BGB: Floating Rate Exposure Benefiting From “Higher For Longer”

Written by Nick Ackerman, co-produced by Stanford Chemist.

Blackstone Strategic Credit 2027 Term Fund (NYSE:BGB) has been on a strong run since our last update. On a total return basis, it has been rivaling the returns of the S&P 500 Index itself, often seen as a measurement for the broader equity market. A portion of the positive performance here were thanks to discount narrowing during this time.

However, BGB is a fund focused on senior loans, and the data of hotter inflation and a resilient economy are beneficial to the fund. This is because it decreases the probability of the number and timing of rate cuts from the Fed. As the underlying portfolio of BGB is nearly all floating rate-based, that means higher income generation is likely to remain for an extended period of time for this fund.

BGB Basics

• 1-Year Z-score: 1.68
• Discount: -7.69%
• Distribution Yield: 9.48%
• Expense Ratio: 2.37%
• Leverage: 37.15%
• Managed Assets: $905 million
• Structure: Term (anticipated liquidation date September 15, 2027)

BGB has an investment objective to “seek high current income, with a secondary objective to seek preservation of capital, consistent with its primary goal of high current income.”

To achieve this, the fund will; “invest primarily in a diversified portfolio of loans and other fixed-income instruments predominantly US Corporate issuers, including first- and second-lien loans and high yield corporate bonds of varying maturities.”

BGB is a term structured fund, though, like most term funds, there are ways to extend or potentially remove that to become perpetual. We discussed that in more depth in our prior update. One of the main points to note is that this fund is fairly unique in that it leaves language in that the fund can be approved for an extension an unlimited number of times. The Board can propose it, but it would require the majority of the shareholders to approve. Of course, a fund can propose to eliminate its term structure entirely and convert to a perpetual structure with shareholder approval.

Performance – Strong Results Thanks To Higher Rates

Like the alternative asset manager they are, they like to charge high fees, and that creates a high expense ratio. When including leverage, the total expenses of the fund come to 3.54%. I view that as a negative, but at least in shorter bursts, such as 2023, the fund was able to outperform several of its peers. However, this was only on a total NAV return basis, while the total share price results for BGB eclipsed the Invesco Senior Loan ETF (BKLN).

This fund carries a hefty amount of leverage, and that’s been beneficial for the fund during this higher-rate environment. They can employ leverage and earn a spread on top of that leverage, while we have seen historically low default rates in the last couple of years. That said, the default rates have been ticking up higher; that was one of the three recent trends in high yield that Juan de la Hoz discussed in a recent piece.

While that piece focused on high-yield bonds, more specifically, it all rolls downhill – or maybe uphill in this case. Senior loans are, well, senior to bonds, but regardless, defaults are on the rise and expected to continue to rise.

This was the projection material posted in December 2023.

We had already risen to 3.7% by the end of February 2024, reaching a level higher than the base scenario default projections heading into the year.

The optimistic note is that historically speaking, recovery rates for senior loans are materially higher. Invesco noted that senior secured loans recovered “80% of principal on average of the last 30 years (compared to 48% for high-yield bonds).”

That bodes well for BGB and other senior loan funds, but one has to consider that being leveraged means any losses will be magnified.

Distribution – Sporting An Attractive ~9.5% Rate

CEFs can often pay level distributions for lengthy periods of time, for years at a time, which isn’t unusual without making any adjustments. In the floating rate senior loan space, there is often much more in terms of adjusting distributions. That’s just a natural impact of being so driven by the Fed’s short-term rates that they set. In the case of BGB, though, they seem to have made even more frequent adjustments since around 2019. They often change the payout every single quarter.

That isn’t inherently negative, but it is something to note, as many income investors prefer more stable distributions that they can rely on more predictably. Despite the higher rate environment and the fact that there has been no Fed cutting yet, the last two distributions declared decreased as well.

Given the fund’s large discount, a benefit is that the share price distribution rate is 9.56%, but the NAV rate is 8.71%. The NAV rate is what the actual underlying portfolio has to produce to cover the distribution to investors.

