FGB: BDC Exposure Through A Closed-End Fund With A Strong Yield

Summary

• A distribution cut last year created an opportunity to buy into FGB as the fund went to some deep discount levels.
• This fund holds a basket of BDCs - these have been under pressure as they are sensitive to economic conditions.
• FGB took a big hit last year due to this positioning, though going forward prospects are looking interesting.
• Looking for a portfolio of ideas like this one? Members of CEF/ETF Income Laboratory get exclusive access to our model portfolio. Get started today »

Written by Nick Ackerman, co-produced by Stanford Chemist

First Trust Specialty Finance & Financial Opportunities Fund (NYSE:FGB) might not be one of the first funds anyone would think of. It is a rather small fund and holds a basket of business development companies ("BDCs") in its portfolio. This makes it a bit unique in their underlying positions, it also makes it a bit of a fund of funds approach. Though, instead of holding other traditional closed-end funds, ETFs or traditional mutual funds; they hold BDCs.

BDCs are actually a type of closed-end fund. The biggest difference to a traditional CEF is that BDCs take a more hands-on approach. They invest in private deals, typically with small to medium-sized businesses. These private deals will even go beyond just financial investments, but also can lead to management guidance too.

These are traditional investments in small to midsized businesses that can't get traditional financing through a bank. Yet, are too small for large financial institutions to back as well. Thus, BDCs provide a bit of a middle ground for these companies to turn to when they need financing. It also provides a way for a retail client to gain access to these types of private deals. Their upsides, as well as their downsides.

One thing that management noted about BDCs as a whole in their latest Annual Report, was that they were hoping institutional investors would get involved with BDCs. As it would help stabilize the market overall. I'm not sure I'm quite as optimistic as they are of this happening, though they mention it as they make remarks on the volatile nature of the securities.

The BDC industry is still evolving and its shareholder base continues to need greater participation from institutional investors. Progress is gradual, but there appears to be a growing understanding among regulators and legislators of the role BDCs play in providing growth capital to small and mid-sized businesses in the U.S. We remain hopeful of regulatory changes that would encourage institutional ownership of publicly traded BDC stocks. We believe that development could improve valuations and perhaps even help stabilize stock prices during times of market dislocation. Until then, our expectation is that BDC stocks may continue to exhibit relatively high levels of volatility during periods of market stress

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."

If you thought traditional CEFs were a black-box, BDCs are black-boxes on steroids. To offset this, and a benefit of investing in FGB means that one is gaining access to a broad basket of these "hedge-fund light" operations. They are also managing the portfolio of BDCs for you.

Due to the fund's size, a limit order for any buying or selling is highly suggested. They operate with only around $61 million in total managed assets. This was higher at one time; however, deleveraging last year forced selling at some lows. Leverage is now around $6.5 million in borrowings or ~10.6% of assets.

The expense ratio for the fund was last reported at 1.78%. When including leverage expenses this comes to 2.35%.

(Source)

Performance - Bright Future, For Those Wanting A Bit Of Risk

Deleveraging and the fact that BDCs continue to remain under pressure themselves, with their underlying positions; means that a rebound has been slow from 2020.

Even further, this fund had a terrible time to launch. They launched midway through 2007. Just in time to slide down to the lows in 2008/09. As we know, BDCs were under immense pressure under those circumstances as well. And boy, did it ever slide if we look at the chart!

(Source - CEFConnect)

The significant pressures of last year's moves had put a huge dent in the fund's total returns too. Looking at the annualized returns, we see they leave a lot to be desired.

(Source - Fund Website)

All this being said, when we picked the shares up at the CEF/ETF Income Laboratory, it was after the collapse of its premium to discount pricing. This was the result of a distribution cut last year. The fund had been trading at a significant premium too prior to this. Though the fund isn't any stranger to premium pricing. Historically, it has traded at premium valuations for a regular period of time.

(Source - CEFConnect)

When we last visited the fund, it was around a 12.3%+ discount. This has contracted some, as we expected. We also even had some recovery in pricing, also as we anticipated. The current discount has now shifted to just 3.91%. Admittedly, the bigger the discount, the better; and that is exactly what we previously had when Stanford Chemist sent out the trade alert. At that time, it was a massive 18% discount! However, if you are optimistic about the economy overall, you can put this fund on your watchlist as the underlying BDCs continue their recovery.

I would also note, as I had previously if we look at returns prior to the collapse last year. Even after the fund collapsed in 2008/09 - it still put up some attractive returns. In fact, it was neck and neck with the VanEck Vectors BDC Income ETF (BIZD) - a non-leveraged BDC ETF. Though that brings up another good point - the fact that leverage didn't seem to help FGB at all previously.

