Blackrock’s BLW: 8.4% Yield Likely Gets Chopped By 25% In 2023 (NYSE:BLW)

Like most funds that are geared towards income investors, BlackRock Limited Duration Income Trust’s (NYSE:BLW) seeks to provide current income and capital appreciation to its investors. It attempts to achieve this by investing in intermediate duration fixed income securities of both the investment grade and high yield kind. Having a preponderance of latter type of securities, Morningstar designates BLW as a high yield bond fund, and gives it a 4-star rating.

The portfolio is made up primarily of USD denominated holdings but could have a limited number of foreign issues denominated in foreign currencies. BLW aims to moderate its interest rate risk by maintaining an average portfolio duration of less than five years. The managers also have the option to employ derivatives to manage the risks and leverage to enhance returns. According to the most recent data, BLW manages a $761 million portfolio, a third of which is bought with borrowed funds. You can see that when examining the difference between net assets and managed assets.

Interestingly the “leverage” numbers shown on the site appear to be completely off the mark and show leverage as only about 2.52%.

Based on the fact sheet and numerous other data points, we think the real leverage is about 50%.

The fund does gravitate towards the low end of the investment pool and about half the assets are rated well below investment grade.

These tend to work well coming out of a recession and in the middle of an economic cycle. Where we are today is the big question though.

Distributions

BLW increased its monthly distribution from 0.0795 cents to 0.0981 cents from October 2019 and has kept it unchanged since then. The clock struck COVID-19 but the fund maintained the distribution, even through the initial choppiness. While previously the distributions were fully funded by the income earned from the portfolio, that stopped being the case starting in 2020. Since then a portion of its distribution is the fund returning capital back to the investors.

While based on the above graphic 2022 has fully income funded distributions and no return of capital [ROC], that is not the case. The fund notes that the designation for ROC is made at the fiscal year end which is December 31 in BLW’s case. Based on preliminary data from the Section 19 notice for December 2022, over 10% of the annual distributions will be designated as ROC.

Note: BLW does caution investors that these numbers are estimates and that they should wait for the official tax document for the final determinations.

Maintaining distributions with assistance from ROC has the beneficial effect of maintaining a smile on the faces of its investors which in turn emboldens them to put some more of their hard earned money into such funds. In the longer run though, the ongoing ROC has been eroding the NAV, as the excess distributions are funded by the existing cash reserves or that generated by selling existing positions.

Nonetheless, the hefty distribution has powered the total returns for believers in the last decade.

This return has done better than SPDR Bloomberg Short Term High Yield Bond ETF (SJNK).

SJNK is an ETF of course and does not use leverage. BLW has also outperformed CEFs in the category over multiple timeframes on NAV.

Outlook

BLW’s yield appeals to the income investors. What is not so peachy are the current leverage levels. The 1.18% expense ratio that is currently published is for the year ended December 31, 2021. Based on the semi-annual financial report for 2022, the number was closer to 1.4% six months later.

BLW has also increased its borrowings on a proportionate basis going into the rate hikes. As all the rate hikes flow through for the fund, expense ratios should gravitate towards 2.0% for 2022. In our opinion 2023 will not provide any respite as we expect the rate hikes to exceed the crowd expectations. Expense ratios should move closer to 3.0% as we run 2023 numbers. One way to offset this is to dial down the leverage. But whichever way you cut it, the high expense ratio will dig into distribution sustainability. This is made worse by junk bonds rallying. In other words, on any given leveraged investment, the spread is getting really narrow. The amount the fund pays on borrowed funds, will be far closer to what it earns on the purchased junk bond. We also think that we are very late in the junk bond cycle and this is a good time to stay away completely if possible. The tiny NAV discount does not remotely make up for these risks.

We think the distribution likely gets cut in 2023 by about 25% as the spread compression gets coupled with some defaults in the back half of 2023. The fund has cut the distributions before so this should not come as a surprise. At the current setup, we rate the fund a SELL and would only consider buying it if we see a 10-15% discount to NAV alongside junk bonds being appropriately priced for the risks ahead.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.