BGT: I See Merit To Buying Floaters

Summary

  • BGT is a closed-end fund focused on floating rate loans. This is an area I view positively heading forward.
  • While I do like floating-rate loans, readers should note BGT is filled with mostly below-investment grade debt, so there are risks to this particular fund.
  • Despite the lower quality debt, high yield loans tend to have a lower default rate than below investment grade bonds. This means there is relative value with floaters.
  • While BGT has had a very positive move since my last review, it still sits at a reasonable discount to NAV.
  • This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

Money flying off stack of bills in man"s hand
PM Images/DigitalVision via Getty Images

Main Thesis/Background

The purpose of this article is to evaluate the BlackRock Floating Rate Income Trust (NYSE:BGT) as an investment option at its current market price. The fund's objective is to "provide a high level of current income", and it does this by investing primarily in senior secured floating rate loans made to corporate and other business entities. This is a fund I suggested investors consider back in April, for those looking for exposure to floating rate loans, or "floaters". Since that review, BGT has indeed performed quite well, seeing a total return just under 6%, as shown below:

Source: Seeking Alpha

Looking ahead, I continue to see a positive future for floaters, and BGT by extension. This is because I expect rising yields, and eventually, interest rates in the new year. Under this backdrop, floaters perform well, because the underlying rate re-sets according to the prevailing, higher rates. By doing so, investors are protected against a rising rate environment in a way that fixed-income investors are not. With inflation metrics ticking up, and the Fed actively discussing tapering sooner than later, I think investors can front-run this eventuality by buying in to a discount floating-rate CEF at the moment.

I See Higher Yields/Fed Tapering In 2022

To begin, I want to give my macro-outlook on one of the primary distinctions I believe we will start to see in Q4 and in the following year. This will be a rise in yields which, as I noted in the opening paragraph, is a tailwind for floaters.

As the economy continues to recover, we will get over the Delta-variant eventually. Further, the Fed has already begun to have discussions over tapering, as reported in the Wall Street Journal. This resulted in some of the volatility we saw this past week, as well as the slight rise in treasury yields. To me, this suggests the Fed, and market participants, are finally getting around to the notion that the easing will slow at some point over the next six to twelve months. I personally believe it will begin by Q2 2022, but this means yields could start to rise well before that as investors begin to anticipate it.

Importantly, I believe yields have a fair bit to rise. This is based on the fact that yields have dropped in 2021 much more than I have anticipated. It has resulted in yields sitting well off the highs of the year. While the 30-year yield has pushed up slightly from the low, it is still 0.6 basis points off the high from March, as shown in the following graphic:

Source: Yahoo Finance

My point here is that I see yields as being much too low. As Americans continue to get vaccinated, booster shots become available, and global economies catch up with the U.S. and Western Europe with distribution and vaccination rates, the future looks much brighter in 2022. While expectations may have been a bit higher for this year, I generally believe we will round the corner in a meaningful way in the new year. Once we push past the flu/winter season at the end of this year and early next year, I think the spring/Q2 2022 will see a real winding down of the current health crisis. This will force central banks to act and will send yields higher as a result.

Importantly, this low yield environment is coupled with rising inflation metrics. While the Fed has pushed a "transitory" message, essentially suggesting that inflation will ease and current metrics are not significant, I do not believe that is going to be the case. By the majority of inflation gauges, we are well above the Fed's 2% target:

Source: Cleveland Fed

This means that even if inflation eases a bit, the Fed will still be in the middle of an environment where the Fed will have a difficult time explaining inaction. So, with this outlook - how can one prepare?

One way is to purchase BGT, since it will benefit from rising yields. As yields and rates rise, the income offered by the fund should rise too, helping to buffer the impact from inflation. Unlike fixed income investments that lose value when interest rates rise, BGT's underlying holdings of floaters may see their underlying values rise.

Aside from just offering higher income streams along with rising rates, floating bank loans have a few other benefits. One, they are often secured, making them a little less risky than unsecured loans or bonds. They are also senior to other creditors or equity holders. Additionally, bank loans tend to default at a rate lower than high yield bonds, making them attractive on a relative basis. While this divergence is consistent over time, the default spread between those two categories has widened over the past decade and sits at a marked difference today:

Source: Charles Schwab

The conclusion here is to consider floating rate or bank loans as a debt portion of a portfolio, especially at the expense of fixed-income alternatives. The income outlook is stronger, and the credit outlook is too.

BGT's Low Duration Level Has Moved Lower

Expanding on the prior paragraph, an attractive attribute of BGT is its low duration level. This is a measure of interest rate sensitivity, which makes logical sense, since BGT benefits from higher inflation. In my last review, I noted how BGT's low duration level was a reason for buying the fund. The good news is this metric has pushed even though since April:

Source: BlackRock

I bring this up simply to show that BGT has become even less interest rate sensitive since earlier this year. With the chance of yields rising higher now than it was a few months ago, I see this as a positive. The takeaway for me is that BGT is indeed set up nicely to benefit from the macro-environment I see forthcoming over the next twelve months.

