BKT: Dissecting This High-Yield, High-Quality CEF

Jan. 22, 2021 3:22 AM ETBlackRock Income Trust (BKT)30 Comments

Summary

  • BKT has been on the radar of many income investors due to its ultra high-quality allocation and a very attractive distribution rate of 6.85%.
  • We take a look at how this fund is able to generate an income yield that is an order of magnitude higher than that of AAA-rated securities.
  • The structure of agency MBS as well as tilts to higher-coupon securities, interest-only strips and duration hedges allow the fund to generate a high income level.
  • The fund's portfolio yield-to-worst, however, is closer to 1.0-1.3% after fees, which reflects the yields of agency indices and sector ETFs.
  • Investors who are after a high income stream at the lowest volatility and who care less about total return or true portfolio yield may find BKT attractive.
  • Looking for more investing ideas like this one? Get them exclusively at Systematic Income. Get started today »

This article was originally published on 13-Jan.

One of the topics we have been discussing in recent articles as well as on the service is how to dial down risk of income portfolio in light of what are fairly expensive underlying valuations as well as tightening CEF discounts. The BlackRock Income Trust (NYSE:BKT) is one potential alternative. In this article we take a look at this fund, see how it works and whether it offers an attractive lower-risk allocation without sacrificing income.

Our main takeaway is that investors who are after a high income level at the lowest possible volatility or drawdown potential will find BKT attractive. However, investors who want to actively use BKT as a dry powder reserve during drawdown periods or who want to generate a sustainable total return level in excess of 2-3% may want to look elsewhere. Our general stance on our Income Portfolios has been to hold funds whose distribution rates more or less reflect their longer-term return potential and so we do not currently hold BKT.

Meet BKT

BKT is a $550m total asset fund, trading at a 2.1% discount, a 6.85% current yield, 28% leverage and a management fee of 0.65% on total assets. The fund allocates almost entirely to agency mortgages, both pass-through and CMOs (across all three agencies: Ginnie Mae, Freddie Mac, and Fannie Mae). For this reason, the fund's credit quality profile is essentially entirely AAA.

The fund looks very attractive across the higher-quality CEF space. If we screen for CEFs that experienced a below 15% NAV drawdown we see that BKT has by far the highest covered yield (defined as net investment income yield on price) among this group of funds. This makes the fund attractive not only on an absolute yield level but on a risk-adjusted level also.

Source: Systematic Income

The fund has generated pretty consistent annual returns with only a single down year, and barely down at that. Over the last 5 and 10 years, the fund's CAGR is 3.3% and 3.6% per annum in NAV terms.

Source: Systematic Income

BKT had a very good drawdown in 2020 by CEF terms with a 7% NAV drawdown and a 10% price drawdown. This compares favorably with many CEFs that had drawdowns on the order of 30-40%, which are trading at similar current yields.

Source: Systematic Income

The fund's distribution coverage is not fantastic, but it's not poor. The fund deleveraged slightly this year, yields on agency assets fell, and there were a number of other headwinds to the fund's income which we touch on below. The fund's managed distribution policy is currently set to a fixed $0.0344 per month or 6.7% on NAV. At the end of the 2020 fiscal year the fund distribution source was 82% income and the rest in ROC.

Source: Systematic Income

When we aggregate all this information BKT looks very attractive. In the context of the high-yield corporate bond index trading with a yield of 4.43%, a fund that is nearly entirely in AAA-rated securities, with a single-digit NAV drawdown, a 6.85% current yield and a 5.6% covered yield looks like an oasis in a desert.

It’s always worth doing some sanity checks to make sure the intuition around a fund corresponds to how it actually behaves. The first task is to check the fund’s longer-term NAV performance and see how it looks relative to its income and the broader market environment. The fund’s 5y NAV return is 3.3% per annum which seems odd in the context of its 5.6% covered yield, long-duration profile and a market environment of falling interest rates. The 5.6% income level alongside a lower rate performance tailwind and no credit risk suggests that its annual performance should be around double of what it actually is.

One of the few constants in finance is the relationship between risk and reward. If we look at other government-backed securities such as Treasury bonds with a similar duration profile as BKT we see that they are yielding on the order of 0.40-0.50% - an order of magnitude below the income level of BKT.

So, how can Treasuries yield 0.4-0.5% and BKT yield more than 10x this without taking on more risk? To answer this question, we need to take a look at how agency mortgage securities work and how BKT allocates within this space.

