BCAT: May Benefit From Future Interest Rate Cuts (NYSE:BCAT)

georgeclerk Overview I always valued the income aspect of investing because it has always made it a lot easier for me to stick with my investments over the long term. Receiving a growing stream of income on a monthly basis that can then be either spent or reinvested into my portfolio has helped build my confidence level as an investor. Market drops seem to matter less because no matter what the portfolio value looks like, the income tends to grow over time. As a result, I started seeking out high-quality asset classes that could satisfy my hunger for a higher yield. BlackRock’s Capital Allocation Term Trust (NYSE:BCAT) sports a large yield of 21% and issues its distributions on a monthly basis. BCAT operates as a closed end fund that has a primary objective of providing a total return comprised of a combination of current income, current gains, and long term capital appreciation. They aim to achieve this through their portfolio of different equity and debt-based investments. The large yield is also supplemented by the fund’s inclusion of an option writing strategy that can collect premiums from the options it writes. The fund has a very recent inception, dating back to 2020, and I think this makes it a bit unique. BCAT hasn’t really had the chance to operate under ‘normal market conditions’ and I will build on that later in the article. Data by YCharts We can see that BCAT’s price has fallen about 19% since inception a few years ago. However, the high distribution rate has helped to offset this and provided total returns nearing 12% over the same period. I think that future interest rate cuts will provide BCAT with a better environment into the future, and I will be looking to capitalize on this. Lower interest rates should provide a more ideal environment for the BCAT’s portfolio to thrive. BCAT is managed by BlackRock Advisors and has a reasonable management fee of 1.25%. BCAT is a bit of a unique fund, so let’s first start by assessing the portfolio strategy used here. Portfolio Strategy BCAT’s portfolio maintains exposure across equities and fixed income securities. According to the latest data on their fund page, 54.78% of net assets are in equities and 42.62% are in fixed income vehicles. Focusing on the equities portfolio first, the portfolio remains diverse with a very healthy balance across sectors. Information technology accounts for the largest slice of this area of the portfolio, making up 13.44% of net assets. This is followed by exposure to the financials and health care sectors, accounting for 8.16% and 7.08%, respectively. This focus on diversity helps mitigate any sort of sector concentration risk, and I like the fact that it maintains some exposure to tech. The tech exposure is nice to have since companies within this sector typically experience more growth and this can help BCAT capture more upside capital appreciation during bull markets. In bear markets, the more dividend focused sectors like consumers, industrials, and energy are a great counterweight that can offset negative price movements. BlackRock According to the fund’s most recent fact sheet, tech companies make up the largest portion of top holdings. Microsoft (MSFT) is the largest equity position, accounting for 3.07%. This is followed by popular companies such as Amazon (AMZN) making up 2.02%, NVIDIA (NVDA) at 1.53%, and Alphabet (GOOG) at1.23%. I have no gripes about the equity portion of the portfolio and am very happy with the level of diversity and weight allocation across holdings. No one specific holding is much larger than the other, and the diversity is great. Moving onto the fixed income portion of the portfolio, we can see that the credit rating breakdown shows a majority of not rated investments. While we have no indication of how risk adjusted these investments are, we can reference the fact that a large portion of these investments fall in the ‘below investment grade’ rating category. Typically, anything rating BB and below is considered below investment grade, and we can see that approximately 11.4% fall here. While these can hold more risk of default since they are lower rated, they can also yield higher returns. BCAT Fact Sheet Looking at their portfolio breakdown, the largest area of focus for the fixed income portfolio is the exposure to UMBS 30 Year TBA Futures. UMBS stands for uniform mortgage backed securities that span across a portfolio of 30-year residential mortgages. However, the exposure here sits at 8.7%, which I believe to be a small piece of the overall net assets of BCAT. It can be difficult to determine what exactly is inside these securities because the details of the specifics that are bought and sold are ‘to be announced’, as indicated from the TBA in the title. BlackRock Lastly, BCAT implements a single stock covered call option writing strategy here. What I really like about this is that the options implemented are typically ‘out the money’, which allows for a greater upside capital appreciation. This is unlike most covered call strategies that are ‘at the money’ which typically have a greater restriction on the upside price appreciation that can be captured. To illustrate this, BCAT’s annual report provides a specific example that I find useful to share. The information