BTZ: Risks May Exceed Upside Potential For Bonds And This Bond CEF

seekingalpha2024-10-05

The BlackRock Credit Allocation Income Trust offers a high yield of 8.96%, appealing to income-seeking investors despite its limited inflation protection.The BTZ closed-end fund's substantial ...

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The risks could exceed the potential rewards.   PM Images The BlackRock Credit Allocation Income Trust (NYSE:BTZ) is a closed-end fund, or CEF, that could be attractive to any investor whose goal is to earn a high level of income from the assets in their portfolios. The fund generates income for investors by investing primarily in a portfolio consisting of bonds, floating-rate senior loans, and other fixed-income securities. This reduces its appeal compared to equity income funds in my mind because fixed-income securities do not do a good job of preserving wealth in the face of inflation. As I pointed out in a recent article, policymakers in the United States may be far too optimistic in declaring victory against inflation. We saw evidence of this earlier today, as the Bureau of Labor Statistics released a jobs report that was stunning, to put it mildly. The United States added 254,000 jobs in September, which beat every month since March:   Zero Hedge The report also showed an uptick in average hourly earnings:   Zero Hedge This points to a much stronger economy than expected, and it may suggest that the Federal Reserve’s 50-basis-point interest rate cut last month was larger than it should have been. A strong economy combined with interest rates that are too low will likely result in an increase in inflation as workers borrow money against their now higher wages to consume. This will increase the money supply faster than economic production and thus lead to a resurgence of inflation. In such an environment, investors should prefer equities and hard assets over fixed-income securities such as those found in this fund. This is because equities, real estate, commodities, and precious metals should increase in price along with everything else in an inflationary economy. The BlackRock Credit Allocation Income Trust does have a reasonably attractive yield of 8.96% right now, which is higher than most domestic fixed-income securities. This chart shows the trailing twelve-month yields of each of the four primary domestic fixed-income indices:   Index/ETF TTM Yield   iShares Core U.S. Aggregate Bond ETF (AGG) 3.73%   Bloomberg High Yield Bond ETF (JNK) 6.49%   Bloomberg US Floating Rate Note < 5 Years Index (FLOT) 6.44%   ICE Exchange-Listed Preferred & Hybrid Securities Index (PFF) 6.21%   Click to enlarge (Figures from BlackRock/State Street as of October 4, 2024.) This is certainly likely to appeal to many income-seeking investors. After all, we all like to receive a high yield on our money and, in a falling interest rate environment, high yields can become difficult to obtain. This fund’s yield is also a bit higher than many of its peers. We can see this here:   Fund Name Morningstar Classification Current Yield   BlackRock Credit Allocation Income Trust Fixed Income-Taxable-Investment Grade 8.96%   First Trust Mortgage Income Fund (FMY) Fixed Income-Taxable-Investment Grade 7.23%   PIMCO Corporate & Income Strategy Fund (PCN) Fixed Income-Taxable-Investment Grade 9.48%   John Hancock Investors Trust (JHI) Fixed Income-Taxable-Investment Grade 8.88%   Western Asset Premier Bond Fund (WEA) Fixed Income-Taxable-Investment Grade 7.43%   Nuveen Core Plus Impact Fund (NPCT) Fixed Income-Taxable-Investment Grade 12.12%   Click to enlarge It is arguable whether the BlackRock Credit Allocation Income Trust should be classified as an investment-grade bond fund. This fund does, after all, invest in various things that are not investment-grade bonds. We will see that in more detail later in this article. However, its yield is reasonably attractive even when compared to junk bond funds, so we cannot complain too much. The high yield might help compensate for the fund’s inability to provide the inflation protection that we might desire. After all, while there are several economists and commentators who are making a solid case that the real rate of inflation is much higher than the 2.5% indicated by the consumer price index, nobody is making a credible claim that it surpasses 8.96%. Thus, if this fund is held in some sort of tax-advantaged account and the distributions are partially or fully reinvested, an investor might be able to maintain their purchasing power through the acquisition of additional shares of the fund. As regular readers might remember, we previously discussed the BlackRock Credit Allocation Income Trust in mid-March of 2024. The fixed-income markets were not particularly strong for the first two or three months following the publication of that article. This is because various market participants were adjusting to the fact that interest rates