First, regular agency mortgage pass-through bonds have two features which cause its coupons to trade above their yields. Mortgages differ from bonds in that they pay out both interest and principal on each payment, behaving a bit more likely annuities than bonds that have a full principal repayment at maturity. This causes them to have a higher coupon than their underlying yield. They also feature embedded options owned by mortgage holders which allow prepayments. Because prepayments typically disadvantage holders of mortgage securities (prepayments tend to run faster when interest rates fall and vice-versa) it means that buyers of mortgage securities need to be compensated for this negative convexity. These two features combine to drive the coupon of mortgage securities well above their yield-to-worst (on the second point this is because the coupon will include the value of the embedded option whereas the yield-to-worst adjusts for it). For example, the S&P Agency Index features a par-weighted coupon of 1.75% and a yield-to-worst of 0.49%. What this means is that the higher than expected income stream is compensated by a fall in the value of the principal. This dynamic, in large part, explains why the fund's income yield is significantly higher than its NAV return.

Secondly, in addition to MBS pass-throughs, the fund also allocates to two other types of mortgage securities: CMOs and interest-only strips. CMOs bundle together mortgages and pass-through securities across different class types or tranches with varying payment characteristics that appeal to different types of investors. For both pass-throughs and CMO BKT tilts to higher-coupon securities which allow it to boost its income levels. One downside is that higher-coupon securities have not enjoyed the support of the Fed given its buy-back focus on lower-coupon MBS and so have traded at slightly wider spreads. This partially explains why the fund's NAV performance has lagged its benchmark over the past year.

Thirdly, the fund also allocates to interest-only or IO strips which are securities that receive the interest-payment cash flows from underlying mortgages. A unique aspect of these instruments is that they are negative duration meaning they fall in price when interest rates fall, unlike, nearly all other fixed-income products. The reason for this is that, when rates fall, prepayments increase, which decreases the flow of interest rate payments to the holder of the IO. A curious consequence of this is that despite a AAA credit rating it is possible for a holder of an IO receive significantly less back at "maturity" than what they paid for the IO in the first place.

The way an IO raises the income profile of the fund is due to the fact that at the start of the mortgage the vast majority of cash flow comes from the interest rather than principal repayments. However, because the IO can trade at a fraction of the overall value of the mortgage e.g. 20% that means that the "yield" of an IO can be on the order of 5x that of the overall mortgage.

Fourthly, the fund uses interest rate swaps and futures to lighten its long-duration profile. While the fund holds both long and short futures and pay-fixed and receive-fixed swaps, on a net basis, its position across these instruments is a "paid-rates" position which makes money when rates rise and offsets the loss in the rest of the portfolio which is long duration. The consequence of this is that it reduces the fund's income level given the steepness of the yield curve and the coupons on the legs of the swaps and it also detracts from performance given the trend lower in interest rates over the past year. It's not clear whether the swap cash flows flow through net investment income rather than the statement of cash flows, but the carry cost of the futures definitely doesn't appear as income. This means that the carrying cost of these duration hedges would not show up as an income detractor, causing the fund to marginally overstate its true income generation.

The thing that is always worth falling back on is that in finance there is no magic. There are only different levels of risk and different compensations for different risks. If we look at the yield-to-worst of the Agency index that number is 0.50%. This sort of makes sense. 5-year Treasuries which have the same credit rating as the instruments that BKT holds have a yield of 0.49% so not exactly a million miles away. The key takeaway here is that no amount of financial engineering can take AAA assets that trading at a yield of 0.5% and transform them into a sustainable 5-6% yielding asset. What the fund does, in essence, is rebalance cash flows between income and principal by allocating to securities with higher income level and worse expected principal performance.

BlackRock, very helpfully, shows portfolio yields of its funds on the fund websites. The portfolio yield-to-worst of BKT is 1.85%. This figure is likely before management and other fees and on a net basis is closer to 1.0-1.3%. If we take a look at the yield-to-worst of the iShares MBS ETF (MBB) it is not hugely different at 1.05% which makes sense as the fund's duration is only slightly shorter than that of BKT. The fund's leverage will magnify the fund's yield versus unleveraged funds. However, it will not be able to add a ton of yield. This is because agency repo levels of around 0.2% added to the fund's management fee of 0.65% eats up a big chunk of the yield of the leveraged portion of the portfolio.