Data by YCharts

Recovering from the March 23rd, 2020 lows, we do see that it has marginally helped. Though I would have anticipated even more here. Regardless, leverage does increase risks as most investors are aware - but FGB has fared a similar fate to BIZD even considering this.

Data by YCharts

Distribution - Coverage Improves

Coverage has improved year-over-year - though helped significantly by the distribution cut. The fund currently yields 9.12%, on a NAV basis this works out to 8.64%.

YoY net investment income [NII] has taken a hit. That being said, the distribution cut and reduced leverage expenses (due to deleveraging and costs going down) had helped improve NII relatively speaking.

(Source - Annual Report)

Annualized, the distribution would require around $4.7 million in total distributions. A drop from the last full year's reported amount of ~$6.2 million. The fund was able to earn ~$4.7 million last year. This would put current distribution coverage around 100%. However, do note that NII over the next year is likely to be different as well. This is because since they deleveraged, they will be earning less - though they will also be paying less in interest expenses too.

For the longer-term, once they started recovering from the 2008/09 lows. We do see a gradual increase in the distribution rate. Of course, before the cuts of the last couple of years.

(Source - CEFConnect)

As the economy continues to recover, I believe that it becomes less of a concern of needing to cut again.

For tax purposes, the majority of the distributions have been contributed to ordinary income. This isn't that unexpected as BDCs invest primarily in fixed-income type investments - meaning that they collect interest. Interest is often taxed at ordinary income rates.

(Source - Annual Report)

For another positive out of a bad outcome, they have considerable losses on the books. They can utilize these against future gains when they materialize.

(Source - Annual Report)

Holdings - New Names Move Up To The Top Positions

FGB is primarily common stock BDC investments. They list around 2.9% in mREITs. Not a material amount, in my opinion. With that, we can just jump right into the top holdings of the fund. Which, they certainly take their time to update their positions as they have the positions listed as of November 30th, 2020. That is from when the latest Annual Report was available.

(Source - Fund Website)

What we do see is that positions have shifted a bit from their top holdings when we last looked. They remain heavily invested in their top positions, which accounts for 66.29% of their portfolio. This is because there aren't too many BDCs that actually trade on the market in the first place. The last report I see is that there were 49 publicly traded ones. Though that was from 2019.

Even more, just like CEFs, not every one is going to be a great position to own. Thus, we see FGB is quite limited in what they can drum up for exposure. Several of the top worth owning are listed here though, in my opinion.

One of the funds that we see that wasn't included previously is Main Street Capital Corp (MAIN). Ares Capital Corp (ARCC) is also a position in their top ten, which was previously listed as well. In the BDC space, I would say these are two of the best run and most popular BDCs available. ARCC is quite massive in comparison too with over $16.1 billion in total managed assets. MAIN is a bit smaller, but still quite a considerable size at ~$2.66 billion.

Investors will balk as these can regularly trade at premium pricing to their NAVs. This is especially true for MAIN, but ARCC has also been starting to show a similar pattern the last few years now.

(Source - CEFData)

Unlike traditional CEFs that mostly report daily NAVs, BDCs report quarterly when they release their earnings. This can mean you have to do a bit of a guesstimating between quarters.

Besides MAIN moving up to the top of the list, we also have Sixth Street Specialty Lending (TSLX). This is a BDC of quite a considerable amount of total AUM as well - with $2.136 billion last reported. Since 2008/09, all three of these BDCs have been able to maintain their regular distributions to shareholders, even through the difficult economic circumstances.

TSLX's distribution is a bit difficult to read through. They offer a regular quarterly amount, then several "specials" and "quarterly variable supplements." This helps BDCs stay compliant with their requirements to pay out a large number of their earnings to shareholders; which translates into not having to pay taxes on the fund level and continuing as a regulated investment company.

Conclusion

FGB is a unique fund that has an opportunity to capture plenty of upsides as the economy continues to recover. The major risk for the fund is the sensitivity to the underlying investments of BDCs and leverage. BDCs are sensitive to economic conditions, even more so than most companies, as they invest in small and midsized businesses. As far as the leverage, FGB has had to deleverage - this led to permanent impairment. Unfortunately, for investors that had held previously, it is unlikely to ever reclaim its former highs.

That being said, the upside potential still remains intact - through appreciation and discount convergence. Considering the fund is still paying quite an attractive distribution, I believe that it is still enticing to most income investors at current valuations.

Analyst’s Disclosure: I am/we are long MAIN. 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.

This article was originally published to members of the CEF/ETF Income Laboratory on February 14th, 2021. May initiate a position in FGB over the next 72 hours.