would not be coming down as quickly as was hoped or assumed at the start of the year. This all changed in July, though, as fixed-income traders aggressively started buying up bonds on expectations of numerous Federal Reserve interest rate cuts in the second half of 2024. The central bank delivered a down payment on those expectations in September, with its first interest rate cut since 2020. This has provided support for fixed-income prices, which generally remain higher than they were a few months ago. As such, we might expect the BlackRock Credit Allocation Income Trust to have also delivered a reasonably strong performance over the period. Unfortunately, this was not really the case as shares of this fund are only up 2.18% since that previous article was published:   Seeking Alpha As we can see, this is less than the gain of all three of the major fixed-rate indices. Domestic investment-grade bonds, domestic junk bonds, and domestic preferred stocks all delivered greater price gains than this fund did. In addition, all the indices managed to do this with less volatility, as they did not decline nearly as much as this fund did during the second half of March and April. Income-focused investors tend not to like volatility, so overall this might scare some away from this fund. As is usually the case with closed-end funds, though, investors in the BlackRock Credit Allocation Income Trust actually did a lot better than the share price performance might suggest. As I stated in a previous article: A simple look at the fund’s share price performance rarely tells the full story of what investors actually receive during a given period of time. This is because closed-end funds tend to pay out all of their investment profits to the shareholders in the form of distributions. These funds do not rely on share price appreciation to provide returns to investors as many index exchange-traded funds do. As such, we should take the distributions paid by a fund into account when examining a fund’s performance. When we include all the distributions that were paid out by the BlackRock Credit Allocation Income Trust as well as the indices since March 12, 2024, we get this alternative performance chart:   Seeking Alpha As was largely expected, we can see that investors in this fund actually made out a bit better than investors in any of the major fixed-income indices over the period. This is because the fund’s yield is much higher than that of the indices, so it was able to offset the weaker price performance. This is usually going to be the case with closed-end bond funds, so income-focused investors might want to prefer such leveraged funds in a low-interest rate environment. However, the use of leverage causes most closed-end bond funds to exhibit much more share price volatility than the indices, so naturally, investors should always take their own risk tolerance into account. As approximately six months have passed since our last discussion on the BlackRock Credit Allocation Income Trust, it is reasonable to assume that a great many things have changed. In particular, interest rates have come down quite a bit and this fund has released an updated financial statement. The remainder of this article will focus on updating our thesis in consideration of these new developments. About The Fund According to the fund’s website, the BlackRock Credit Allocation Income Trust has the primary objective of providing its investors with a high level of current income, current gains, and capital appreciation. Ordinarily, I would criticize a fixed-income fund for having an objective of delivering long-term capital appreciation, since bonds are generally incapable of doing this. As I explained in a previous article: Bonds by their very nature are income securities, as they do not deliver any net capital gains over their lifetimes. This makes sense, as an investor will purchase a bond at face value and receive face value back when the bond matures. The only investment return for a bond held over its entire lifetime is the coupon payments made to the bond’s owner. Thus, bonds do not deliver capital appreciation over their lifetimes. The BlackRock Credit Allocation Trust has a twist that makes its long-term capital appreciation objective reasonable. From the fund’s website: BlackRock Credit Allocation Income Trust’s investment objective is to provide current income, current gains and capital appreciation. The Trust seeks to achieve its investment objective by investing, under normal market conditions, at least 80% of its assets in credit-related securities, including, but not limited to, investment grade corporate bonds, high yield bonds (commonly referred to as ‘junk’ bonds), bank loans, preferred securities or convertible bonds or derivatives with economic characteristics similar to these credit-related securities. The Trust may invest in such securities or synthetically through the use of derivatives. It is the fact that