BLW: Silently Outperforming Due To Its Low Duration (NYSE:BLW)

Thesis

BlackRock Limited Duration Income Trust (NYSE:BLW) is a fixed income CEF. The vehicle comes from the behemoth asset manager BlackRock, and represents a leveraged take on a portfolio of high yield bonds and floating rate loans. In a year of relentless higher rates where many fixed income instruments continue to lose value, BLW has managed to silently outperform, being up over 10% on a total return basis:

We can see how BLW has managed to outperform the unleveraged SPDR Bloomberg High Yield Bond ETF (JNK) and the Invesco Senior Loan ETF (BKLN) in the past year. Leverage magnifies returns, both on the upside as well as on the downside, thus it is quite a feat to see the CEF outperform in a rising rates environment.

Its robust performance boils down to its collateral composition, which is 50% made up of floating rate loans, and its credits selection, which have outperformed the wider market:

‘Term Loans’ in the above graph refers to floating rate leveraged loans, which have been able to reset higher as rates have increased. Fixed income asset managers like to leverage up this asset class to boost returns, but leverage in this instance only negatively affects a portfolio when credit spreads widen, not when rates move higher. Why? Let us have a look.

Leverage on floating rate loans

Let us walk through a typical Total Return Swap (‘TRS’) facility that is usually used by a CEF to finance itself. BLW will work with an investment bank in order to obtain said leverage on a pool of assets. Let us pencil that pool at $100, paying SOFR+400 bps. A bank will lend against said collateral at a certain loan to value, call it 80%.

So for the asset pool of $100, the bank will lend BLW $80. In effect, BLW only needs $20 of its own capital in order to obtain the return associated with $100 worth of assets. The financing is going to come at a price, so the investment bank will charge BLW SOFR+100 bps on the $100 of assets. This leaves BLW with a return profile of 300 bps on $100 of assets, where BLW only put up $20 in capital.

If rates move higher (SOFR moved from 3.5% to 5.5% for example) the cost of financing is not going to increase, because the underlying pool of loans will still pay SOFR, which in turn is passed to the investment bank. If credit spreads do not move, a floating rate loan facility is not negatively affected by higher rates (outside of the impact of actual loan prices, but let us assume they stay flat).

BLW collateral pool and risk factors

As highlighted above, the fund mainly contains leveraged loans and high yield bonds, with a small investment grade bond sleeve and a RMBS one. As a result, most of its collateral is below investment grade:

We can see that 31% of the fund collateral is in ‘BB’ rated names, while 52% of the holdings are rated ‘B’. There is a small ‘CCC’ bucket, but it is fairly contained.

The fund’s performance really comes down to the overall low duration for the CEF, which is only 3.5 years.

Given its short duration, the fund has hedged out nicely a large part of its duration profile, but it still leaves it exposed to credit spreads. A large risk-off move in the market that widens credit spreads will have a significant impact on this CEF, similarly to what we saw with the regional banks crisis in March 2023 when the fund had a -10% drawdown. While the move was faded out by the market, we are not out of the woods yet, with bankruptcies increasing.

We expect another significant risk-off event in the next six months, an event which will put pressure on credit spreads and see BLW experience another large drawdown.

BLW distribution coverage

As of the latest available data, the fund is almost fully covering its distribution:

We can see from the above August Section 19 notice that over 87% of the dividend comes from net income, thus only a modest 13% return of capital usage here.

What is surprising though is that the CEF has recently increased its distribution to $0.1079/share:

* BlackRock Limited Duration Income Trust (BLW) declares $0.1079/share monthly dividend, 10% increase from prior dividend of $0.0981.

* Forward yield 10.14%

* Payable Oct. 31; for shareholders of record Oct. 16; ex-div Oct. 13.

We do not think that a CEF should increase distributions when there is any ROC utilized in the prior payment periods. It puts additional pressure on the NAV, especially in today’s environment. While this move will work towards closing out the small discount to NAV for the fund, long term it is not the best corporate action.

Premium/Discount to NAV

The fund has had a fairly narrow range for its discount to NAV:

BLW moved from being flat to NAV to a discount when rates moved higher, but its discount range has been fairly well contained in an 8 point range. This is not a high beta discount fund that will overact to significant market moves.

Conclusion

BLW is a fixed income closed end fund. The vehicle mainly focuses on leveraged loans and high yield bonds, and represents an offering from the fixed income behemoth BlackRock. The fund is up over 10% on a total return basis in the past year, and has represented a very pleasant surprise on the back of relentless higher yields.

The CEF has achieved this feat via its large floating rate loan bucket, where higher rates were captured and correctly hedged the funding liability of the vehicle.

The CEF just increased its dividend to $0.1079/share, but we do not agree with this move. The fund had an 87% dividend coverage as of the last available Section 19 notice, meaning that it will actually just use ROC for its dividend increase. We see this move as a strategic play to close out the discount to NAV, but long term it will have an adverse effect on the fund’s NAV. If you already are in this name, continue to hold clipping the yield. New money should wait for a better entry point at the current NAV levels.