BANX: Floating Rate Assets Helped This Unique Fund

Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on January 5th, 2023.

ArrowMark Financial Corp (NASDAQ:BANX) isn’t your traditional closed-end fund. They invest in a rather niche way. They operate similarly to the way we see the CLO closed-end funds, with quarterly reports and conference calls. Similar to what we see from traditional companies or business development companies, but not a regular feature of most CEFs. This is a positive for these funds, as they are unique, and it can give better insight into current conditions.

Performance since our previous update on BANX has performance fairly flat. For 2022 overall, they performed relatively well, with the underlying portfolio providing positive results compared to losses in most fixed-income and equity funds.

However, one thing we touched on was the floating rate exposure that BANX carries in its portfolio. We mentioned that helped the boost to head into 2022 – and it ultimately led to a special year-end being paid out. To maintain their regulated investment company status, they need to pay out the majority of their realized gains and income.

Additionally, based on the latest estimated NAV reported, we have seen the fund’s discount widen a bit further.

The Basics

• 1-Year Z-score: -0.83
• Discount: -15.49% (based on 11/30 estimated NAV)
• Distribution Yield: 8.88%
• Expense Ratio: 3.80%
• Leverage: 25.86%
• Managed Assets: $200 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.”

They utilize leverage to enhance their returns potentially. This isn’t that uncommon for CEFs, but in a rising rate environment, it can mean higher expenses. When including the leverage expenses, the expense ratio climbs to 5.55%. The weighted average interest rate for their borrowings at the end of June 30th, 2022 came to 2.89%.

That would be high for most traditional CEFs, but it is low relative to CLO CEFs and competitive or better than BDCs. Again, it’s important to reiterate that this isn’t your traditional CEF. They invest in areas of the market that take much more skill and research that isn’t publicly available.

Fortunately, to help counteract higher leverage expenses, their floating rate portfolio is a natural hedge. Here’s what they had to say in their last earnings call:

We believe a rise in rate should be beneficial to our portfolio due to the floating rate structure of a majority of our investments. Today, approximately 83% of the company’s total investments are in floating rate assets, which provides a potential inflation hedge to the portfolio.

As I mentioned last quarter, we believe that every 25 basis points increase in base rates may translate to as much as an additional $0.005 to $0.01 per share per quarter in net income, all things being equal.

The fund is relatively small, which can mean liquidity is a problem for larger investors.

Performance – Relatively Strong Results

Through 2022, their share price took a big hit. On the other hand, on a NAV basis, they held up relatively well.

Their latest NAV was reported at $21.18 at the end of November. So things improved towards the end of the year, and losses on the underlying portfolio were limited. According to CEFConnect, when including the distributions being reinvested (i.e., total NAV return), we see that come in at 3.62%. That isn’t too bad, considering most other performances of other assets in 2022.

I believe that also doesn’t reflect NAV movement from the end of November to December, as it hasn’t been reported yet. If NAV improved further, results would be even better. Of course, that also means that if NAV deteriorated from the end of November, results would also be weaker. Although, it wouldn’t appear that things would have fallen so badly to push them deep into negative total return territory.

Looking back historically, when the fund traded at discounts such as it is now, it proved to be a fairly attractive time to consider investing. This is a fund that could be a diversifier for one’s portfolio. Below, we see the average discount and the latest discount based on the last reported NAV.

Distributions – Well-Covered And Growing

The distribution is a function of the income of their underlying portfolio. We touched on the fact that most of their portfolio is based on floating rates but that their leverage was more expensive.

Ultimately, rising rates were a net positive for the portfolio. For the three months ended September 30th, 2022, total investment income or TII climbed to $5.348 million from $5.037 million a year ago. Their expenses climbed from $1.978 million to $2.073 million, primarily driven by investment advisor fees and interest expenses.

The higher TII was enough to surmount these higher expenses, resulting in NII going from $3.058 million to $3.275 million. On a per-share basis, that worked out to an NII of $0.46. Their regular distribution is $0.39, giving us a distribution coverage of 118%. Thus, why a special of $0.10 for the year-end was declared. This was to distribute out excess earnings they’ve accumulated throughout the year.

“This special distribution reflects the Company’s relatively stable Net Asset Value and its ability to generate income in excess of our regular quarterly dividends during 2022. It also reflects our continued commitment to creating long-term value for our shareholders,” said Sanjai Bhonsle, Chairman and CEO.

Having high distribution coverage isn’t new, though, as they’ve been doing this for years.

The management believes we should continue seeing NII growth going forward too. Of course, this is the result of the Fed remaining committed to raising interest rates.

As of the end of last week, Fed funds futures were pricing in a peak policy rate of nearly 5.2% in Q2 2023, which is accurate, such as there could be as much as 150 basis points of additional rate increases that could drive anywhere between $0.03 to $0.06 of earnings per quarter just related to the increase in base rates for our floating rate assets.

Given the trajectory, I wouldn’t be surprised to see an increase announced with their next distribution. That being said, we also must be aware of the current economic situation we face. They could also be more conservative, leaving the distribution in place and just paying out a year-end special. That way, they don’t ultimately get too aggressive with raising, only to have to potentially cut if things head south in a year where most predict a recession.

BANX’s Portfolio

As mentioned, the largest allocation of their portfolio is to regulatory capital securities.

This is how they describe what these are:

…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.

While investors might not be overly familiar with them, they are softened issued by “Globally Systemic Important Banks or GSIBs.” These are the largest banks globally that “are frequently subjected to more regulatory scrutiny and oversight restrictions…” As their name would suggest, these regulatory capital securities help improve bank capital ratios.

ArrowMark has 12 years in this market and is the 2nd largest investor in the market. ArrowMark became the sponsor when they acquired BANX in 2020, though the name didn’t change until 2022. These securities can be level 2 or level 3 securities, as shown in their last semi-annual report.

Level 3 securities can be harder to value, which sometimes leads to discounting in funds. In this case, they use two different ways to value the portfolio; either through an “independent third-party valuation firm or a fair value estimate determined in good faith by the Board of Directors, in accordance with procedures established by the Board Of Directors.”

That’s why there can be a bit of an unknown with level 3 securities, as they are really only worth what someone is willing to pay. If they aren’t trading regularly through a public or private market, placing an accurate value can be more difficult.

The weighted average credit quality of the portfolio is BBB to BB for BANX. They list that the individual exposures range from AA to B- ratings and no positions in CCC+ or below.

The smaller allocation to community banking securities is through various debt offerings such as senior loans, trust preferred and other preferred types of securities.

Conclusion

BANX’s had a strong year in 2022. NII ran higher thanks to rising rates, more than offsetting the negatives of interest rates. However, the share price reacted as if they were performing poorly. That has created quite an interesting opportunity to invest in a heavily discounted and unique closed-end fund.