CII: This Diversified Option-Income CEF Deserves Consideration Today

One of the biggest problems faced by Americans today is the pervasive inflation that has dominated the economy over the past year. This inflation, which has been centered around food and energy, has forced many Americans to take on second jobs or perform other tasks in order to obtain the extra income that they need to keep themselves fed and warm at home. Indeed, a recent survey determined that 77% of Millennials and 81% of Generation-Z members have considered taking on work in the gig economy in addition to their regular jobs just to make ends meet. This budgetary pressure from rising prices has had an impact on all of us as investors as well.

Fortunately, we have other methods that we can employ to generate the additional income that we need to support our lifestyles. One of the best of these methods is to purchase shares of a closed-end fund, or CEF, that focuses on the generation of income. These funds are not particularly well-followed in the investment community but they should be as they provide a very easy way to acquire a diversified portfolio of assets that can utilize certain strategies that boost their yields well beyond that of any of the underlying assets.

In this article, we will discuss the BlackRock Enhanced Capital & Income Fund (NYSE:CII), which is one fund that investors can use for the generation of income. The fund boasts a reasonably impressive 6.99% at the current level, which is clearly higher than that of most other things available today. In addition to its high yield, the fund also sports a reasonably attractive valuation, so let us investigate and see if this fund could be right for your portfolio today.

About The Fund

According to the fund’s webpage, the BlackRock Enhanced Capital & Income Fund has the stated objective of providing its investors with a combination of current income and capital appreciation. This is not exactly unusual for an equity fund, since common equities are by their very nature a total return instrument. After all, investors typically purchase shares of a closed-end fund with the intent of generating capital gains and receiving income through the dividends that the stock pays out. This fund goes a step further than this though as it uses both call and put options in order to generate additional income. This is the meaning of the word “enhanced” in the name of the fund. As such, this should be thought of as an option-income fund akin to those that made fellow fund manager Eaton Vance famous. Option-income funds have a very real advantage over many other types of funds in flat markets because of the way that the strategy works. Basically, the fund receives an upfront premium from the sale of the option and will not generally wind up with the option being exercised against it if the stock price does not appreciate significantly. The received premium thus essentially acts as a synthetic dividend and provides a return when capital gains cannot.

The fact that this fund is utilizing an options strategy is something that might immediately turn away some potential investors. After all, we have all heard of the risks of loss when it comes to options. However, the strategies that are being used by the BlackRock Enhanced Capital & Income Fund are among the safest option strategies that are possible. The fund is primarily writing covered calls, which means that it already owns the stock that it would have to deliver if the option is exercised. This prevents the fund from having to go out and purchase the stock in the market, potentially paying a very high price, in the event that the option is exercised.

The worst-case scenario with the fund’s strategy is that it will have to sell its stock at the price specified by the call option contract. While this can result in the fund selling the stock for less than the current market price, if properly done the fund will still generate a capital gain. This is accomplished by ensuring that the strike price of the sold call options is higher than the price that the fund paid to buy the stock. Thus, the strategy has virtually no risk of loss that would not be present by owning the stock independently of the written option. Of course, the ideal scenario is that the option expires worthless and that the fund can write another option against the stock. The fact that the fund keeps the upfront option premium even if the option expires worthless is why this can be a fairly effective strategy for flat markets since it still provides a return.

One thing that separates the BlackRock Enhanced Capital & Income Fund from other option-income funds is that the fund will sometimes write put options. These are almost certainly cash or margin-covered put options, which are likewise almost as low-risk as covered call options. This is because the worst-case scenario with a covered put option is that the fund will be forced to purchase the stock at the strike price of the option. As the fund already has the cash available to purchase the stock, this is not really a big deal as long as the strike price is set at a level that the management believes is undervalued for that respective stock. The risk with writing puts would present itself if the fund had no way to actually purchase the stock that was assigned to it and had to start dumping other assets at fire sale prices in order to raise the money. Naturally, the outcome that the fund really wants is for the option to expire worthless since that would also allow it to keep the option premium and then write another put option for another upfront premium. In some ways, this strategy acts as a way to increase the interest paid received for holding idle cash.

