BlackRock has three strong multi-sector bond CEFs, all of which offer investors diversified holdings, strong distribution yields, and market-beating returns.
The Multi-Sector Income Trust (BIT) is the riskiest, focusing on high-yield corporate bonds, with some smaller investments in investment-grade bonds. BIT has the strongest returns, but risks are quite high too. I last covered BIT here.
The Core Bond Trust (BHK) is the safest, focusing on investment-grade bonds, with some smaller investments in high-yield corporate bonds. BHK is significantly safer than BIT, but returns are only slightly lower, due to consistent generation of alpha. Strongest risk-adjusted returns of the bunch, and not particularly close. I last covered BHK here.
The BlackRock Credit Allocation Income Trust (NYSE:BTZ) is somewhere between BIT and BHK on quality and risk measures, investing in both investment-grade bonds and high-yield bonds in equal measure. It also has the lowest returns of the bunch, due to lack of alpha, but performance is rapidly improving.
BTZ is a fine choice, but both BHK and BIT have delivered stronger returns and alpha in the past. As such, I would pick BHK or BIT over BTZ, although BTZ is not a bad choice in any case.
Which to choose depends on what, specifically, an investor is looking for, in my opinion at least.
If you want safety, pick BHK.
If you want strong distributions and returns, pick BIT.
If you want both, pick both.
And remember that the situation is not symmetrical. BHK is significantly safer than its peers, and only slightly less profitable.
Finally, a quick table with select information for the three funds, plus a 50%-50% combination of BHK and BIT. As mentioned previously, BHK is significantly safer than its peers, see the extremely low losses during 1Q2020, but performs quite well regardless.
(Source: Fund Corporate Websites - Chart by Author)
BTZ is an actively-managed diversified leveraged bond CEF. As with its sister funds BHK and BIT, the fund's investment thesis rests on the fund's:
BTZ focuses on investment-grade corporate bonds, but also invests in high-yield bonds, mortgage-backed securities, preferred shares, and securitized products. Only major asset class missing is treasuries.
BTZ's diversified holdings reduce portfolio risk and volatility, and are a significant benefit for the fund and its shareholders.
(Source: BTZ Corporate Website)
BTZ's holdings are roughly evenly divided between investment-grade bonds and non-investment grade bonds.
(Source: BTZ Corporate Website)
BTZ is also leveraged, and currently sports a 28.8% leverage ratio. Leverage boosts yields, returns, volatility, and losses during downturns.
BTZ's holdings and leverage combine to create a fund that is roughly as risky as a high-yield corporate bond index ETF, as evidenced by their performance during 1Q2020, the onset of the coronavirus pandemic.
BTZ is still more diversified than the average corporate bond index fund, an important benefit to consider.
BTZ offers investor a strong 6.5% distribution yield. The fund's yield itself is quite high, and much higher than the yields offered by most bond index funds.
BTZ's strong distribution yield is a significant benefit for the fund and its shareholders. Importantly, BTZ's distribution has been sustainable in the past, with the fund managing to grow its NAV for the past ten years. There have been no destructive ROC distributions, the opposite in fact.
BTZ's distribution coverage ratio of 85% is not so great, and indicates that the fund's managers will have to generate a minor amount of capital gains every year to fund the distribution. BTZ's managers have managed to generate said capital gains since inception, as evidenced by the fund's stable, sometimes growing, NAV.
BTZ's strong 6.5% distribution yield and stable NAV combine into market-beating returns. BTZ generally outperforms comparable indexes, and has done so for the past ten years or so, although performance does vary quite a bit.
BTZ offers investors diversified bond holdings, a strong 6.5% distribution yield, and market-beating returns. This is a solid investment thesis, and makes BTZ a worthwhile investment.
Some readers have probably noticed that BTZ's investment thesis is quite similar to that of BHK and BIT, previously covered here and here. That is indeed the case, with all three funds sharing the following key benefits:
Although these three funds are quite similar, they do have one big difference: the riskiness of their underlying holdings.