below can be spotted on page 6 of the report. (1) Assume a common stock purchased at and currently trading at $37.15 per share. (2) a three-month call option is written by a Trust with a strike price of $40 (i.e., 7.7% higher than the current market price) (3) The Trust receives $2.45, or 6.6% of the common stock’s value, as a premium. If the stock price remains unchanged, the option expires and there would be a 6.6% return for the three-month period. If the stock were to decline in price by 6.6% (i.e., decline to $34.70 per share), the option strategy would “break-even” from an economic perspective resulting in neither a gain nor a loss. (4) If the stock were to climb to a price of $40 or above, the option would be exercised and the stock would return 7.7% coupled with the option premium received of 6.6% for a total return of 14.3%. Under this scenario, the Trust loses the benefit of any appreciation of the stock above $40, and thus is limited to a 14.3% total return. I believe that this perfectly explains the concept of covered call strategies and exactly why the upside is capped. At the money option strategies typically set a strike price much closer to the current trade price of the underlying asset. Therefore, I think BCAT’s strategy is much more beneficial for investors that also want the ability to capture the possibility of high capital appreciation. Dividend & Financials BCAT is a great income investment for retired investments because of the monthly distributions. This monthly distribution adds a bit of flexibility and can be useful for investors that depend on the income generated from their portfolio. The good news is that the distribution was recently increased by a very slight 0.1% to $0.2869 per share. While the history is short, it is also very consistent so far. We can see that the distribution has never been reduced since the fund’s inception and has been trending in the proper upward direction so far. Seeking Alpha The question going forward will be how sustainable this distribution rate will be? Well, a quick look at the 2023 annual report reveals that the distribution is typically comprised of both net investment income and net realized gains within the portfolio. Net investment income totaled $0.55 per share, while net realized gains landed at $1.37 per share. This resulted in an increase of $1.92 per share, which fully covered the annual distribution amount of $1.51 per share. BCAT 2023 Annual Report However, some investors may also notice that despite being funded by gains and net investment income, the distribution includes some return of capital. Return of capital amounted for $0.93 per share for the full year of 2023. While this can be harmful when used excessively during years of negative earnings, I do not see it as an issue so far. Despite the return of capital being implemented here, the NAV (net asset value) at the end of the year still showed an increase up to $17.25 over the prior year’s total of $16.84. Ultimately, if the NAV continues to grow, then it indicates that BCAT is retaining enough of the earnings and is not distributing too much out as a dividend. While it is true that the NAV has decreased between 2020 and 2022, I believe that the unusual market conditions may have contributed to this performance. I would like to see how BCAT performs under more ‘normal’ market conditions. While I realize that there may not be such a thing as ‘normal’ conditions, I want to see how BCAT’s NAV will grow under a period where we aren’t in a post pandemic world and the interest rates aren’t being aggressively hiked to their decade high. Additionally, the return of capital classification can simply be a way to categorize the income that was produced from the option strategy implemented here. It can be a bit difficult and unclear on how to separate the two forms of ROC, but if the NAV continues to grow, then we have nothing to worry about. I also like the fact that BCAT can strategically retain earnings on very strong years as a buffer for any underperforming years. BCAT Section 19a Notice Looking at the most recent section 19a notice reveals that most of the distribution has been classified as return of capital. On a positive note, return of capital distributions typically have better tax treatment than ordinary dividends. Therefore, a holding in BCAT may actually be suitable based on your circumstances. Lastly, I want to mention the dividend reinvestment benefit that I spotted in the annual report. If BCAT’s NAV is less than 95% of the market price, reinvested distribution will be issued at 95% of the market price, otherwise a 5% discount. Valuation In terms of valuation, since BCAT operates as a closed end fund, we are capable of seeing the price to NAV relationship over time. At the moment, BCAT trades at a slight 5.6% discount to NAV. While this isn’t as attractive of a discount as the average 11.6% that the price has traded at over the last three years, I still believe that it can be an attractive entry point for new shareholders such as myself. CEF Data My thoughts here are that BCAT never really had the chance to operate under normal market conditions. When the fund started in 2020, we were in the midst of the global pandemic that had markets in elevated levels of uncertainty. The unemployment rate was skyrocketing at