Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on April 16, 2022.
BlackRock Capital Allocation Trust (NYSE: BCAT) continues to be avoided by investors. The discount has widened considerably, having more than doubled since the last time we hedged the fund. Net asset value has held up relatively well as the stock price plummets.
The fund launched towards the end of 2020. It captured the overall market bounce that most investments were experiencing. For this reason, the fund started quite strong. Now that most investments have been under pressure – especially bonds and growth stocks – BCAT has struggled over the past six months.
If this overall struggle in the market is expected to continue, BCAT might not be the perfect fit for it. However, for a longer-term investor, the discount is quite compelling right now. It’s a bit hard to believe that at one time this fund was trading at a premium.
- Z-score over 1 year: -2.07
- Discount: -16.01%
- Distribution yield: 7.83%
- Expense ratio: 1.54%
- Leverage: 17.99%
- Assets under management: $2.12 billion
- Structure: Temporary (early liquidation date of September 25, 2032)
BCAT investment objective is “to provide total return and income through a combination of current income, current gains and long-term capital appreciation”.
To achieve their goal, they simply “invest in a portfolio of stocks and debt securities”. They add a bit more color with, “the Trust may emphasize either debt securities or equity securities”. Along with this, they “will employ an option writing strategy with the aim of generating gains from option premiums and enhancing the Trust’s risk-adjusted returns.”
BCAT is a true multi-asset approach offering from BLK. Currently, the percentage of wallet crushed is 10.59%. This is only a slight increase from our previous update in late November.
The fund is quite large, partly thanks to the leverage of around 18% that the fund uses. As a general rule, BlackRock does not use leverage on its equity funds. This is primarily an options-only selling strategy. Since fixed income is the largest allocation, they must feel better about doing it in this fund.
The fund’s expense ratio is 1.54%. This includes a 0.02% “vested funds fee and expense”. This comes from the ETFs the fund carries in the fund, which is a rather small allocation at the moment. The cost rate is 1.63% taking into account interest charges.
Performance – Struggling in 2022
I think BCAT has several things working against it going into 2022, and that’s been most of the last six months as well. The first is the large allocation to fixed income assets. The allocation at the end of March 2022 had fixed income securities at 57.57% and equity positions at 44.91%.
Rising interest rates put direct pressure on these interest rate sensitive investments. This is especially true for the portion of their fixed income securities that is allocated to investment grade. These tend to be even more sensitive to changes in interest rates than long-term assets.
The other issue is the tilt towards tech stocks in the equity portion of the fund. These were also referred to as longer duration assets. Although usually long lasting refers to fixed income investments. The idea is that investors want to invest in things with cash flow now, not what might happen in the future.
This resulted in what we see on a YTD basis for 2022 performance. For more context, I’ve added several different ETFs that are relevant to BCAT.
I have included the SPDR S&P 500 (SPY) as a general indicator of market performance for the year. I have also included the iShares iBoxx High Yield Corporate Bond ETF (HYG) – which has proven to be the best performer so far. After that, I included the iShares iBoxx Investment Grade Corporate Bond ETF (LQD). LQD represents higher quality bonds, as mentioned above, which are particularly affected. Finally, we have the SPDR Technology Sector (XLK) to represent the evolution of technology. As we can see, XLK came in at the bottom as the worst performer.
It should be noted that, based on total stock price, BCAT was the worst. Based on total net asset value return, BCAT is only marginally worse than HYG.
If we go back to the fund’s inception, we see that the net asset value is always positive on a total return basis. This would include any distributions the fund has paid. It really is the stock price that has been hammered the most.
This is exactly what led to the roughly 16% discount we are seeing today. This is also why we’ve seen the discount expand significantly on a YTD basis, as we’ve highlighted above.
