BCAT CEF: Heavily Discounted Multi-Asset Fund

Written by Nick Ackerman, co-produced by Stanford Chemist. A version of this article was originally published on February 1st, 2023, to members of the CEF/ETF Income Laboratory.

BlackRock Capital Allocation Trust (NYSE:BCAT) hasn’t been getting any love, which has been fairly common throughout 2022. After the fund launched, it enjoyed trading at some premiums, which quickly turned into a deep and persistent discount. The fund overall is highly diversified between fixed-income and equity positions, investing in various sectors and industries, and it is also spread across different credit qualities within the fixed-income sleeve.

Since our last coverage, shares of BCAT have provided relatively attractive results compared to the broader market. The S&P 500 Index isn’t an appropriate benchmark directly, but it provides some context of how things are looking overall.

At this time, the fund’s discount has narrowed some. However, it remains at an attractive and deep discount. That could make it a compelling and appropriate choice for an investor’s income portfolio as it provides an attractive monthly distribution. Significant diversification means that it could complement any well-rounded portfolio already without disrupting the diversification harmony.

The Basics

• 1-Year Z-score: 1.32
• Discount: -13.03%
• Distribution Yield: 10.01%
• Expense Ratio: 1.54%
• Leverage: 0%
• Managed Assets: $1.901 billion
• Structure: Term (anticipated liquidation date of September 25th, 2032)

BCAT’s investment objective is “to provide total return and income through a combination of current income, current gains and long-term capital appreciation.”

To meet their objective, they simply “invest in a portfolio of equity 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 “utilize an option writing strategy in an effort to generate gains from options premiums and to enhance the Trust’s risk-adjusted returns.”

At this time, the fund lists no leverage in its portfolio. However, this fund can employ leverage, and they have. So this is a metric we should regularly watch for this name. At one point, they were running with nearly $700 million in borrowings, which was reduced to around $102 million in their last semi-annual report to now nothing at the end of 2021.

Additionally, the fund also isn’t being overly aggressive with the portion it’s overwritten in its options sleeve. At this time, the percentage overwritten is below 11%. That’s down slightly from the 13.34% previously. One of the reasons this is important is because the more overwritten they are, the more they could potentially be seen as bearish. They write against both individual positions and indexes – representing yet more diversification and flexibility in their approach.

The portfolio’s effective duration is quite low. One of the reasons for this is due to the floating rate credit investments they have on their fixed-income sleeve. However, they also implement various derivatives that can drive down interest rate sensitivity too. That includes going short U.S. Treasury futures contracts or interest rate swaps. This would be similar to some of the black box-like exposure of PIMCO funds.

Not that we don’t know what these funds are investing in or that derivatives are ‘scary,” but we don’t know exactly what they are investing in at any one time. With active management, they can enter and exit these sorts of derivatives at will and with the flexibility to invest in anything, anywhere. That also includes at any time; there is a big reliance on management here to make the right calls.

Performance – Competitive Results

We know that 2022 wasn’t a year to be envious of being invested. Unless you invested entirely in energy or were heavily weighted toward defensive positions, you did fairly poorly. This is reflected below by the comparisons of BCAT up against the SPDR S&P 500 (SPY), and I’ve also included iShares iBoxx $ High Yield Corporate Bond ETF (HYG) plus the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).

We see that, for the most part, BCAT’s total NAV returns were right in line with where we would expect.

However, the big drop came in the form of the total share price results. That’s directly impacted by the fund’s discount widening out significantly in the last year. At one point, BCAT had been flirting with a premium. In fact, that flirting with a premium had been in place for most of the first year of the fund.

We are off the lows that we saw earlier in 2022. However, we are still at quite an attractive level to consider this fund, in my opinion.

As a term fund, this discount can eventually be realized. That being said, we still have plenty of time before that component kicks in. They are anticipated to liquidate or utilize a tender offer sometime in September 2032. That’s nearly 10 years away, so that factor probably won’t become more relevant until the last year or two.

