For an extended period of time, one of the biggest problems that has been facing retirees is an inability to generate income off of the assets in their portfolios. This problem is caused by the policies that have been pursued by the Federal Reserve and other central banks for many years now and as such are highly unlikely to go away anytime soon. This has unfortunately made retirement much more challenging than it was for previous generations due to the difficulty of obtaining any source of safe income apart from the meager payments offered by Social Security. Fortunately, there are some options available. One of the best of these is fixed-income closed-end funds, which have the advantage of professional management as well as the ability to use a variety of strategies to boost their yields. In this article, we will take an in-depth look at one of these funds, the BlackRock Multi-Sector Income Trust (NYSE:BIT), which currently yields an attractive 7.95%. BlackRock has long been a respected name in the fund management space so that alone might attract some investors so let us investigate and see if this fund could be right for your portfolio.
According to the fund’s website, the BlackRock Multi-Sector Income Trust has the stated objective of generating a high level of current income with a secondary focus on capital appreciation. This is certainly not unusual as most fixed-income funds have somewhat similar objectives. The fund seeks to achieve these objectives by investing in loans and other debt instruments. This is also not unusual as essentially every fixed-income fund invests in debt instruments such as bonds. Admittedly though, the investment is loans is a little more novel. These are what are known as leveraged loans, which are bank loans that are made to a company that either already has a substantial amount of debt or a poor credit history. As such, these loans are much riskier than investment-grade bonds but they also carry higher interest rates in order to compensate investors for this risk. In addition, these loans will in many cases have floating interest rates so that the payment made by the borrower goes up as interest rates do. This could be a good thing as interest rates have nowhere to go but up, as we will see in just a bit.
The largest positions in the fund are not exactly what we would expect to see in a fund of this type. Here they are:
As we can quickly see, the largest positions in the fund are all either the United States government itself or one of its agencies. This should provide comfort to anyone that is concerned about the risks surrounding the leveraged loans in the fund. This is because it is generally accepted that the United States government has no default risk. With that said, the United States government does not explicitly back the securities issued by the Federal National Mortgage Association (Fannie Mae), which is by far the largest single position in the fund. However, the government did step in to back this company’s securities during the housing crisis a decade ago and we can expect that the same thing would happen again in a worst-case scenario. Thus, while the default risk of these securities is technically not zero, it is as close as anything that you are likely to find in the markets.
One of the best forms of protection that we have against counterparty default risk is diversification. After all, the smaller our proportional exposure to any given counterparty, the smaller the impact any single default will have on our entire portfolio. Fortunately, as we can see above, the fund is highly diversified since there is no position other than the Fannie Mae securities and the U.S. government bonds that accounts for much more than 1% of the fund’s total assets. However, it is more diversified than it seems since many of these securities actually represent packages of loans or bonds and are not actually loans made to a single entity. These are what are called securitized bonds or collateralized loan obligations, and while these got a bad name during the financial crisis, they can actually be beneficial for investors looking to reduce risk because they reduce the investor’s exposure to any single borrower. The fund also has 1,756 securities in the portfolio, so we can be doubly certain that the exposure to any single borrower is quite low. Thus, despite the risky nature of leveraged loans, the fund should overall have fairly low default risk barring a major financial crisis.
We can get further confidence that the fund’s holdings have a reasonably low default risk by looking at the credit ratings of the securities that make up the portfolio. As everyone reading this is no doubt well aware, the major ratings agencies assign a letter value to most fixed-income securities that ostensibly predicts the risk that the borrower will default on the mandatory payments. Here is the credit quality breakdown for the BlackRock Multi-Sector Income Trust:
Source: CEF Connect
As a general rule, anything rated BBB or above is considered investment-grade and has relatively low risk of default. Unfortunately, investment-grade securities also have the lowest interest rates, which is likely why they only account for a minority 28.4% of the portfolio. The largest proportion of the portfolio (45.79%) are BB and B-rated securities, which are the two highest ratings for junk bonds. These securities have substantially higher interest rates than investment-grade securities so it makes a lot of sense that a fixed-income fund that is attempting to maximize its income would choose them for its portfolio. The fact that it appears to be choosing the highest quality junk bonds is also encouraging as it appears that the fund is attempting to both maximize its income and limit its risk of loss.
As mentioned in the introduction, one of the biggest challenges facing investors today, particularly retirees, is generating any degree of income off of the investments in their portfolios. The reason for this the policies that have been pursued by the Federal Reserve, specifically the central bank’s control of the federal funds rate. The federal funds rate is the rate at which commercial banks lend money to each other on an overnight basis. The bank cut this rate to near all-time lows following the collapse of Lehman Brothers in 2007 and left it there until the Trump Administration. Although the bank did start raising it shortly after Trump took office and the economy finally started to recover, the outbreak of the pandemic forced it to reverse course and the bank once again cut the rate to all-time lows, where it remains today:
Source: Federal Reserve Bank of St. Louis
As of the time of writing, the federal funds rate sits at 0.08%. The reason why this is important is that this rate affects the interest rate of everything else in the economy. The fact that this rate is low is thus the reason why things such as savings accounts and certificates of deposit are paying essentially nothing. This has rendered traditional retirement strategies that depend heavily on these types of accounts essentially useless. This has thus naturally forced retirees to seek out other options.