Distribution – Solid yield of 7.83%
Currently, the fund has continued to maintain the same distribution that investors were paying. This might turn into an incredibly poor call from me, but I don’t see the cast being cut. I think when they launch these CEFs they put it at a payout where there is some downside protection. If we go back once again to the net asset value of BCAT, it stands at $18.55. So about a dollar and a half since the launch of the fund
I think that’s a bigger factor in determining whether CEF management will continue to pay out the same distribution or not – not what the actual stock price does. I think it’s also worth noting that historically BlackRock has been a fund sponsor that has stuck to paying the same distribution for longer. This means they are not as quick to cut payouts to investors.
So for now, at a NAV yield of 6.65%, I don’t see the need to cut.
To cover the distribution to shareholders, it will eventually be necessary for significant capital gains to materialize. Either that or there will be a destructive return of capital. The reason is that the net investment income coverage is about 43%. Unfortunately, it’s not even a level indicating that the fixed income round is covering.
With this report, we can also see that even if we add the NII, realized gains and unrealized gains; it still came short for fiscal 2021. That makes sense because towards the end of the year is when bonds and tech stocks really started to take a hit.
This resulted in a destructive return of capital used to pay shareholders. I believe that’s probably at least one of the reasons for the steep discount. At some point, however, a discount still becomes quite tempting.
Looking at the portfolio, we can see that as of March 31, 2022, fixed income was still the fund’s largest allocation.
This was the case at the end of October 2021, when fixed income securities were also the largest allocation. As for credit quality, that hasn’t changed much since our previous update either. However, note that the following was reported at the end of January 31, 2022. This is two months before the update they provided for their asset allocation.
The investment grade weightings amount to 12.11% of the fund. This was similar to the 12.31% weighting previously. The largest allocation is still to the BB rating, which is the first notch in below investment grade.
Among the weights that have seen a fairly noticeable increase are those that are unrated.
Taking a look at the top ten credit holdings, we see quite a mix. We also have foreign government holdings, US Treasury holdings and private debt holdings.
That being said, the effective duration they provided is 0.53 years. This would suggest that the sensitivity of their bond leg is quite low. However, we haven’t seen that happen as the net asset value has slipped this year.
Turning to the equity side of the equation, we see that technology remains the main sector weighting. However, the fund remains fairly diversified overall. There is no significant overweight in any particular sector.
For the top ten equity positions, we see several household names. It is the mega-cap tech names that dominate most CEFs.
These are Microsoft (MSFT), Amazon (AMZN) and Alphabet (GOOG), (GOOGL). These three stocks did not escape the downward pressure. Below is the YTD price performance of each of these three.
That being said, these were not the only top 10 holdings that contributed negatively to performance. Below is the performance of the other seven top stocks on a year-to-date basis, based on price only. We can see that Mastercard (MA) and Mercedes-Benz (OTCPK:DDAIF) have had quite significant difficulties so far in 2022. DDAIF is trading on the pink sheets, which may add additional risks that investors need to be aware.
We then have EQT Corp (EQT), Sempra (SRE) and Enbridge (ENB) in the lead. EQT is on a substantial rally. Unsurprisingly, EQT is an energy player as a natural gas production company. As natural gas and crude oil prices soared, EQT benefited significantly. For BCAT, energy is a fairly small contributor. So it didn’t have a significant impact, but it certainly doesn’t hurt either.
BCAT continues its slide into discount territory. While I’m not one to invest too heavily in fixed income, BCAT’s valuation definitely catches my eye. The fund is highly diversified, so it could be a great fit for an investor who only holds a few funds. This can make it a great choice even if you’re already diversified, as it shouldn’t disrupt your portfolio in terms of weightings.
I could even see an investor argue if they only wanted to hold BCAT in their portfolio. After all, they list 827 holdings, and we’ve looked at all the weightings and know they’re split across assets and sectors. On the other hand, do not expect spectacular performance either. It is a total fund of the stock market and the total bond market combined. There are too many stocks for the fund to outperform. At the same time, the chance is always presented to outperform other hybrid funds, here is the current fund discount.