Discount Still Present, Albeit Not As Attractive

The next attribute for BGT I will discuss is the fund's valuation. This is a straightforward metric, but it remains a buy signal in my view. Importantly, the discount is not as attractive as it was the last time around. However, the fund still has a discount to NAV and, in this environment, finding value is not an easy task. For comparison, the graphics below show BGT's discount in April and now, respectively:

Source: BlackRock

There are two ways to look at this story. One, the discount has narrowed, so investors may want to wait to see if it reverts back to a cheaper level before buying in. While I would not fault someone for being cautious here, I personally see the 3% discount level still worth buying in at. Yes, the fund could get cheaper in the future, but with elevated equity levels, frothy bond prices, and elevated duration risk across the fixed-income world, finding true "value" is not an easy task. To see a fund with a positive outlook that also has a market price that lets investors buy in for less than they are worth, I see that as a win.

Why Not Just Stick With Equities?

I now want to shift to a macro-look on why I see merit to buying income-oriented products at the moment, rather than just sticking with an all-equity portfolio. Clearly, this depends on each individual investor - their own unique risk tolerance and income needs. For me, I like to take a balanced, diversified approach, so I use both debt vehicles and equity vehicles in my portfolio. As a result, looking at BGT is a natural extension for me. However, for others, that may not be the case. Yet, I see the current environment as an opportune time for anyone to decrease their equity exposure, whether through BGT or otherwise.

One of the reasons for this has to do with the general elevation in equity markets. At these levels, while I would not advocate broad selling, I would certainly look to be more selective in my purchases and start to beef up the other portions of my portfolio to decrease my reliance on equity performance. A reason for this perspective has to do with the continued, almost uninterrupted rise in equities, which makes me cautious. Stocks seem ripe for a pullback, inherently, but also when we consider historical trends. For example, the number of days the S&P has gone without a 5% (or larger) drop is well above the average over the past seventy years:

Source: Charles Schwab

My conclusion here is not that stocks are suddenly going to collapse tomorrow. Rather, I want to emphasize that what we are seeing now is abnormal, and investors need to start to prepare for a reversion to the mean. This could mean less equity exposure, and using funds like BGT as a way to do as we move closer to normalized Fed policy.

Any Downside? Income Metrics Still Subpar

Through this review, I have taken a positive connotation, and I stand by that. However, this is not a "sure" thing, and I don't want to suggest it is. Aside from being made up of below-investment grade credit, investors also have to consider the sustainability of the income stream. This is an important point, since BGT cut its distribution under a year ago. Fortunately, the income stream has been steady since then, but the income metrics suggest the fund is not completely earning what it needs to. Therefore, readers should understand the income story for BGT is not perfect, and will continue to be under pressure if yields do not rise as I project.

For perspective, let us take a look at recent income metrics. Unfortunately, BGT is still under-earning its stated distribution rate. The good news is the funds distribution coverage ratio has risen slightly since April. The bad news is the UNII balance is still negative, and that negative balance has grown since April. To illustrate, the two graphics below show the UNII report from April and the most current one, shown below, respectively:

Source: BlackRock

The takeaway here is that readers should be confident in the credit and income outlook for BGT before buying in. The fund has been struggling because yields have declined as 2021 went on, neutralizing the primary benefit of floating rate loans. If rates do not move higher, the underlying assets do not generate a higher income stream. If anything, that income stream could decline. With BGT seeing a distribution in December, and still under-earning its lower rate today, the future is still uncertain. Until we see yields rise in a meaningful way, this will continue to be a headwind for BGT, and readers need to consider their risk tolerance and income needs before selecting this fund.

Bottom Line

BGT's floating rate exposure should service investors well in the coming months. With yields at rock-bottom levels, there is really only one direction for them to go - up. If they do, BGT's income production will improve, and that is great news for income-oriented investors. Couple this with the fund's discount price, and it seems like a winning play for the near term. With equity levels still very frothy, diversifying in debt products is a smart move in my view, and it is something I am looking at in the immediate term. As a result, I suggest investors give this fund some consideration at this time.

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This article was written by

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CEF/ETF income and arbitrage strategies, 8%+ portfolio yields

Macro-focused investor, working for a major U.S. bank. I grew up in New York, but escaped to North Carolina. I was a D1 athlete in college (men's tennis) and compete competitively to this day. My Bachelor's and MBA are both in Finance.

I provide reasoned, fact-based analysis of different funds and sectors. I list my portfolio here so readers can gain insight into what I am buying/holding, what I'm not, and how that lines up with the views I present in my articles. 

Broad market: VOO; QQQ; DIA, RSP

Sectors: VPU / BUI; VDE / UCO; KBWB; XRT

Non-US: EWC; EWU; EIRL; EWA

Dividends: DGRO; SDY, SCHD

Municipals/Debt Funds: NEA, BBN, PDO, BGT

Stocks: WMT, JPM, MAA, SWBI, MCD, DG, WM

Cash position: 25%

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in BGT, over 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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