Summary
- The latest semi-annual report shows FRA had covered its distribution in the last six months.
- That was from the prior reporting period, when they had trimmed the payout.
- As a floating rate fund, future NII could increase, and that should bode well for coverage and a chance for an increase in the distribution.
Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on August 30th, 2022.
BlackRock Floating Rate Income Strategies ( FRA ) had their latest semi-annual report showing some good results in terms of distribution coverage. However, it was primarily a result of the reduced distribution from the previous reporting period. The annualized income generated in the latest report was only a slight increase.
On the other hand, with primarily floating rate exposure, the fund's income is set to continue to increase. That should bode well for investors as the distribution's cut could be reversed, seeing increases in the coming years. On top of this, the fund's current discount is quite attractive. Though not quite the 13%+ discount we saw in our last update .
The Basics
- 1-Year Z-score: -0.64
- Discount: 7.04%
- Distribution Yield: 6.59%
- Expense Ratio: 1.17%
- Leverage: .0.16%
- Managed Assets: $643.3 million
- Structure: Perpetual
FRA's investment objective is "to provide shareholders with high current income and such preservation of capital as is consistent with investments in a diversified, leveraged portfolio consisting of floating-rate debt securities and instruments."
To achieve this investment objective, "at least 80% of its assets in floating rate debt securities, including floating or variable rate debt securities that pay interest at rates that adjust whenever a specified interest rate changes and/or which reset on predetermined dates." As is typical with these sorts of funds - the portfolio "invests a substantial portion of its investments in floating rate debt securities consisting of secured or unsecured senior floating rate loans that are rated below investment grade."
The weighting towards below-investment-grade will be a function of the type of investments they are making. Junk-rated companies dominate the senior loan fund space. They wouldn't be issuing floating-rate loans if they could help it. That means it can be more sensitive to economic conditions.
The fund's expense ratio in the latest semi-annual report came to 1.17%; when including leverage expenses, it came to 1.76%. Those are the leverage expenses that should rise when rates rise. To give somewhat of an idea, the fund's expense ratio climbed to 2.45% in 2019, at its peak in the last five years. The Fed is expected to be even more aggressive through this cycle, which only gives us a loose guide of what to expect from here.
The 1.76% is also increased from the 1.54% in the previous fiscal year. On the other hand, we have seen NII rise anyway - which we'll discuss more on the distribution. However, that reflects the expectation that variable rates in the underlying portfolio will counteract and overcome the variable rate financing they utilize. That is what we expected to happen, but leverage is leverage. No matter which way you slice it, it increases risks.
Performance - Discount Tightened, Producing Attractive Short-Term Results
Since that last update, the fund extended its sell-off but then participated in the sharp rebound. That produced attractive total return results since then relative to the broader market. A large part of that was primarily from the discount contraction.
FRA Performance (Seeking Alpha)
One thing we highlighted in our last report was that discount widening was a significant factor for such downward performance for FRA. That was particularly hitting the share price. Of course, the impact on the actual NAV was much more limited. However, credit risks are also a factor due to their mostly lower quality rated holdings.
We can see that despite these two big factors working against the fund, it has performed quite admirably relative to the market that is represented by the SPDR S&P 500 ( SPY ) and the Vanguard Total Bond Market ( BND ). These aren't appropriate benchmarks but can give us some context of how the fund is performing. We can see that on the total NAV return basis, in particular, much stronger results.
YCharts
That still means that the fund had some discount widening through the year. However, the upside from discount widening going forward has diminished since our last update. The fund is now close to parity with its longer-running average valuation.
YCharts
Additionally, fears of a deeper recession are back on the table, with Powell saying there will be "some pain." In other words, the Fed is okay with being more aggressive to avoid potentially greater disaster down the road. That likely means the weakest companies (those rated below investment grade) are more precarious.