Distribution – Steady

Since the fund’s launch, they’ve continued to pay out the $0.1041. Now they’ve upped this to $0.1275, providing a 22.5% increase starting with February’s distribution. This was a move to a 9% NAV distribution based on the 3-month average NAV ending December 2022. Thanks to setting a fairly reasonable level at launch and 2022 not being too dire for the fund, they seemed able to provide this increase.

BlackRock (BLK) will often keep its funds paying predictable distributions, even if, in a shorter-term period, it seems unsustainable. They will cut if it becomes too elevated at some point, but they tend to hold off. A move like this would suggest they are looking for ways to minimize the discount.

The 10.01% distribution yield on the share price and the NAV rate of 8.70% seems reasonable. Given the raise, I wouldn’t anticipate a cut for at least a year. Since the bump, the NAV rate has even gone down, meaning there has been further appreciation.

That being said, it should still be noted that being a half-equity fund, they will rely on capital gains to fund their distributions. In their last semi-annual report, we saw that NII coverage came to ~42%.

Worth noting is that they continue to repurchase shares after this reporting period. Another attempt to reduce the fund’s sticky discount.

Despite the fund producing a realized capital loss for this six-month period, two factors contributed heavily to reducing these losses. That includes the futures contracts and the forward foreign currency exchange contracts that materially reduced losses. Had it not been for these, the results would have been worse by about $70 million.

Given the increase in the distribution, going forward, the distribution coverage will take a hit. They’ll require further capital gains in order to cover the payout.

All that being said, for tax purposes, we have seen destructive return of capital utilized to maintain the distribution. It would be considered destructive because the fund didn’t generate enough NII and gains for the payout in 2021.

We should be getting the 2022 tax classification breakdown before too long.

BCAT’s Portfolio

The fund’s flexibility would seem to increase the fund’s portfolio turnover naturally, so seeing fairly elevated levels isn’t too unexpected. In the last six-month report, it was at 31%. For the entirety of 2021, it came to 90%. A higher turnover means that the fund can change somewhat drastically from update to update.

At the end of 2022, the portfolio’s overall asset allocation has shifted somewhat materially. They’ve put fixed-income and equity allocations much closer together from the previous 53.12% in fixed-income and 41.14% in equity. That was as of the end of July 2022. So we are looking at around a six-month period between updates.

They’ve also put all their cash to work as it previously stood at a 5.72% weight. This could indicate that they are looking to be a bit more aggressive and bullish on equities.

At the same time, since they’ve dropped leverage to nothing, that could be playing a role in what we see too. If their leverage was invested in fixed-income securities, liquidating those would naturally drop the weighting. Additionally, underlying portfolio performance always changes the weights we see simply from underlying price changes.

With that being the case, we’ve also seen a shift in sector weightings. Now we see that on the equity side of the portfolio, tech’s weighting and healthcare weightings have increased.

The energy weighting has also increased, and while it’s a fairly small amount, the actual relative increase from 2.80% is fairly hefty. The energy sector was a strong performing area of the market, which could have contributed to some of this increase. Overall, the portfolio remains highly diversified with a broad mixture of sector allocations.

The top ten equity positions reflect this heavy diversification. Microsoft (MSFT) is the fund’s largest equity position but comes in at a fairly low 1.43% weighting. CEFConnect lists a whopping 1665 total positions.

On the fixed-income side of the portfolio, we see that, once again, credit investments are the largest allocation. A meaningful allocation then follows that to securitized investments. They’ve dropped their sovereign exposure and rate derivatives. Municipal exposure remains an incredibly small amount of the portfolio.

When looking at the top ten here, it might be interesting to note that the largest position is quite massive – at least relatively speaking at a 6.6% weighting. That belongs to a UMBS 30-Year TBA security. This is a pool of residential mortgages. So while it’s one position, it isn’t dedicated to just one investment backing it. That means within itself, it can be diversified around many different properties.

Conclusion

BCAT is highly diversified and trading at a deep discount. The discount has narrowed more recently but still presents a compelling opportunity for an income investor. The current distribution doesn’t appear at risk, even with weaker overall results in the market and relying on capital gains. The recent raise only makes me more confident. It marked another move in an attempt to reduce the fund’s discount on top of share repurchases.