Interest rates

FGB: Higher interest rates improve the performance of this CEF (NYSE: FGB)

da-kuk/E+ via Getty Images

Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on April 28, 2022.

First Trust Specialty Finance & Financial Opportunities Fund (NYSE: FGB) may not had the best history in terms of price appreciation. However, this year it has resisted the downward movement of the overall market. It has remained virtually flat through 2022, although it has slipped slightly on a net asset value basis.

Chart

Y-Charts

Although a riskier fund overall, the underlying business development companies or BDCs may benefit from higher interest rates. This is mainly because they largely borrow at fixed rates and lend at variable rates. Even though FGBs may hold other types of financial “opportunities”, they invest heavily in BDCs.

They may be more risky since they lend capital to small and medium-sized enterprises. These are the types of businesses that can be most affected during an economic downturn. Given the performance so far, it would appear that most BDCs have been able to hold up relatively well despite the potential for a recession that some investors predict within the next year or two.

FGB isn’t quite hitting our buy zone yet, but it’s getting close. The objective, in this case, would be to buy at an 8% discount and then sell at parity.

The basics

  • Z-score over 1 year: -0.29
  • Discount: 7.14%
  • Distribution yield: 8.19%
  • Expense ratio: 1.49%
  • Leverage: 12.11%
  • Assets under management: $71 million
  • Structure: Perpetual

FGB has a investment objective to “seek a high level of current income. As a secondary objective, the fund aims for an attractive total return”. To do this, the fund “will invest, under normal market conditions, at least 80% of its assets under management in a portfolio of securities of specialized finance companies and other financial companies which, according to the Fund’s sub-advisor, offer attractive opportunities for income and capital appreciation.”

The fund is quite small, which means that large investors might not feel comfortable investing in this fund, or investors who want to move in and out of funds quickly might not have that opportunity with this fund .

The fund has moderate leverage, which makes it riskier than owning a basket of BDC alone. Remember that BDCs can have their own high leverage, so it is leverage on leverage. This may be the reason why First Trust has not yet taken advantage of this fund.

The fund’s expense ratio is 1.49% and it is 1.78% with leverage expenses. While BDCs often have fixed rate borrowings, traditional CEFs generally do not have fixed rates. This is the case of FGB which borrows at LIBOR 1 month plus 85 basis points. Therefore, higher rates mean higher interest charges for that fund. At the same time, this should not have too negative an impact on the underlying holdings.

GBF expenses

GBF expenses (first trust)

Performance – Near Buy Zone

As noted above, this fund has held up relatively well since the start of the year. This is in line with the VanEck BDC Income ETF (BIZD). BIZD is a fair benchmark to provide some comparison, but the ETF is not leveraged. On a YTD basis, BIZD was actually able to hold up a bit better in terms of total net asset value return – touching positive territory at the time of writing. On the other hand, FGB was able to reduce its discount a bit, so the actual total stock price return favored FGB.

Chart

Y-Charts

This helps underline why CEFs can be a great idea to keep when they get bigger discounts. Despite minor underperformance so far based on net asset value, shareholders would still be better off.

Longer term, we can see that these funds have provided similar returns until around 2020. Indeed, even this modest leverage had permanently damaged FGB.

Chart

Y-Charts

As the fund went through 2020, they had borrowings of $25 million, then cut them down to just $6.5 million. That’s a pretty big percentage reduction for a small fund.

Longer term, there was a time when FGB regularly traded at a premium. This is why over the past decade the average discount has come to quite a low level. The discounts really weren’t persistent until 2020. In 2008/09, a big discount was also present.

Chart

Y-Charts

Distribution – 8.19% distribution yield

One of the reasons for owning a CEF is due to the higher distribution yields they can often pay. They can do this because they use leverage in addition to distributions with capital gains or return of capital. BDCs are also higher yielding instruments since they are also required to pay out most of their profits.

The current distribution yield for FGB amounts to 8.19%. On a NAV basis, this amounts to 7.60%. They have cut several times, but are mostly due to 2008/09 and 2020. However, they have also had a cut in 2019. There has not been a particularly notable deep sell – unless you count on the crisis of the fourth quarter of 2018.

FGB Distribution History

FGB Distribution History (CEFConnect)

In terms of distribution coverage, because of these dividends and distributions from the underlying BDCs, we often see higher net investment income for the fund. This then results in higher NII coverage.

GBF Annual Report

GBF Annual Report (first trust)

In their last fiscal year, we can see that NII coverage has reached almost 80%. The remainder was offset by realized gains.

When it comes to tax classifications, most distributions qualify as ordinary income. It also makes sense since BDCs often charge interest on their outstanding loans.

GBF Annual Report

GBF Annual Report (first trust)

FGB Wallet

Overall, FGB’s portfolio is lightly invested. According to CEFConnect, they only held 29 positions. It’s been pretty consistent since I started following the fund. Their turnover is not that high either. In the last fiscal year, turnover was only 8%. This means that they don’t do a lot of buying and selling of their underlying positions.

As mentioned above, FGB is dominated by its BDC positioning. They list some exposure to REITs, but those are through mREIT. Next, they also list exposure to diversified financial services and insurance. This was quite close to the fund’s weightings in our previous update at the end of November. However, BDC’s exposure was down slightly from the 96.26% it had previously reported.

FGB Portfolio Weighting

FGB Portfolio Weighting (first trust)

Taking a look at the fund’s top ten holdings, we see some of the household names we saw last time around. In fact, each position is the same, but some weightings have changed, as would naturally be the case when the market turns. They hold several of the most popular BDCs. Overall, there are only about 50 BDCs last I knew of, so there’s not a huge basket to choose from if they stay invested in this market sector. If they diversified into other financial offerings, they could certainly diversify more broadly.

Top 10 FGBs

Top 10 FGBs (first trust)

The largest holding remains Hercules Capital (HTGC). I’ve had this BDC mentioned many times by readers and have browsed it many times on FGB; I decided to dive deep into the name under the Cash Builder Opportunities profile. All in all, it seems to be quite an attractive BDC that has offered attractive returns and income for investors. It makes sense that we continue to see it in FGB’s portfolio and as its most important position.

From there, we have Ares Capital Corp (ARCC) as the second largest position, exactly where it was also in our previous update. ARCC is currently the largest BDC on the market.

Main Street Capital (MAIN) is another of the most popular BDCs today. In fact, on the Seeking Alpha platform, he has more followers than ARCC. MAIN has 58.94,000 subscribers and ARCC has 54.65,000 subscribers. That seems to be the power of a monthly dividend.

MAIN was previously the third largest weighting for FGB, but that has now slipped below PennantPark Investment Corp (PNNT). The main reason for this seems to be due to the performance of PNNT far exceeding that of MAIN over the period we are looking at. It would be between the end of November and the end of February.

Chart

Y-Charts

Conclusion

FGB is right next to buy territory, but it could easily be taken over by investors right now. Ideally, we would like to see a bigger discount to ultimately add more downside protection. However, that doesn’t mean we’ll ever see that level, and if an investor really wants a basket of BDC exposure, FGB could be a great option. Making capital work in BIZD is also still an option until FGB gets a bigger discount. One downside is that the quarterly distribution varies, where FGB pays out a generally more consistent quarterly payout.