With that higher rate environment, we’ve seen in the last couple of years how BGB’s net investment income has increased materially in the latest fiscal year. It rose nearly 32% year-over-year, and that’s why we saw the distribution trend higher through the 2022 period.

That means that when rates are cut, we should expect to see NII decline, and so will the distribution. However, what was originally looking like 3 or more cuts could be likely this year seems to be declining rapidly and pushed back? Some suggest we shouldn’t expect to see any rate cuts from the Fed this year, or if we do, it’ll be only 1 or 2 near the end of the year.

For what it’s worth, the Fed’s latest projection material still expected 3 rate cuts this year but reduced the number of cuts in 2025 and 2026. That material was shown in their March meeting. If inflation remains sticky, it would seem likely that the chances for the number of cuts would be reduced further.

The other side of this would be that rate increases would be needed if inflation really starts to take off again. That doesn’t seem likely at this point, but it can’t be totally ruled out.

It looks like we could see a few cuts over the next year or two, and that bodes well for BGB and its distribution. Rates aren’t expected to go back down to zero unless we are experiencing a substantial drop in the economy that’s leading to a recession, where the Fed needs to try to spur growth. The Fed does have a dual mandate, after all, where they have to watch unemployment as well. That hasn’t been the focus for the last several years as inflation has dominated, but under a tougher economy, it would be a factor once again.

For tax purposes, the fund has listed the 2023 and 2022 distributions entirely as ordinary income. This is to be expected as the fund receives interest-based income from its portfolio of underlying bonds and loans. This would make it more appropriate in a tax-sheltered account rather than taxable.

BGB’s Portfolio

BGB isn’t a pure-play senior loan fund, but an incredibly large portion of the portfolio is allocated to senior secured loans. The other material sleeve of the portfolio is high-yield bonds, with rather negligible equity holdings also listed. This is why the portfolio primarily has a floating rate based on 84% of the fund’s investments. For the most part, there hasn’t been a meaningful shift since our prior update.

As is generally the case with senior loan CEFs, the fund is heavily tilted toward below-investment-grade holdings. In this case, the largest category is B2 at 35.4%. Ba1 debt is the first rung of the ladder to enter below-investment-grade territory. For BGB, we see that only 6.6% of the portfolio would be considered investment grade. Again here, this was largely the same when we last looked at the fund, too.

The duration of BGB’s portfolio is 0.62 years, a touch lower than the 0.77 years previously. That means that for every 1% change in interest rates, BGB’s portfolio should move by 0.62%, either up or down, depending on the direction of the rate movement. This is an incredibly low-interest rate sensitivity, and it would actually quite likely be even lower if they didn’t carry that ~16% allocation to high-yield bonds.

The fund’s portfolio is also showing a slight discount, with the average asset price being $97.32. So you are getting a bit of a discount on a discounted portfolio. In this case, that was up from the $93.86 average asset price in our prior update.

The data here is as of the end of January 31, 2024.

A small discount here reflects a rather optimistic outlook and doesn’t price a substantial loss expectation in the holdings. Invesco Senior Income Trust (VVR) had its weighted average holding price as $92.39, though that was as of the end of December 31, 2023.

Unfortunately, I wasn’t able to find the data provided at the exact same period or more recent data. Still, it can give us a bit of context between these two peers.

They list 511 positions, not counting cash. The top ten really reflects how diversified the fund is. A fund can hold hundreds of holdings but still significantly overweight a select few top holdings. In BGB’s case, the largest weighting of 1% suggests that even if Carnival Corp goes under, that doesn’t jeopardize the entire portfolio.

Conclusion

BGB provides significant exposure to floating rate-based senior loan securities. That helped to benefit the fund in this higher rate environment by seeing its NII rocket higher, and that took the fund’s distribution higher as well. The Fed is expected to cut rates over the next year or two, but the number of cuts and the timing of those cuts has been being pushed back. As long as inflation remains sticky, and the employment numbers remain strong, the Fed doesn’t really have a reason to cut rates. That should bode well for BGB, and with its current discount, it looks like an interesting opportunity here.