BlackRock BHK – CEF Rate-Focused Fixed Income (NYSE: BHK)
BlackRock Core Bond Trust (NYSE: BHK) is a closed-end, fixed-income fund whose primary objective is current income. The fund was launched in 2001 and seeks to achieve its primary objective by investing primarily in a diversified portfolio of high quality bonds. Portfolio holdings may include corporate bonds, US government and agency securities, and mortgage securities. At least 75% of its total assets will be invested in high quality bonds. Up to 25% of its total assets may be invested in bonds which are then rated Ba/BB or lower.
The vehicle currently has a high allocation to Treasuries and agency mortgage-backed securities (36%), investment grade bonds (24.9%) and high yield bonds (15%). Given its mandate and current portfolio structure, the fund is primarily driven by Fed rates and policy. We are currently in an incipient tightening cycle with market implied rate hikes for the rest of the year hovering above 6 following the Fed’s action yesterday. With 10-year rates currently trading around 2%, we can see a substantial upside depending on inflation readings and the Fed’s willingness to tackle it aggressively. The fund is down more than 20% since the start of the year due to its very high duration of 10.25 years and there is still room if rates indeed follow the path of 2018 when they peaked at around 3% (for the 10 annual returns).
BHK is a good long-term vehicle, however, with solid total returns that stand at 5.5% and 6.2% over a 5- and 10-year horizon. Returns were obtained with a Sharpe ratio of 0.61 and a standard deviation of 7.61 (both measured over a 5-year look-back period). We like this long term fund and think it is a solid buy and hold, but we are currently in the worst environment for this long term rates vehicle, namely an aggressive tightening cycle. With inflation creeping up and at historic highs, it’s unclear how far high rates will have to go to bring us back to a neutral inflationary environment. BHK should see more rate weakness and maybe even a bit more of the widening of the NAV discount. Although we like the long-term fund, we don’t think it’s prudent to stick with the name now and expect more weakness to come. We rate this name a To sell currently to be reviewed in the summer months when we should have more clarity on the Fed’s future actions.
The fund is currently overweight treasury bills and investment grade bonds:
We can see that treasury bills and agency mortgages make up over 36% of the portfolio, making the vehicle very sensitive to rate movements due to inflation, rate hike expectations and the possibility of a recession in the next few years.
Analysis of the ratings paints a similar picture:
Government and government equivalent securities fall into the AAA bracket, while the rest of the ratings analysis shows that the vast majority of the portfolio is investment grade.
The portfolio has a very high weighted average life and maturity profile:
We see that the tranche with the most assets is in the 20+ year segment, which explains the very high duration of the portfolio, which exceeds 10 years:
Credit and market risk
As we observed in the Holdings section, the fund has very little credit risk, with only around 23% of its assets in below investment grade bonds. Moreover, half of this allocation is in the double BB tranche, which is the safest tranche of high yield credit. The main risks of this fund are market risk, and more specifically interest rate risk.
The fund has a very high duration of 10.25 years and has seen its net asset value and performance outlook plummet this year due to rising interest rates. The fund is down more than 21% from a price point of view this year and it could drop further depending on inflation performance and the Fed’s stance.
From a market risk perspective, there is also a small component of credit spread risk associated with the investment grade bond portfolio, where in a recessionary environment we may see those spreads widen, but this will be offset by the compression of the risk-free rates at time, and more than offset by the sheer compression of the yield on treasury bills and agency mortgages.
The fund is down more than 20% based on year-to-date prices:
The increase in yields this year, and in particular 10-year rates, has weighed heavily on the fund since the start of the year. The fund has a very long duration and is driven by rate movements, and a Fed tightening environment is the worst type of market setup for this vehicle. If rates continue to rise, expect this fund to continue to lose value, both in terms of net asset value and market price.
Longer term, the picture is not bleak, with the fund showing stability and resilience in a rolling currency cycle setup:
When you switch to a 5-year total return chart, we can clearly see how the dividend yield gives us that nice annual return of around 6% that we see on a 5-year basis:
Premium/Rebate to NAV
The fund typically trades at a discount to net asset value:
We can see from the matrix above (where green indicates a discount and blue a premium to NAV) that the fund typically trades at a discount to NAV. 2021 was an outlier for the fund, when we saw a premium to net asset value thanks to a zero rate policy from the Fed and investors looking for yield. We are now back to a more normalized rate environment and the fund has already started trading at a discount to the net asset value, which could approach the extreme level of 8-9% if inflation does not subside. not and that investors continue to flee the duration and the fixed rate. cash assets.
BHK is a fixed income CEF focused on treasury bills and investment grade bonds. Yields on these asset classes are rate driven, and BHK does not disappoint with a high duration of over 10 years. Having lost more than 20% on a price basis in 2022 given rising 10-year yields, the vehicle is likely to weaken further as rates rise, as we saw in 2018 when 10-year yields peaked at 3%. This year has seen strong outflows from investment grade bond funds and this weakness in outflows is expected to continue. We expect a lower net asset value and lower BHK price over the next few months, due to higher yields that are far from their highs in this tightening environment. We rate this name a To sell currently to be reviewed in the summer months when we should have more clarity on the Fed’s future actions.