the BlackRock Credit Allocation Income Trust can invest in convertible bonds that makes its objective of delivering long-term capital appreciation make sense. In a recent article, I explained that convertible securities can be converted into common stock. Common stock has unlimited upside, and some investors are willing to assign a high value to the convertibility feature of these instruments if the common stock of the issuing company has done (or is expected to do) very well. For example, Tesla’s 2014 convertible bonds delivered an 800% gain when they expired in 2021. As Forbes explains:  March 1, 2021 marks a historic day for Tesla. It’s the day in which holders of Tesla’s convertible bonds issued back in 2014 will convert those bonds into shares, realizing whopping gains of more than 800%. It is also a day that likely marks the end of Tesla’s extensive convertible bonds issuance. … The typical convertible issuer is a non-investment grade, high growth company that isn’t a traditional straight debt issuer. And Tesla falls precisely into the category of a speculative grade technology company. In fact, when Tesla issued its first convertible bond back in 2013 it was not even rated by one of the major credit rating agencies. …By issuing convertible bonds, Tesla was able to get away with offering its investors a very low coupon--that is, the annual interest rate paid until the bond reaches maturity. For example, its 7-year convertible bond issued in February 2014 that is maturing on March 1 st 2021 offered investors a coupon of 1.25%, while its 5-year convertible offering in 20214 was able to attract investors with a coupon as low as 0.25%! [Investors] agreed to those ultra-low coupon rates since they were attracted to the possibility that they could convert the bonds into stocks if Tesla’s stock price appreciated enough.  These securities can, therefore, provide the fund with very substantial capital gains in certain circumstances. That makes its objective a little easier to accept. However, right now, the fund does not appear to have a significant allocation to convertible bonds. The fund’s semi-annual report provides the following asset allocation as of June 30, 2024:   Asset Type % of Net Assets   Asset-Backed Securities 18.5%   Common Stocks 0.0%   Corporate Bonds 112.0%   Fixed Rate Loan Interests 0.0%   Floating Rate Loan Interests 7.5%   Foreign Agency Obligations 2.0%   Investment Companies 0.4%   Municipal Bonds 1.0%   Preferred Securities 12.4%   Warrants 0.0%   Money Market Funds 1.0%   Purchased Options 0.1%   Written Options (0.1%)   Click to enlarge As of June 30, 2024, the BlackRock Credit Allocation Income Trust did not have any convertible bonds in its portfolio. Thus, the fund appears to be unable to take advantage of the potential for considerable capital gains from the securities in its portfolio. This actually makes it quite difficult to achieve any sort of long-term capital appreciation, since the other securities in the portfolio are limited in the extent to which they can deliver long-term gains. This is because interest rates cannot really go much below zero before bond investors start being unwilling to purchase bonds. The lowest yield ever for the ten-year U.S. Treasury note was 0.55% set on July 27, 2020:   MacroTrends As that was set during a time in which a pandemic was ravaging nations all over the world and investors were terrified and running to Treasuries for safety, it seems unlikely that bond yields will ever go much below what we saw in that period. This effectively puts a cap on how high the price of a given non-convertible bond can go. This, therefore, limits the fund’s ability to provide its investors with capital gains in the absence of convertible bonds. With that said, we could still see the fund provide short-term gains (current gains) by trading bonds as their price fluctuates with interest rates. This fund does appear to engage in a great deal of trading, so that is a very real opportunity for it. The semi-annual report states that the fund’s turnover in the first six months of 2024 was 91%. It does not state whether that figure is annualized or not, though. Most other funds do not annualize the turnover rates that they provide in their semi-annual reports, so if we assume that this was the same here, then this fund had an annualized portfolio turnover of 182%. That is a much higher figure than this fund has had in previous years:     FY 2023 FY 2022 FY 2021 FY 2020 FY 2019   Portfolio Turnover 155% 42% 20% 34% 20%   Click to enlarge (All figures from June 2024 semi-annual report.) The fund’s very high turnover in 2023 compared to previous years shows a marked increase in trading activity during that year. This is not difficult to understand, considering how volatile longer-term interest rates were in 2023. As we can see here, all the domestic fixed-income indices bounced around quite a bit that year:   Seeking Alpha This provided the