ArrowMark Financial Stock: An Interesting Operation At A Deep Discount (NASDAQ:BANX)

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Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on September 20th, 2022.

In the world of closed-end funds, you can run across some pretty interesting and niche exposures. Then there is ArrowMark Financial Corp (NASDAQ:BANX), along with the CLO funds, that are run more similarly to corporations. They have quarterly earnings calls and provide an NAV update quarterly, similar to a BDC. However, similar to the CLO, they also provide a monthly estimated NAV for investors.

The company describes itself as “an SEC-registered non-diversified closed-end investment company … The company is structured as a non-BDC RIC.” We looked at this name previously at the end of September, and since that time, the company has moved to a deep discount based on the last estimated NAV. History has suggested that the shares move up towards their NAV sooner or later, presenting a unique opportunity.

Additionally, since the last update, the name has changed to ArrowMark Financial Corp from what was formerly StoneCastle Financial. This was the natural progression due to being acquired by ArrowMark Partners earlier in 2020. The name change officially took place earlier in 2022.

The Basics

  • 1-Year Z-score: -1.83
  • Discount: -14.08% (based on 8/31 estimated NAV)
  • Distribution Yield: 8.61%
  • Expense Ratio: 3.96%
  • Leverage: 26%
  • Managed Assets: $201.6 million
  • Structure: Perpetual

BANX’s primary investment objectives are “income generation, capital preservation and providing total risk-adjusted returns.”

To achieve these investment objectives, they will invest in “banking-related assets across the spectrum of community banks to global money center banks. The company invests across asset classes including, term loans, structured debt, regulatory capital relief securities and to a lesser extent equity. Under normal circumstances, we intend to invest at least 80% of the value of our net assets plus the amount of any borrowings for investment purposes in these assets.”

The total size of the fund is rather small, which can be a concern if you are a larger investor wanting to get in and out of the market quickly. It doesn’t automatically make it a fund that should be avoided, but it should be considered before jumping in.

The fund is also rather moderately leveraged, which can add further volatility. This is a credit agreement with Texas Capital Bank. The borrowings are variable rates based on SOFR+2.61%; this was from a LIBOR+2.85% previously. Another change was that the amount they were allowed to borrow under the agreement went from $62 to $70 million.

The interest rate is on the higher end and will only run higher as rates are increased further. On the other hand, 78% of the portfolio the company invests in is floating rate too. Therefore, any increase in the fund’s leverage expenses should also result in an income increase for the fund, too.

Another similarity between BANX and CLO, and BDC funds is the expense ratio. At 3.96%, that’s certainly a bit of a shocking number. When including leverage expenses, it goes up to 4.87%. However, that is actually less than some of the CLO funds and BDCs that are out there. The bulk of BANX’s portfolio is invested in regulatory capital relief securities.

They describe regulatory capital securities as;

…senior unsecured debt obligations that are credit linked to the performance of a reference portfolio of certain loan related claims on corporate and similar entities. The fair value of regulatory capital securities is generally based on broker quotes. Regulatory capital securities are generally categorized as Level 2 or 3 in the fair value hierarchy, depending on the availability of broker quotes.

Performance – Challenging 2022

Like most of the other asset classes and sectors in this market, BANX has had to navigate a challenging 2022. Here’s a look at the performance between a broad set of comparisons. SPDR S&P 500 (SPY) represents U.S.-large cap performance or the “market.” Then I’ve also included iShares Preferred Income Securities (PFF), Vanguard Total Bond Market (BND) and iShares iBoxx High Yield Corporate Bond (HYG) to highlight how everything has been challenged, not just equities.

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We can see in the case of the total share price return performance, BANX is right in the middle. More interestingly is the NAV performance we see here.

At the end of December 31st, 2021, they reported an NAV of $21.44. At the end of June 30th, 2022, it had only slipped to $20.94, but we also have to consider that two distributions were paid during that time. Now, with the latest estimated NAV for August 31st, 2022, we see it coming in at $21.23. So essentially, the NAV is flat for the year while everything else is falling – including the company’s share price.

What history has shown us for BANX is that it tends to rise back along towards its NAV.

BANX NAV History

BANX NAV History (ArrowMark)

That’s why the estimated ~14% discount is looking quite attractive at this time. Of course, we can also see that the NAV can drop sharply during times of panic. If we are only expecting a mild recession, then we might only expect a mild drop in NAV. Much less of a drop than what the price is actually reflecting, it would appear.

Also, if you are worried about the accuracy of the valuation of their portfolio, the majority of assets are level 2. There is only a small sliver of level 3 assets. They also solicit “a minimum of two independent, third-party quotes in order to value the portfolio.” Meaning there is no in-house conflict of interest potential in the valuation.

Trying to gauge the company based on the historical performance over the longer term would be hard or not very helpful. Past performance is even less helpful in this case because the most glaring reason would be the fund’s new management. Also, they had previously been holding a Community Funding CLO position that was running an allocation greater than 25% of the fund. That position is no longer in the portfolio.

BANX Dividend – A Boost

Heading into 2022, the company boosted its quarterly dividend from $0.38 to $0.39. They’ve also been paying some extra supplemental dividends out to investors on a few different occasions. Since they are an RIC, they are still required to pay out the majority of their earnings or pay excise taxes.

BANX Dividend And Coverage

BANX Dividend And Coverage (ArrowMark)

The coverage of the dividend has been strong, too, as shown in the graph above. Here’s a look at the earnings in the last semi-annual report as well.

BANX Semi-Annual Report

BANX Semi-Annual Report (ArrowMark)

We can see that NII coverage came to 109%. That was an improvement above the rather strong 98.52% they had reported last year. However, the last fiscal year is also showing the total distributions paid, accounting for the extra $0.10. Without that extra, NII coverage would have been over 100%.

Considering the current environment, looking for funds with coverage coming solely from NII isn’t a bad idea. It is generally more predictable than capital gains. However, the company has been able to provide realized capital gains nonetheless.

BANX’s Portfolio

As mentioned above, the portfolio is invested primarily in level 2 securities with an overweight allocation to regulatory capital relief securities. They account for around 78% of the portfolio. The majority of these are credit-linked notes with varying coupons and maturities. The portfolio hasn’t changed too much since last year. Although, they no longer have any ETF exposure, and they’ve put most of their cash to work. Last year they were sitting on around $54.5 million in cash.

BANX Investments Types

BANX Investment Types (ArrowMark)

With about 78% of the portfolio in floating rate assets, the increased interest rates are welcomed. That’s where increased interest rates are better for BANX as the yields rise on these underlying holdings.

BANX might be at a bit of risk due to the narrow focus of its portfolio. They don’t hold many positions, with CEFConnect putting the number of holdings at just 46. A lack of diversification could mean a few securities held have a larger impact on the fund.

However, BANX will ultimately be at the mercy of things going well. If defaults start to tick higher, these credit-linked notes will suffer losses. Higher interest rates might mean their floating rate debt will be providing more income, but at a certain point, the cost of the debt could become burdensome. They state that “a majority of the transactions offering exposures to sub-investment grade borrowers.”

Conclusion

BANX provides unique exposure to regulatory capital relief securities. Whether an investor was looking for this type of exposure or not is going to be up to each individual investor. They state they are “the only public company that offers an entry into a traditional private market product.” That’s the regulatory capital securities that they are mostly invested in.

Given how well the portfolio has been holding up, it certainly lends credibility to why an investor would want this type of exposure. While most assets and sectors have been hit hard, the NAV for BANX has held up. They are even providing some gains when factoring in the distributions. At the same time, the share price has come down, opening up an attractive discount.

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