BIT is the riskiest, focusing on high-yield bonds, and hence highest-yielding.
BHK is the safest, focusing on investment-grade bonds, and hence lowest-yielding.
BTZ is somewhere in between these two, with an equal(ish) proportion of high-yield and investment-grade bonds.
A quick look at the credit quality and yields of the different funds.
From the above, it seems clear that BHK should perform reasonably well during downturns and recessions, BIT should perform quite badly during these, with BTZ performing somewhere in the middle. That was indeed the case during 1Q2020, the last downturn and onset of the coronavirus pandemic.
BIT, being the highest-yielding fund, should have the strongest returns.
BHK, being the lowest-yielding fund, should have the weakest returns.
BTZ should be somewhere between these two funds.
The above should be true, but isn't, with BTZ having the weakest returns of the three for the past ten years or so.
I see very few reasons to invest in a fund with an average level of risk but below-average returns, and so would not be investing in BTZ at the present time.
BHK is significantly safer than BTZ, and offers comparable returns. Seems like the better choice for most investors.
BIT offers greater yields and returns when compared to BTZ, but risks are higher too. Seems like the better choice for more risk-seeking investors.
Investing 50% in BHK and 50% in BIT approximates a full investment in BTZ, and is better than the former in most relevant metrics.
Finally, I wanted to end the article with a more quantitative analysis of the funds, focusing on understand the difference in performance between these.
Figures here are about two weeks old, from when the article was originally published to CEF / ETF Income Laboratory subscribers, but nothing material has changed in these past two weeks. I made sure to check.
Let's start from the beginning.
We have been discussing bond funds throughout the article.
The largest bond fund in the market is the iShares Core U.S. Aggregate Bond ETF (AGG). It is an investment-grade bond index ETF, provides investors with exposure to most relevant bond sub-asset classes, and is quite cheap too.
So, why not just go with AGG? Seems like the simplest choice.
For most investors, it's because AGG only yields 1.8%, and they want something with higher yields (and returns).
So, we need something like AGG, but with higher yields.
Two ways to do this.
First is to increase the beta of the fund, its holdings, securities, or portfolio.
This is generally done by investing in higher-yielding securities, say high-yield corporate bonds. These securities tend to yield more than bonds in general:
have higher returns:
but suffer greater losses during downturns, i.e. 1Q2020, the onset of the coronavirus pandemic:
Beta can also be increased through leverage. In simple terms, more leverage means more assets which means more income, yields, and returns. Risks are higher too, as the debt has to be paid back no matter what, and this might prove difficult during downturns.
BHK boosts its yield and returns using both methods. BHK has as its core holdings a diversified set of investment-grade bonds, quite similar to AGG, and then some smaller investments in high-beta high-yield corporate bonds bought with debt, basically HYG. These smaller investments have been instrumental in BHK's market-beating returns.
Second way to boost a fund's yield and returns is through alpha.
Instead of buying an index including all high-yield high-risk securities, buy a couple that seem undervalued, and profit once their valuations and prices rise. Also, sell those that seem overvalued, and reduce your losses once their prices decrease to more rational levels. This is easier said than done, but it is possible to do.
BHK has a lot of alpha too, with the fund consistently selling overvalued bonds, and using the proceeds to buy undervalued securities.
As an example, sometime in mid-2020 the fund sold (overvalued) treasuries and bought (undervalued) investment-grade corporate bonds. Treasuries soon underperformed, while investment-grade corporate bonds outperforming. Said trade was quite profitable for BHK, and allowed the fund to outperform AGG in the following months.
BHK consistently generates alpha. The fund's long-term returns are quite dramatic, with the fund consistently outperforming all relevant bond sub-asset classes since inception, and for all relevant time periods.
BHK outperformed its peers due to beta, the high-yield corporate bonds and use of leverage, and alpha, picking undervalued best-performing securities.
These are two distinct sources of returns, but with some math we can say which is which.