opportunity for the fund to earn profits by selling bonds when prices were rising, while selling them during periods in which bond prices were declining. This supports the fund’s current gains objective. We also saw considerable volatility in fixed-income prices during the first half of 2024, although it was perhaps not as prominent as what we saw over the full-year 2023 period:   Seeking Alpha Thus, it makes a certain amount of sense that the fund would continue its strategy of earning profits through the buying and selling of fixed-income securities as expectations of long-term interest rate changes cause bond prices to move. The need to rely on trading for profits will likely become more important if the Federal Reserve continues to reduce interest rates. Federal Reserve Projections The Federal Reserve’s latest dot plot projections are much more aggressive than we saw back in March. As of right now, the Federal Reserve is projecting an effective federal funds rate of 4.40% at the end of 2024, 3.4% at the end of 2025, and 2.9% by the end of 2026:   Federal Reserve Bank of St. Louis The current federal funds target range is 4.75% to 5%. These projections, therefore, would require two 25-basis point cuts in 2024 (in November and December), four 25-basis point cuts in 2025, and two more cuts sometime in 2026 to achieve. The market, meanwhile, has priced for basically the same thing. Federal funds futures are projecting a 75.4% chance that the federal funds target will be 425-450 basis points at the end of this year:   Chicago Mercantile Exchange The futures market is also projecting a 29.2% probability that the federal funds target will be 325-350 basis points by the end of 2025:   Chicago Mercantile Exchange These probabilities are very much in line with what the central bank is saying. This means that unless the Federal Reserve cuts more aggressively than its own guidance, bond prices will have very limited upside over the next two years. This will limit any further capital gains that the fund will be able to earn, although there is still the possibility of earning profits on company-specific factors (such as a company significantly improving its balance sheet). In any case, though, we probably should expect that the fund’s performance will be a bit weaker going forward than we saw over the past year or so. The big question, though, is whether the Federal Reserve will actually be able to cut interest rates in line with its expectations. As we saw in the introduction, as well as in a previous article that I linked in the introduction, inflationary threats as well as threats to the U.S. dollar internationally are very real. These factors could apply upward pressure on yields (and pressure bond prices downward) regardless of whatever the Federal Reserve does. After all, many investors will be reluctant to accept negative real bond yields, so inflation will naturally mean that market participants will want a higher yield to avoid losing too much purchasing power from their bond investments. Earlier today, the Food and Agriculture Organization of the United Nations released its most recent food price index. From the agency’s report: The FAO Food Price Index, which tracks monthly changes in the international prices of a set of globally-traded food commodities, averaged 124.4 points in September, up 3.0 percent from August and 2.1 percent higher than its corresponding value a year earlier. This marks a change from the trend of the past year, which had generally shown declining rates of food price inflation:   Zero Hedge As mentioned in the introduction, the latest report from the Bureau of Labor Statistics indicates that the employment situation in the United States is remarkably strong. The Federal Reserve’s rationale for the 50-basis point cut in September was that inflation is slowing and employment in the United States is weakening. The most recent data, which came from governmental and supranational organizations, suggests that the opposite is true. Inflation is showing signs of reacceleration, and the labor market appears to be healing. There could be some reasons to believe that if the data keeps coming in like the most recent reports suggest, the Federal Reserve will have to make a hawkish pivot. Thus, we have a situation where all the interest rate cuts that are likely to happen are already priced into bonds. This limits the upside potential that bonds have right now. Meanwhile, recent reports weaken the case for further interest rate cuts. The conclusion from this appears to be that the risks of investing in bonds outweigh the potential rewards right now. Fortunately, the BlackRock Credit Allocation Income Trust can increase its exposure to floating-rate securities. Floating-rate securities should be fine if the Federal Reserve is unable to follow through on its recently proposed monetary easing plan due to inflationary pressures. However, as already mentioned, right now, this fund is most heavily weighted to corporate bonds so it would still take a hit from such an event. Leverage As is the case with most closed-end funds, the BlackRock Credit Allocation Income Trust employs leverage as a method of boosting the effective yield and total return that it receives from the assets in its portfolio. I explained how this works in my previous article on this fund:  In short, the fund borrows money and then uses that borrowed money to purchase bonds or other debt securities. As long as the interest rate that the fund pays on the borrowed money is less than the yield that the fund receives from the purchased securities, the strategy works pretty well to boost the effective yield of the portfolio. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, this will usually be the case. It is important to note though that this strategy is not as effective today with borrowing rates at 6% as it was three years ago when the borrowing rate was basically 0%. However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that a fund is not employing too much leverage because that would expose us to an excessive amount of risk. I do not typically like a closed-end fund’s leveraged assets to exceed a third of its portfolio for this reason.  According to CEF Data, the BlackRock Credit Allocation Income Trust has leveraged assets comprising 35.62% of its overall portfolio. This represents a slight decrease from the 36.50% leverage that the fund had the last time that we discussed it. It is not surprising that the fund’s leverage did not decrease by very much. After all, as we saw in the introduction, its share price was only up by 2.18% since the publication date of my previous article on it. Usually, a share price increase means that the fund’s portfolio got larger, which would reduce leverage. This was the case with this fund over the period. This chart shows the fund’s net asset value development since March 12, 2024:   Barchart As clearly shown, the fund’s net asset value has increased by a relatively meager 1.91% since the date of our last discussion. This is a fairly meager gain, but it is in line with the meager gain that the fund’s share price experienced. Thus, a small decrease in the fund’s leverage would be expected, given that its outstanding borrowings now represent a smaller proportion of the fund’s assets than they did previously. We still see that the BlackRock Credit Allocation Income Trust has a leverage ratio that is a bit higher than the one-third of assets level that we would prefer. This may be concerning, but let us compare it to its peers to see if the fund is using an unsafe amount of leverage for its strategy. Here is the peer comparison:   Fund Name Leverage Ratio   BlackRock Credit Allocation Income Trust 35.62%   First Trust Mortgage Income Fund 0.00%   PIMCO Corporate & Income Strategy Fund 11.49%   John Hancock Investors Trust 39.76%   Western Asset Premier Bond Fund 32.79%   Nuveen Core Plus Impact Fund 33.98%   Click to enlarge (All figures from CEF Data) As we can see here, only one fund in the peer group has a higher level of leverage than the BlackRock Credit Allocation Income Trust. This could be a sign that this fund is employing more leverage than is actually safe. However, most of the funds that actually use leverage are pretty close to the same level as this one, so it is probably okay. After all, a 1% or 2% movement in a fund’s assets can cause the leverage ratios to move by enough to get them all at the same level. Thus, we probably do not need to worry too much about the fund’s leverage right now, but we should still monitor it and ensure that it does not go much higher. Distribution Analysis The primary objective of the BlackRock Credit Allocation Income Trust is to provide its investors with a high level of current income and current gains. As is the case with most closed-end funds, this fund primarily provides its returns by paying the investors a distribution funded by its investment profits. In the case of this fund, the amount is $0.0839 per share monthly ($1.0068 per share annually). This gives the fund a reasonably attractive distribution yield of 8.96% at the current share price. Unfortunately, this fund has not been especially consistent regarding its distributions over the years. We can see that here:   CEF Connect As I stated in my previous article on this fund: This might reduce the fund’s appeal in the eyes of those investors who are seeking a safe and consistent income from their own portfolios in order to pay their bills or finance their lifestyles. However, we can also see that this is one of the few bond funds that did not have to cut its distribution back in 2022 or 2023 once interest rates started rising and bond prices started falling. After all, that scenario resulted in losses for many funds and the reduction of the distribution is a natural reaction to such losses. The fact that this fund did not reduce its distribution is