Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on September 20, 2022.
In the world of closed-end funds, you can come across some pretty interesting and niche exposures. Then is ArrowMark Financial Corp (NASDAQ:BANX), as well as CLO funds, which are managed more similarly to corporations. They have quarterly earnings calls and provide a quarterly NAV update, similar to a BDC. However, like the CLO, they also provide an estimated monthly net asset value to investors.
The company describes itself as “an SEC-registered non-diversified closed-end investment company…The company is structured as a non-BDC RIC.” We previously reviewed this name at the end of September, and since then the company has moved to a steep discount based on the latest estimated NAV. History has suggested that stocks will rally towards their net asset value sooner or later, presenting a unique opportunity.
Also, since the last update, the name has changed to ArrowMark Financial Corp from what was previously StoneCastle Financial. This was the natural progression due to the acquisition by ArrowMark Partners earlier in 2020. The name change officially took place earlier in 2022.
- Z-score over 1 year: -1.83
- Discount: -14.08% (based on estimated net asset value as of 08/31)
- Distribution yield: 8.61%
- Expense ratio: 3.96%
- Leverage: 26%
- Assets under management: $201.6 million
- Structure: Perpetual
The primary investment objectives of BANX are “the generation of income, the preservation of capital and the provision of risk-adjusted total returns”.
To achieve these investment objectives, they will invest in “bank-related assets across the spectrum from community banks to global currency center banks. The Company invests in asset classes including term loans, structured debt, regulatory capital relief securities and, to a lesser extent 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 in these assets.
The total fund size is rather small, which can be a problem if you are a large investor who wants to enter and exit the market quickly. This does not automatically make it a fund to avoid, but it should be considered before jumping in.
The fund is also moderately leveraged, which can increase volatility. This is a credit agreement with Texas Capital Bank. Borrowings are at variable rates based on SOFR+2.61%; it was LIBOR + 2.85% previously. Another change was that the amount they were allowed to borrow under the deal was increased from $62 million to $70 million.
The interest rate is at the high end and will only increase as rates rise further. On the other hand, 78% of the portfolio in which the company invests is also variable rate. Therefore, any increase in fund leverage expenses should also lead to an increase in fund income.
Another similarity between BANX and CLO, and BDC funds is the expense ratio. At 3.96%, that’s certainly a bit of a shocking number. Including leverage spending, it rises to 4.87%. However, this is actually less than some of the CLO and BDC funds that exist. The majority of BANX’s portfolio is invested in regulatory capital relief securities.
They describe regulatory capital securities as;
… senior unsecured debt obligations that are credit-linked to the performance of a benchmark portfolio of certain loan-related claims on corporations and similar entities. The fair value of regulatory equity 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.
Performance – Challenge 2022
Like most other asset classes and sectors in this market, BANX had to go through a tough 2022. Here’s a look at performance across a wide range of comparisons. The SPDR S&P 500 (SPY) represents US large cap performance or the “market”. Then I also included iShares Preferred Income Securities (PFF), Vanguard Total Bond Market (BND) and iShares iBoxx High Yield Corporate Bond (HYG) to highlight how everything has been questioned, not just stocks.
We can see in the case of total share price return performance, BANX is right in the middle. More interesting is the NAV performance we see here.
At the end of December 31, 2021, they reported a net asset value of $21.44. By the end of June 30, 2022, it had only slipped to $20.94, but you also have to consider that two distributions were paid during this period. Now, with the latest estimated NAV for August 31, 2022, we see it coming in at $21.23. So essentially the net asset value is flat for the year while everything else is down, including the company’s stock price.
What history has shown us for BANX is that it tends to go up towards its net asset value.
That’s why the estimated discount of around 14% looks quite attractive right now. Of course, we can also see that the net asset value can drop sharply in times of panic. If we only expect a slight recession, we can only expect a slight drop in net asset value. Much less downside than what the price actually reflects, it seems.
Also, if you are worried about the accuracy of their portfolio valuation, the majority of assets are level 2. There is only a small portion of level 3 assets. They also solicit “minimum two independent third-party ratings to assess the portfolio”. This means that there is no potential for internal conflict of interest in the evaluation.
Trying to value the company based on longer-term historical performance would be difficult or not very helpful. Past performance is even less useful in this case because the most obvious reason would be the new management of the fund. Additionally, they previously held a position as a community fundraising CLO who managed an allocation greater than 25% of the fund. This position is no longer in the portfolio.
BANX Dividend – A Boost
Heading into 2022, the company increased its quarterly dividend from $0.38 to $0.39. They have also paid additional extra dividends to investors on a few different occasions. Since it is an RIC, they are still required to remit the majority of their earnings or pay excise taxes.
Dividend coverage has also been strong, as shown in the chart above. Here is also an overview of earnings in the latest half-yearly report.
We can see that the NII coverage amounted to 109%. That was an improvement from the rather strong 98.52% they reported last year. However, the last financial year also shows the total distributions paid, which accounts for the additional $0.10. Without this supplement, the coverage of the NII would have been greater than 100%.
Given the current environment, looking for funds with coverage only from NII is not a bad idea. It is generally more predictable than capital gains. However, the company was still able to provide realized capital gains.
As mentioned above, the portfolio is invested primarily in level 2 securities with an overweight in regulatory capital relief securities. They represent approximately 78% of the portfolio. The majority of them are credit-linked notes with variable coupons and maturities. The portfolio has not changed too much since last year. However, they no longer have any exposure to ETFs and they have put most of their money to work. Last year, they were sitting on around $54.5 million in cash.
With approximately 78% of the portfolio floating rate, rising interest rates are welcome. This is where rising interest rates are better for BANX as yields rise on these underlying holdings.
BANX might run a bit of risk due to its narrow portfolio concentration. They don’t hold many positions, with CEFConnect putting the number of stocks at just 46. A lack of diversification could mean that a few stocks held have a greater impact on the fund.
However, BANX will ultimately be at the mercy of how well things go. If defaults begin to increase, these credit-linked ratings will suffer losses. Higher interest rates could mean that their variable rate debt will provide more income, but at some point the cost of debt could become burdensome. They state that “the majority of transactions provide exposures to sub-investment grade borrowers.”
BANX offers unique exposure to regulatory capital relief securities. Whether or not an investor seeks this type of exposure will depend on each individual investor. They state that they are “the only public company that offers entry into a traditional private market product”. These are the regulatory capital securities in which they are mainly invested.
Given the holding of the portfolio, this certainly lends credence to why an investor would want this type of exposure. While most assets and sectors were hit hard, BANX’s NAV held up. They even provide gains when taking distributions into account. At the same time, the share price fell, opening an attractive discount.