Performance In Context

Yield and income levels are important, but they are not all there is to fund allocations. Our mantra has been that income and returns are not mutually exclusive - ultimately, income derives from a capital base and if the capital base is depleted no amount of financial engineering will be able to manufacture a high level of sustainable income.

Based on the fund's own metric BKT has outperformed its benchmark over the last 3 and 5 years by 0.23% and 0.28% per annum respectively in NAV terms for the period ending in June of last year.

Source: SEC

If we take a look at ETF benchmarks, we see that the BKT NAV has been running away in early 2020 and then gave a lot of it back. An actively-managed fund Janus Henderson Mortgage-Backed Securities ETF (JMBS) has actually slightly beaten BKT over its short life (the chart starts at the inception of JMBS). This chart suggests that active management alongside leverage in the sector do appear to work (the other lagging funds in the chart are all passive), although somewhat inconsistently as JMBS has only outperformed starting in 2020. Perhaps the additional volatility and dislocations of the agency sector in 2020 allowed it to drive superior results. With the Fed backstopping the agency market it's not clear whether similar opportunities will be readily available in the medium term.

Source: Systematic Income

Investors who are interested in dry-powder allocations will be interested in how the fund's price moved relative to the passive funds. Here we see that the fund's price underperformed and substantially lagged the recovery. This was primarily due to the widening of the fund's discount. There are many reasons to hold dry powder allocations. Investors who just want a relatively robust security won't care too much if the fund's price is depressed for a few months relative to its NAV, particularly, if it allows them to buy more shares. However, more active investors who want to be able to draw on the reserve of dry powder to invest in more attractive opportunities during drawdown periods will probably want to look at open-end funds since they offered much stronger drawdown control over several months following the March drawdown given their tighter discount control.

Source: Systematic Income

If we don't include JMBS we can take a longer-term perspective. The chart below plots the BKT NAV total return versus the returns of the 3 passive agency ETFs. We see that BKT has generated significant outperformance since about 2010 which equates to about a bit over 4% per annum and around 1.1% of outperformance per annum over this period.

Source: Systematic Income

The bulk of this outperformance appears to have been generated in the period of 2010 to 2013. If we look at the 1-year rolling BKT NAV returns versus the average of the passive funds we see that it has averaged (marked by a red line) around 0.3% per annum over the past 5 years - quite a bit lower than earlier in the decade. This is likely due to the fall in interest rates as well as the agency market becoming more efficient. Given the fund's management fee is around 0.85% higher than the fees of the passive funds, on a net asset basis, it means that the fund's alpha over the past 5 years has been around 1.15% (0.3% + 0.85%) per annum so about 75% of its generated alpha has gone back to the fund in terms of fees with investors receiving about a quarter of the total amount.

Source: Systematic Income

In valuation terms, the fund appears to be on the expensive side with a 5-year z-score of 2 and a 5-year discount percentile of 95% (meaning the discount has only been tighter about 5% of the time in the last 5 years). Relative to the agency CEF sector, the discount also looks historically tight as it has tended to trade substantially wider of the sector and has now converged with it. So long as the fund maintains its managed distribution policy the discount is probably not in danger of substantial widening, however, the recent deterioration in the fund's distribution coverage poses a question of how sustainable its current policy is over the medium term.

Source: Systematic Income CEF Tool

Takeaways

How should investors think about BKT? The facts appear to be the following. In terms of returns, the fund has delivered 5 and 10-year NAV returns of around 3.3% and 3.6%, respectively in a supportive environment of falling interest rates, marginally outperforming passive sector funds. The fund's real underlying yield (not its distribution rate or income yield) is a bit over 1% net of fees. Investors who don't care a whole lot about how a fund generates its income and just want to receive an attractive income level at the lowest possible risk will find BKT attractive. There is some risk of a distribution cut but it's probably not imminent.

Investors who want to be able to call on BKT as an active dry powder reserve during drawdowns may want to consider open-end funds in the same space. They are likely giving up about 0.3% of performance by being in passive funds but are gaining a significantly stronger drawdown profile as BKT underperformed passive funds by 5-10% this year during and shortly after the drawdown period.

And investors who are after total return that is sustainably stronger than 2-3% may want to look at lower-quality CEFs that have more upside (though, naturally, more downside) potential in what is an early cycle macro environment.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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