic is one of the key reasons why the fund had never reclaimed its pre-Covid levels, nor do I suspect it will overtake that level again.
Ycharts
Still, that doesn't mean total returns can't be attractive when including distributions going forward. Case in point, the fund has provided solid results since the crash.
Overall, I think it's fair to suggest that some wider discount level would be appropriate, but the current level still suggests excessive discounting is taking place.
Distribution - Coverage Likely Improving
During the Covid crash, the fund had cut its distribution. However, there was also a distribution cut just before Covid began too. That's likely another culprit that's contributing to the fund's larger discount post-cut than the premium it often flirted with prior to the cut.
Since our last update, the fund hasn't posted any new financials to glean new information from in terms of the coverage of the distribution. That means we would still be looking at the fiscal year-end 2022 report.
FGB Annual Report (First Trust)
While BDCs have been benefiting from growing income streams due to higher yields on their loans, we should anticipate that to trickle through to FGB at this point. Unlike the BDCs themselves, this rising income from higher interest rates isn't automatic - the underlying BDCs in FGB's portfolio itself have to increase their dividends before seeing the higher income bump for FGB. That's why we saw only a flat year-over-year net investment income for this fund in the above report. I fully expect the next report to show a sizeable increase in distribution coverage as BDCs have begun passing the higher cash flows to their investors.
For tax purposes, we would typically expect most of the distribution to be classified as ordinary income. The fund has classified a portion as return of capital in the last couple of years. Still, with such a large classification of ordinary income, a tax-sheltered account appears to be the best account to consider holding FGB.
FGB's Portfolio
Turning to the fund's portfolio, we can see that the overall weighting of the fund's holdings has remained fairly consistent in terms of the asset breakdown.
FGB Asset Exposure (First Trust)
This consistency is also the case with the fund's largest holdings. Some changes have come simply due to normal market gyrations as prices swing around. In fact, we only see one position different in the top ten, the Blackstone Secured Lending Fund ( BXSL ), and we don't see OFS Capital Corp ( OFS ). As of the last N-PORT filing , OFS was still listed as a position as of February 28th, 2023.
FGB Top Ten Holdings (First Trust)
The BDC space isn't that massive, so having a sizeable weighting in the fund to some of these positions isn't unusual. That's why we see a relatively concentrated ~67% of the portfolio in the top ten alone.
BXSL has been on a strong run, and seeing it climb into one of the top spots isn't that unexpected. YTD, BXSL has been the top performing in terms of price increase compared to these other top ten. The only other name that came close to it was HTGC.
Ycharts
However, while Blackstone ( BX ) is certainly a famous alternative asset manager with some solid backing and a reputable name, it might not be as strong under the surface as this move implies. This is because while it has definitely delivered a solid underlying performance with its portfolio in the top half of its peers, its NAV performance has ranked quite a bit lower than its share price results. Here is what CEFData shows for BXSL:
Note that it is the fourth-best-performing BDC on a share price basis YTD. If we look at the NAV rank, though, it drops down to the fourteenth best-performing. NAV performance for BDCs can be a bit tricky since it's only based on the last reported NAV; it then factors in the distributions that a BDC has paid out to determine the total NAV results. We are right on the verge of getting all the new quarterly reports and updated NAVs for BDCs as they report their results. So these rankings can shift, and we will likely see that happen over the next month as new reports start coming in.
As I said, these are still solid results. It's a relatively newer BDC that has become popular. Unfortunately, most of this move has come from the fact it was trading at a deep discount to start off this year, and it's now run into a premium. It simply means that they hopefully have the results in their underlying loans to back up the results that shareholders have assigned it.
BXSL Discount/Premium to NAV (CEFData)
Admittedly, the BDC had traded at an even richer premium out of the gate, so it certainly could return to that level as well - or even higher, as we often see HTGC and MAIN. Only the future will tell for that. While we are on the topic of BDCs and BXSL more specifically, we can also use this one as an example of why we should see higher income for FGB going forward. BXSL has been a huge booster in terms of its dividend over the last year or so. The latest payout is at $0.77 compared to last year's Q3 dividend of $0.60, representing a 28.33% increase.
MAIN is another regular raiser, but it also represents how higher rates have been benefiting them. Their latest monthly dividend comes to $0.23, and that's over the $0.215 paid a year ago. These are fairly small numbers, but in terms of a percentage, that's looking at a nearly 7% increase from a year ago. That was an increase in the pace of increases from the Q3 2022 vs. Q3 2021 increase that was closer to 4.9%.
They have also regularly been paying supplemental again, and those have been increasing. They are up to $0.40 in supplementals paid in 2023 so far, above the $0.35 seen in 2022.
Conclusion
FGB should be benefiting from strong dividend increases seen across the board from its underlying BDC holdings. That should generate better distribution coverage, and it could lead to a potential increase in the payout itself if it remains in this trend. At the same time, the fund sports an attractive discount that could be worth considering to provide potentially outsized returns if that discount can contract.
For further details see:
FGB: Basket Of BDCs At A Discount