somewhat confusing, especially considering that it does not have a sufficiently high allocation to floating-rate securities to prevent or significantly offset the losses from the fixed-rate side of the portfolio. As such, we should take a closer look at the fund, as we do not want it to be overdistributing and reducing its net asset value. Such a scenario is almost never sustainable over the long term. The BlackRock Credit Allocation Income Trust has not changed its distribution since the last time that we discussed it, so there is nothing to update investors on in that respect. However, the fund did release its semi-annual report for the six-month period that ended on June 30, 2024, which was linked to earlier in this article. This is a newer report than the one that was available to us the last time that we discussed this fund, so we should take a look at this report to get an update on its distribution coverage. For the six-month period that ended on June 30, 2024, the BlackRock Credit Allocation Income Trust received $465,016 in dividends and $53,496,302 in interest from the assets in its portfolio. When we combine this with a small amount of income from other sources, we see that the fund had a total investment income of $54,324,129 during the period. The fund paid its expenses out of this amount, which left it with $32,301,254 available for shareholders. That was not sufficient to cover the $46,979,532 that the fund paid out in distributions during the period. The fund was, unfortunately, not able to make up the difference via capital gains. For the six-month period that ended on June 30, 2024, the BlackRock Credit Allocation Income Trust reported net realized losses of $6,882,372 along with net unrealized losses of $9,223,423. Overall, the fund’s assets declined by $30,784,073 after accounting for all inflows and outflows over the period. Thus, this fund failed to cover its distribution during the six-month period. This is disappointing, as it suggests that the fund may be having trouble covering its distributions. However, it did pretty well during the full-year 2023 period, and overall, its assets are up $5,422,109 after accounting for all inflows and outflows over the past eighteen months. The fund’s net asset value per share is also up 4.27% since June 30, 2024 (the closing date of the semi-annual report):   Barchart Thus, it does not appear that there is any reason to panic about the fund’s ability to sustain its distribution right now. For the most part, this fund appears to be in good shape. Valuation Shares of the BlackRock Credit Allocation Income Trust are currently trading at a 4.36% discount to net asset value. This is slightly better than the 3.84% discount that the shares have had on average over the past month. Expenses BlackRock funds in general tend to have fairly low expense ratios, and the BlackRock Credit Allocation Income Trust is no exception. The fund’s current expense ratio is 4.18%, but most of that is due to the carrying costs associated with the fund’s leverage. If we exclude these carrying costs, the fund has a 1.06% expense ratio. This fund’s expense ratio compares reasonably well with its peers, as shown here:   Fund Name Expense Ratio Expense Ratio ex-Leverage Carrying Costs   BlackRock Credit Allocation Income Trust 4.18% 1.06%   First Trust Mortgage Income Fund 1.36% 1.36%   PIMCO Corporate & Income Strategy Fund 2.49% 0.84%   John Hancock Investors Trust 5.55% 1.33%   Western Asset Premier Bond Fund 3.55% 0.97%   Nuveen Core Plus Impact Fund 5.25% 1.79%   Click to enlarge (All figures from CEF Data) The BlackRock Credit Allocation Fund has lower management and other fees than most of the others on the list. Once we include the leverage carrying costs, the fund is in the upper half of this group in terms of price, but the leverage is also one of the reasons why it can boast an 8.96% yield from a portfolio of fixed-income securities. Overall, it does not appear that investors are paying an excessive price here. Conclusion In conclusion, the BlackRock Credit Allocation Income Trust is an interesting fund that invests in both fixed-rate and floating-rate debt. The fund also claims to have the ability to invest in convertible bonds, but none of these are found in its portfolio right now. This is a bit disappointing since convertible bonds are better positioned to protect investors against inflation than most traditional debt securities. Unfortunately, there is a possibility that the market is overpricing bonds right now. The most recent data shows that inflation is not beaten, and worries about the job market are overblown. That could force the Federal Reserve to pause its current monetary easing campaign, which would jeopardize current bond valuations. This means that the downside risks could exceed the upside potential right now.  Editor's Note: This article covers one or more microcap stocks. 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