BIT: Trouncing The Competition

Summary

• BlackRock Multi-Sector Income Trust (BIT) is a fixed income closed-end fund.
• The fund has exhibited an extraordinary resilience in the face of the Fed tapering announcement and increased rates.
• The fund is running negative duration via swaps.
• BIT has trounced the vaunted PIMCO funds on a year-to-date total return basis.

Klaus Vedfelt/DigitalVision via Getty Images

Thesis

BlackRock Multi-Sector Income Trust (NYSE:BIT) is a fixed income closed-end fund with a sizable AUM of ~$700 million. The fund has very robust 3- and 5-year total returns, which are above 10%, and has exhibited an extraordinary resilience in the face of the Fed tapering announcement and increased rates expectations. While the allocation is typical for a multi-sector fixed income bond fund, consisting of high-yield debt, agency MBSs, investment-grade bonds and preferred securities, what makes this fund stand part is its active duration management. Like any fixed income fund, BIT is naturally long duration and would lose money in a rising interest rate environment absent an active duration trading strategy. In the past three months we have seen a significant repricing of the interest rate curve with more rate hikes now priced in, and an increasing inflation market concern. Many of its peers have lost significant market and NAV value in the past quarter while BIT shines brightly and has trounced the competition. We rate it a "Buy" given the lack of viable alternatives in the fixed income CEF space in terms of funds actively managing duration and safely navigating a rising interest rate environment.

Performance

When looking at BIT's performance since the Fed started to talk about tapering its asset purchases and the market started pricing in a higher number of rate hikes we can see a clear overperformance from the BIT side when compared to its peers:

Source: Seeking Alpha

On a year-to-date basis BIT stands tall among its peers, with the vaunted Pimco funds closing in on a flat total return figure. Please note that the above total return calculations are run on market prices, not on NAV, and thus incorporate the shrinkage of the premium to NAV that some of the funds are experiencing. Nevertheless as a retail investor who purchased fixed income CEFs at the beginning of the year to get some yield you would be up 12% on BIT, +0.5% on PTY, +4.5% on PDI and +6.6% on ACP. There is a clear winner in this cohort and that is BIT.

Why the difference you might ask. Duration. By definition any fixed income fund purchases bonds which have a certain duration. That means that as interest rates go up, the bond prices and implicitly the NAV and market price of the fund go down. What sets BIT apart is its active investment strategy that eliminated duration via swaps and actively managed the rates interest rate path:

Source: BlackRock

The fund, although leveraged, currently has a negative duration number, namely -0.78 years.

Duration Mechanics

How can a fund run negative duration, you might ask. Well, let us have a look at the BIT fund composition and what it does to eliminate duration:

Source: BlackRock

The fund is heavily invested in high yield bonds (which usually are fixed rate), followed by securitized products and agency mortgages. If we look at the maturity breakdown of the underlying components we can see that the fund is heavily skewed towards the "3-5 Years" and "5-7 Years" maturity buckets in terms of assets allocation. This would mean that at the first glance an investor would expect a fund duration of somewhere around 6-7 years.

What asset managers do in order to hedge duration is to swap it out via Interest Rate Swaps and Swaptions. This means that it enters into derivative contracts with banks where the sensitivity of the swap is opposite to the bond - i.e. if interest rates go up the swap makes money while the underlying bond loses value. If an asset manager choses to run negative duration, he/she will simply do a large notional of swaps that will have a larger profit-and-loss impact that the underlying bonds themselves. Let us have a look at the BIT semi-annual report:

Source: BlackRock

We can see from the above that the fund has about $122 million in interest rate swaps that pay a fixed rate which can be netted out with the receive leg for a net $92 million in duration hedging via vanilla swaps. The fund also has a tremendous amount of swaption notionals (options on swaps) with a net figure around $250 million.

The main takeaway here is that a fund can run negative duration via swaps but it is a dangerous game since a lack of materialization of higher rates would have a very negative drag on fund performance. BIT has a very experienced management team who has proven it can successfully navigate a rising interest rate environment.

Conclusion

Coming from a very experienced management team, BIT has delivered very strong historic results. The BIT management team actively trades the fund's duration profile (currently set up with a negative duration) as well as its credit positioning. BIT is one of the very few CEFs that has held up during the current interest rate onslaught, with the golden standard Pimco funds suffering significant loses in the past three months. If you are looking for yield in the CEF space and you need a vehicle that is robust enough to sustain a rising interest rate environment we believe BIT is the correct vehicle to express that view.

Disclosure: I/we have a beneficial long position in the shares of BIT either through stock ownership, options, or other derivatives. 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.