Let's focus on BHK's 1-year returns, to simplify the math.
Just from looking at the graph, it seems clear that BHK generated strong alpha these past twelve months. Remember, BHK is mostly AGG, and the fund has outperformed its index by 7% these past twelve months. BHK also has some leverage and high-yield corporate bonds, but not enough to fill that performance differential.
Let's do a quick calculation of the above, trying to estimate beta and alpha for BHK for that one year period.
We start with BHK's holdings, adjusted for leverage.
For every $100 invested in BHK, you get $112 of diversified investment-grade bonds (AGG). The extra $12 comes from leverage / debt.
Returns from these bonds were:
112% * - 0.55% = -0.616%
So, BHK's investment-grade bonds "should" have returned -0.6%, assuming no alpha.
For every $100 invested in BHK you also get $41 of diversified high-yield corporate bonds (HYG). The entire $41 comes from leverage / debt.
Returns from these bonds were:
41% * 11.80% = 4.84%
So, BHK's high-yield corporate bonds "should" have returned 4.8%, assuming no alpha.
Add the bonds up, and you get 4.2% in returns, compared to -0.6% for AGG. The 4.8% difference is almost exclusively due to the leveraged exposure to high-yield corporate bonds, which is pure beta.
BHK's actual NAV returns were equivalent to 6.4%, higher than the 4.2% explained by the fund's beta / underlying holdings. This 2.2% differential is pure alpha: excess returns through savvy investments with market-beating returns.
BHK is mostly beta, but that alpha is more important than it looks. Remember, more beta means more yield, returns, and risk, but more alpha just means higher returns, no risk or other negatives. With enough diversification, low beta, and high alpha, you can construct a high-yield low-risk fund or portfolio. There are not too many of these, but BHK is one.
Doing the same calculations as above, we can disaggregate the returns of these three funds into beta and alpha. I've done just that, using 8 year NAV returns. I've also included results for AGG and distribution yields for reference. Results are as follow.
From the above, several things stand out.
BHK is the safest fund, with the lowest beta. Returns are quite strong too, due to the fund's consistent generation of alpha.
BIT is the riskiest fund, with the highest beta. Returns are the strongest of the bunch, but not by a lot, and most of it is beta. There is some alpha, but not a lot, and inconsistent.
BTZ has moderate risk, but the lowest returns, due to lack of alpha. Although there is nothing wrong with BTZ as a fund, it compares unfavorably to its peers, both of which have generated alpha in the past. As such, and as previously mentioned, I see little reason to invest in BTZ at the present time.
Notwithstanding the above, there is nothing wrong with BTZ per se. It has a solid investment thesis, based on the fund's diversified holdings, strong 6.5% distribution yield, and market-beating returns.
As a final point, there is no guarantee that BHK and BIT's managers will be successful in generating alpha moving forward, past results notwithstanding. This is particularly the case for BIT, whose alpha is quite inconsistent. As an example, BTZ has actually performed quite well these past three months:
As mentioned previously, there are no guarantees that BHK and BIT will continue to outperform through the generation of alpha. I think this is likely, but definitely not guaranteed.
BTZ offers investors diversified bond holdings, a strong 6.5% distribution yield, and market-beating returns. BHK and BIT offer investors a similar deal, but stronger returns due to alpha. BTZ seems like a fine fund, but both BHK and BIT seem stronger.
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This article was written by
Juan has previously worked as a fixed income trader, financial analyst, operations analyst, and economics professor in Canada and Colombia. He has hands-on experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs, and enjoys researching strategies for income investors to increase their returns while lowering risk.
I provide my work regularly to CEF/ETF Income Laboratory with articles that have an exclusivity period, this is noted in such articles. CEF/ETF Income Laboratory is a Marketplace Service provided by Stanford Chemist, right here on Seeking Alpha.
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.
Additional disclosure: This article was originally published to members of the CEF/ETF Income Laboratory on July 20th, 2021.