the time, and no one really knew which direction the stock market or housing market would go. As a way to stimulate the economy, the Fed cut interest rates to near zero levels. As we can see below, BCAT has reacted negatively to the change in interest rates. Data by YCharts As soon as the Fed announced plans to begin hiking interest rates, BCAT’s price retracted to the downside. This likely effected the portfolio of fixed income holdings the most, since this area of the portfolio is already most rated as below investment grade. While I could not locate a transparent way of seeing into the rate of defaults within the portfolio, we can assume that higher interest rates likely increased the stress of these holdings. Higher interest rates directly correlate to higher interest payments for debt focused investments. Higher interest rates can also put higher costs of strain on operations, and I believe that this is why we’ve seen BCAT react this way to higher rates. However, I believe that the tide will be turning soon for these higher interest rates and a cut will be upcoming. For example, the unemployment rate now sits at 4.3% and has consistently trended upward over the last twelve-month period. At the same time, inflation levels have consistently trended downward over the last several months and now sits at the 3% level, which is getting closer to the Fed’s 2% target. Lastly, we have the US Presidential elections upcoming and this may cause higher levels of volatility and uncertainty in the markets. The combination of these facts may be enough of an incentive for the Fed to begin cutting interest rates. Vulnerabilities & Risks There is an ongoing drama with Saba Capital Management, an activist hedge fund, that wants to make changes to improve shareholder returns. Saba wants to improve performance so that the current discount to NAV can be reduced, and aims to get this done by essentially replacing board members and altering the investment strategies implemented. There have been ongoing proxy battles that rage on, and this may cause some price suppression as they continue. This can affect performance in the short term and create some levels of uncertainty as things play out. We haven’t been made aware of what the proposed changes in strategy are, but the feud presents a level of vulnerability. Additionally, the inclusion of an option strategy here does cap the upside potential. While not as strong as the cap on at-the-money call option strategy, the upside is still limited here. Therefore, if you are an investor who is looking for a bit more capital appreciation, BCAT is definitely not the fund for you as the main goal here is to generate income. Therefore, the main risk here would be underperformance when compared against the underlying assets within, as we can see from the chart below. Data by YCharts The future growth of BCAT is dependent on whether or not management can successfully grow the fund’s NAV over time. The NAV per share decreased between 2020 and 2022 due to changing market conditions, and there’s a chance that NAV may fail to grow going forward. Suppose we see a scenario where interest rates are, in fact, not cut, and we remain in an elevated rate environment. Even worse, if interest rates were to get increased once more, we may see prices retract further to the downside. The longer we experience higher interest rates, the higher the probability that we begin to see some of the income investments within the portfolio default, since BCAT contains exposure to below investment grade loans. Additionally, if NAV fails to grow, then I assume that BCAT may continue to use return of capital as a way to compensate for the distribution. Prolonged use of return of capital may be destructive for the fund’s NAV if the underlying assets aren’t earning enough in net investment income or the managers aren’t capturing enough realized gains. Therefore, the high distribution rate could ultimately be stealing from the fund’s long-term return potential during periods of underperformance. The markets have retracted in the past week as confidence in the US economy gets weaker. While data such as a rising unemployment rate can get us closer to the possibility of interest rate cuts, it can simultaneously get us closer to the possibility of the US going into a recession. This may affect markets and also contribute to further downside of BCAT. Takeaway In conclusion, I believe this to be a very opportune time for entry into BCAT. BCAT hasn’t really had a fair shot at operating under normal market conditions since the fund launched following the pandemic and then was forced to operate under higher interest rates shortly after. The fund may have found its footing now, and the catalyst of future interest rate cuts could improve performance. The distribution seems to be covered by a mix of net investment income and net realized gains thus far. I don’t believe the use of return of capital has been too damaging to the fund so far, and the decreases in NAV were more related to the rapidly rising interest rates that caused a shift in the markets. Therefore, I believe that BCAT may be a good choice for high-yielding income into the future.

Buy cryptocurrency

Source link

Refer And Earn Demat Account – Get ₹300 | Referral Program

Open Demat Account In Angel One For FREE