One of the tactics that these people have employed is taking money out of bank accounts and putting it into riskier assets such as stocks and bonds in search of some sort of yield. This influx of new money has naturally increased the demand for these assets and suppressed their yields. We can see this quite clearly by looking at the S&P 500 index (SPY), which currently yields a paltry 1.28%. At this yield, a $1 million portfolio would only generate $12,800 in annual income. The bond market is not really any better as the iShares Core U.S. Aggregate Bond ETF (AGG) only yields 1.88% at the current price. The only kicks the income off of our $1 million portfolio to $18,800 annually. It is a safe bet then that neither of these options will generate enough income to support the lifestyle of someone that managed to amass $1 million over the course of their careers.
The BlackRock Multi-Sector Income Trust is able to do much better than this. The reason for this is that the fund invests in higher yielding securities than the exchange-traded funds do along with its ability to utilize other strategies to boost its yield, one of which we will discuss in just a moment. As noted in the introduction, the fund yields a remarkable 7.95% at the current price, which kicks the income off of our hypothetical $1 million portfolio to $79,500 annually. When we combine this with likely Social Security Income, a retiree should be able to enjoy a reasonably comfortable lifestyle in most parts of the country.
One of the strategies that the fund uses to boost its yield beyond that of comparable funds is the use of leverage. Basically, the fund borrows money in order to purchase high-yield bonds. As long as the interest that it collects off of the purchased securities is higher than the interest rate that it has to pay on the debt then this works quite well to boost the overall yield of the portfolio. As we have already seen, interest rates are at extremely low levels and the fund can borrow at institutional rates (which are lower than retail rates) so this will typically be the case. However, leverage is a double-edged sword because it amplifies both gains and losses. As such, we want to ensure that the fund is not using too much debt so that we are not exposed to too much risk. As I discussed in a previous article, I typically like to see a fund’s leverage under a third as a percentage of assets for this reason. The BlackRock Multi-Sector Income Trust currently has 37.75% leverage as a percentage of assets so it is admittedly a bit above this. With that said though, it is not dramatically above that so we are probably okay in terms of leverage risk.
As noted earlier, the primary objective of the BlackRock Multi-Sector Income Trust is to provide its investors with a high level of current income. As such, we might expect it to pay a regular distribution to its investors. This is indeed the case as the fund pays out a monthly distribution of $0.1237 per share ($1.4844 per share annually), which gives it a 7.95% yield at the current price. The fund has been remarkably consistent with this payout over the years:
Source: CEF Connect
This stability in payments is something that is likely going to be very appealing to those investors that are looking for a steady source of income. Another thing that is likely to be appealing is the fact that these payments are almost entirely classified as dividend income, although it does have a small return of capital component:
Source: Fidelity Investments
The return of capital component may be somewhat concerning to more conservative investors. The reason for this is that a return of capital distribution can be a sign that the fund is returning the investors’ own money back to them. This is obviously not sustainable over any kind of extended period. There are other things that can cause a distribution to be classified as return of capital however such as the distribution of unrealized capital gains. Admittedly though, these things are much less common in bond funds than they are in stock funds. While the presence of the return of capital is only a small percentage of the fund’s total distributions in certain quarters, we should still examine its finances to see how the fund is paying for these distributions and how sustainable they are likely to be.
Fortunately, we have a fairly recent financial report that we can consult for this task. The fund’s semi-annual report is for the six-month period ended April 30, 2021 so it should be able to give us an idea of how the fund has been financing its most recent distributions as well as how well the value of its assets has been doing given the market rally that we have seen so far this year. During that six-month period, the fund received a total of $1,175,270 in dividends and $25,364,689 in interest off of the investments in its portfolio. When combined with a small amount income from other sources, the fund brought in a total of $26,569,554 in income during the period. It paid its expenses out of this amount, leaving it with $20,506,582 available for the investors. This was not enough to cover the $27,860,404 that it actually paid out during the period, however. Fortunately, the fund was able to make up for this with capital gains as it had $21,148,143 in realized and $19,119,701 in unrealized capital gains. The same thing was true during the full-year period ended October 31, 2020 as the fund failed to cover its distributions through net investment income and realized capital gains but did have enough unrealized capital gains to cover its distributions. Thus, it does not appear to be overdistributing and the return of capital that we see is simply the fund paying out unrealized capital gains.
As is always the case, it is critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate suboptimal returns off of that asset. In the case of a closed-end fund like the BlackRock Multi-Sector Income Trust, the usual way to value it is by looking at a metric known as net asset value. The net asset value of a fund is the total current market value of all of the fund’s assets minus any outstanding debt. It is therefore the amount that the investors would receive if the fund were immediately shut down and liquidated.
Ideally, we want to purchase shares of a fund when we can acquire them at a price that is less than net asset value. That is because such a scenario implies that we are acquiring the fund’s assets for less than they are actually worth. That is unfortunately not the case here. As of July 12, 2021 (the most recent date for which data is available), the fund had a net asset value of $18.49 per share but actually trades for $18.67 per share. This represents a 0.97% premium to net asset value, which is a bit above the 0.70% premium that the fund has averaged over the past month. Thus, it does currently look a little pricey right now but the difference is not that great so it could still be worth it if you are interested in the fund, otherwise there may be an opportunity to purchase the fund at a better price in the near future.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.