The largest positions in the fund will likely be familiar to any investor. Here they are:

With the exception of Corteva (CTVA) and Ross Stores (ROST), we have here many of the largest companies in the United States and the largest positions in many funds. One immediate thing that we notice from these holdings is that the BlackRock Enhanced Capital & Income Fund is not specifically focusing on dividend stocks. After all, Alphabet (GOOG), Amazon (AMZN), and Berkshire Hathaway (BRK.B) do not pay a dividend. Even among the companies here that do pay a dividend, the yield is so low as to be negligible. The fund clearly expects the options strategies to be the source of most of the portfolio income.

That is not really a problem, as a covered call strategy can usually result in substantially higher effective yields than just about any dividend-paying stock. I will admit, though, that I am not particularly enthusiastic about seeing four of the five mega-cap technology companies as the fund’s four largest holdings. As I pointed out recently, these stocks significantly underperformed the S&P 500 Index (SP500) in 2022, and so their presence will almost certainly serve as a drag on the fund’s performance. With that said, though, this fund has held up surprisingly well in the challenging market environment that has existed over the past year. As we can see here, the fund only slightly underperformed the S&P 500 Index over the trailing twelve-month period:

When we consider that the BlackRock Enhanced Capital & Income Fund has a much higher yield, it actually outperformed the index over the period. This does show the overall power of the fund’s options strategy to buffer losses during weak markets. As the stock market appears unlike to recover to its previous glory anytime soon, this is something that could prove very attractive to an investor today.

One unfortunate thing about this fund is that it is greatly underexposed to the energy sector, which was by far the best-performing one in 2022. The traditional energy sector only accounts for 4.66% of the fund’s portfolio:

This is actually a bit below the 5.06% weighting to energy in the S&P 500 Index. Admittedly, it is not exactly surprising to see an underweighting to energy from a BlackRock fund, considering that BlackRock has been a strong proponent and supporter of the environmental, social, and governance trend that has held great importance on Wall Street over the past few years. Unfortunately, the fund’s lack of exposure to that sector in favor of technology and consumer discretionary does mean that its returns were not nearly as good as they could have been over the trailing twelve-month period. The fund is basically carrying itself with the option strategy but it is still prevented from maximizing returns due to the sector exposures of its portfolio.

Fortunately, the fund is reasonably well-diversified among the individual companies that comprise its portfolio. As my long-time readers on the topic of closed-end funds are no doubt well aware, I do not generally like to see any individual asset in a portfolio account for more than 5% of the fund’s total assets. This is because this is approximately the point at which an asset begins to expose the fund to idiosyncratic risk. Idiosyncratic, or company-specific, risk is that risk that any asset possesses that is independent of the market as a whole. This is the risk that we aim to eliminate through diversification but if the asset accounts for too much of the portfolio, then the risk will not be completely diversified away. Thus, the concern is that some event may occur that causes the price of a certain asset to decline when the market itself does not, and if that asset accounts for too much of the portfolio, then it may end up dragging the entire fund down with it.

As we can clearly see above, there is only one asset that accounts for more than 5% of the portfolio, so potential investors in the fund should ensure that they are willing to be exposed to the specific risks of Microsoft (MSFT) individually before making an investment in the fund. While it is a bit disappointing to see any stock so heavily weighted in this fund, we do not have the outsized exposure to a small number of companies here that we see in the Eaton Vance option-income funds. Overall, the BlackRock Enhanced Capital & Income Fund is doing a better job at achieving portfolio diversification than many of its peers.

Distribution Analysis

As stated earlier in this article, the primary objective of the BlackRock Enhanced Capital & Income Fund is to provide its investors with a high level of both current income and capital appreciation. As the fund’s strategy largely revolves around writing single stock options in order to generate a synthetic yield off of its assets, which is a fairly high-yielding strategy, we might assume that the fund itself would boast a suitably high distribution yield. This is certainly the case, as the fund pays out a monthly distribution of $0.0995 per share ($1.194 per share annually), which gives it a 6.99% yield at the current price. This is admittedly not as high as some other closed-end funds provide, but it is quite a bit higher than the 1.66% yield on the S&P 500 Index. The fund’s distribution has varied a bit over its lifetime, but its recent history is quite admirable:

The one thing that we notice is that the fund has steadily increased its payout since 2017, albeit at a very slow rate. This sort of consistency is not exactly unusual among option-income funds, as the options strategies tend to provide for more stable income than what can be generated by investing solely in stocks or fixed-income assets. This is one reason why hedge funds and similar entities tend to make extensive use of options. Another thing that may please potential investors is that the fund’s distributions are classified as capital gains and do not contain a return of capital component:

The reason why this can be pleasing is that a return of capital distribution can be a sign that the fund is returning the investors’ own money back to them. This is obviously not sustainable over any sort of extended period. However, capital gains have a problem too and that is that there is no guarantee that the fund can continue to generate sufficient capital gains to maintain the distribution. It is, admittedly, easier to generate capital gains with the options strategy than by simply buying and selling stocks. That is particularly true in today’s bear market, which provides us with a small amount of comfort. As is always the case though, we want to investigate the fund’s finances in order to determine exactly how it is financing its distributions. After all, we do not want to be the victims of a distribution cut that would both reduce our incomes and most likely cause the fund’s share price to decline.

Fortunately, we have a somewhat recent document to consult for this purpose. The fund’s most recent financial report corresponds to the six-month period ending June 30, 2022. As such, it will not include any information from the past six months but it is still more recent than the documents that some other funds have made available. In addition, the current bear market started in earnest around the end of 2021 so a report for the first half of 2022 will give us a pretty good idea of how well the fund has been handling the market weakness. During the six-month period, the BlackRock Enhanced Capital & Income Fund received a total of $5,343,337 in dividends and surprisingly nothing in interest. Once we net out the foreign withholding taxes that the fund had to pay, it had a total income of $5,225,598 during the period. The fund paid its expenses out of this amount, leaving it with $1,261,802 available for the shareholders. This was, to put it mildly, nowhere close to enough to cover the $26,346,881 that it paid out in distributions during the period.

However, the fund does have other methods through which it can obtain the money that it needs to pay its distributions. In particular, the money that the fund brought in via its options strategy is not included as income for the purposes of the previous paragraph. This is because the income from the options strategy is considered either a return of capital or capital gains depending on the circumstances. The fund also may have generated capital gains from the stocks in its portfolio. Overall, it reported a net realized capital gain of $78,221,752 during the period but this was offset by net unrealized losses totaling $215,014,285. Overall, the fund’s assets decreased by $161,877,612 after accounting for all inflows and outflows. While this is disappointing, the fund did have more than enough net realized capital gains to cover the distributions that it paid out with a great deal of money left over. Overall, it does not appear to be struggling to maintain the distribution but we should still keep an eye on its asset base as the more its asset base declines, the more difficult it will be for the fund to generate the capital gains that are needed to maintain the distribution. However, for the time being, we do not really have anything to worry about here.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate a suboptimal return on that asset. In the case of a closed-end fund like the BlackRock Enhanced Capital & Income Fund, the usual way to value it is by looking at the fund’s net asset value. The net asset value of a fund is the total current market value of all of the fund’s assets minus any outstanding debt. It is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can acquire them at a price that is less than the net asset value. This is because such a scenario implies that we are obtaining the fund’s assets for less than they are actually worth. That is indeed the case with this fund today. As of January 3, 2023 (the most recent date for which data is currently available), the BlackRock Enhanced Capital & Income Fund had a net asset value of $17.55 per share but the shares currently trade for $17.18 per share. This gives the shares a discount of 2.11% to net asset value at the current price. This is unfortunately not quite as attractive as the 4.41% discount that the shares have averaged over the past month. It therefore might make sense to wait a day or so to see if the shares begin to offer a more attractive discount. The current price is certainly not horrible, though.

Conclusion

In conclusion, the BlackRock Enhanced Capital & Income Fund appears to be one of the more attractive option-income funds available in the market today. The fund’s options strategies are reasonably safe and work pretty well to generate income in flat markets, such as the one that we are likely to see over the next year. The portfolio itself could be better but it is still more diversified than many other funds and that is nice to see.

The 6.99% distribution appears quite sustainable, and the fund has been remarkably consistent about it over the years. This is comforting for those investors that are seeking a reasonably safe source of income. The BlackRock Enhanced Capital & Income Fund is also trading at a reasonable valuation. It thus appears that this fund may be worth picking up for a portfolio today.