BKT CEF: Not an attractive entry point after rate cut (rating downgrade)

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At the beginning of the year I saw an article about BlackRock Income Trust (NYSE:BKT) who did not seem to properly understand what CEF was doing and its risk factors. So I wrote an article titled “BKT: Understand what you’re buying, MBS likely to deliver”. And BKT has certainly delivered since then, with a total return of over 9%:

An investor will note not only CEF’s healthy return, but also the fact that BKT has outperformed the S&P 500 since we assigned it a “Buy” rating.

In today’s article we will discuss the significant rate cut that has taken place over the past few months, the impact on BKT and why we are now downgrading the name to ‘Hold’ given that the current price is not an attractive entry point. more.

Rates have moved significantly this year

Over the past four months, we have seen a very significant narrowing of rates in the middle portion of the yield curve:

Rates fell by about 100 bps at many intermediate points of the curve, triggering a rally in Treasuries and mortgage-backed securities. As we pointed out in our article at the beginning of the year, CEF has a very high sensitivity to rates, benefiting from lower rates:

The fund has a duration of 8.13 years, meaning that for every 100 basis point tightening in MBS spreads, CEF will generate an 8% capital gain through the NAV of its underlying bonds. As the Fed cuts rates in 2025, CEF is set for significant capital gains. Think of this name as buying 8-year Treasuries with a wider spread and extra leverage.

In our original article we were very prescriptive about highlighting to investors why the fund was a buy, even though CEF’s performance was not supported. The market showed us exactly why that deep dive into the structure was right.

The duration of the fund has now decreased, with an effective duration of just 7.3 years:

The portfolio’s yield to maturity is 4.67%, while its average coupon is 2.66%. Leverage has also fallen slightly to 21.7% now.

Valiant Proxy for Mortgage REITs

Another point we made in our original article was that BKT was a good proxy for mortgage REITs, with the fund displaying a very high correlation with the top names. CEF made this correlation in 2024 as well:

When stripped of all the bells and whistles, BKT represents a leveraged portfolio of MBS bonds. AGNC Investment Corp ( AGNC ) and Annaly Capital Management ( NLY ) engage in the same business, only with layered hedging complexities in their portfolios. BKT is ultimately a very clean and transparent expression of the same trade.

Year-to-date, BKT and NLY have very similar total returns, while AGNC outperforms the cohort. Expect this correlation to continue, with a slight outperformance of mortgage REITs given their active positioning in duration management. BKT does not use futures contracts or swaps to exploit market discrepancies or mispricing. CEF represents a more static interpretation of the basic relation at hand.

Dividends are still outstanding

Even if the fund has performed, the dividend is still unsupported:

We can see a 62% return on capital utilization starting with the payment date of August 2024. Expect a high ROC figure to continue as MBS bonds do not pay a dividend yield of 8.5% even when they are raised. As previously stated, BKT is a NAV play with lower rates and firmer MBS prices. Dividends are high for marketing purposes only because the fund has no term financing, uses a high leverage ratio, and buys mostly agency MBS.

A non-accepted dividend does not make BKT a bad CEF. It only makes a game of installments in certain historical cases. That’s why we assigned the name a buy rating at the start of the year, and that’s why the fund produced such a strong total return.

Discount at NAV

The market rewards CEF for being a leveraged interpretation of MBS in a falling rate environment:

We can see the fund pull back from NAV as the market has started to price in the September Fed tapering. The only other historical time when CEF was close to NAV or more was in the zero rate environment from 2020 to 2021. We don’t expect that to happen again. We believe the market will bid this to NAV as it prices in rate cuts, but will revert to a discount when the Fed disappoints in the speed of rate cuts.

Unlike other CEFs, the discount to NAV here is not very volatile and is mainly driven by rates. Expect a narrow range of -5% to payout to NAV going forward, unless we see a resurgence of inflation again.

Conclusion

BKT is a closed-end fixed income fund. The vehicle invests in agency MBS bonds and represents a leveraged approach to the sector. CEF has a long-term total return that is highly correlated with NLY and AGNC and represents a bet on lower rates. The fund is up over 9% since the last article, benefiting from lower rates on the intermediate side of the yield curve. CEF’s 8.5% distribution rate is not supported and will continue to display this feature. The fund has a high yield for marketing purposes and should be viewed as a total return/accumulated NAV play rather than a true dividend distribution. With significant rates narrowing now behind us, we feel the price of CEF is no longer cheap, thus downgrading CEF to ‘Hold’.