On top of this, I've brought up a point in other floating rate fund discussions but not in FRA specifically. There is a point where higher rates are detrimental to the underlying holdings. As rates rise, the variable yields also rise. There is a point where rates become too high, which puts these companies in a position where they might not be able to afford the financing.
To counteract that, the hope is that managers would have appropriately selected the underlying investments. They also utilize what I like to call the "buckshot" approach. We see this in many high-yield bond funds, and it is the same here. They invest in hundreds of companies. That way, if a few go under, it doesn't drag the entire fund with it.
Distribution - Fully Covered
One of the bright spots in the latest report is that the fund is now covered its distribution from net investment income entirely. However, that was partially the result of last year's distribution cut.
FRA Distribution History (CEFConnect)
FRA's distribution history is quite standard for floating rate funds. They make quite a few adjustments over the years and can be all over the place. That happens as rates rise and fall. For most of the last decade, they were right around 0%. Therefore, we see some of the lowest payouts during this period. FRA's latest NII coverage came to 101%.
FRA Semi-Annual Report (BlackRock (highlight from author))
If we annualized the last six-month figure, that would have worked out to an increase of around 1.3% from the prior period. That certainly isn't anything massive. On a percentage basis, the NII ratio went from 4.76% to 5.04%. On a per share basis, it came in at $0.34 for the six months. That can be compared to the full 12-month period with a per share NII of $0.67.
So things are heading in the right direction on these metrics. With rates set to only continue higher, the chances NII further grows going forward increases. That could result in the distribution rising once again for shareholders.
For tax purposes, we see that most of the distribution will be characterized as ordinary income. This is to be expected from a loan or bond fund, which makes it more appropriate for a tax-sheltered account. Though that does mean one would lose the benefit of return of capital as a way to defer tax obligations.
FRA's Portfolio
The reason why FRA's portfolio can hold up so well is precisely because of the floating rate underlying holdings. That translates into an effective duration of just 0.29 years. With floating rate senior loans as the primary investment, we can see that below-investment-grade credit quality dominates this fund. This is to be expected.
FRA Credit Quality (BlackRock)
Since the last update on the fund, there haven't been massive shifts in the ratings of the underlying holdings. BB and B rated investments slipped to slightly lower allocations while CCC and not rated jumped up a bit. The largest relative change was the cash and/or derivatives category, which went from -3.51% to a positive 0.72%.
According to CEFConnect, FRA holds 448 positions. That is the buckshot approach that I was talking about above. Additionally, the fund invests this across a wide swath of industries and sectors. That can provide even better diversification for the fund. In case of an economic slowdown, some sectors can continue to perform relatively well.
FRA Industry Exposure (BlackRock)
Moving onto the fund's top holdings, we can further see that no position makes up a meaningful overweight allocation over another. Again, that is reiterating basically the buckshot approach to invest in many different companies to spread the risk around. By the time we get to the ninth and tenth-largest position here, we are already sub-1% weightings.
The entire top ten make up around 11.43%. That was only a slight increase from the 11.16% we saw at the end of April 2022. However, the total number of positions had also increased from the 432 CEFConnect listed in the previous report.
Overall, I'd say the fund is positioned just as junky as it was previously, with no material change in the composition of the fund from our previous update.
Conclusion
The fund's discount has narrowed quite materially. Going forward, I would suspect that the fund's performance will rely more on the broader economic outlook and how that changes as we proceed. I don't think we should be looking at further discount narrowing as a meaningful contributor to the fund's results going forward. Instead, if it happens, it could be a bonus.
On the other hand, I don't see it as a material detractor over the long term, either. As we saw recently, during times of panic, it can definitely move to a significant 13%+ discount - but it hadn't stayed there for very long.
With the distribution fully covered and rates still rising, there is a better chance that the fund could increase its distribution at some point. When or by how much is always incredibly difficult to guess for CEFs. They can essentially pay whatever they want, for as long as they want - up until NAV drops to $0.
For further details see:
FRA: Fully Covered 6.59% Distribution, Protection From Rising Rates