Floating rate funds pt. 4 ares dynamic credit allocation fund – ares dynamic credit allocation fund (nyse ardc) seeking alpha electricity in water experiment

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To close out my 4-part series on higher-yielding floating rate funds which might supplement a traditional, 2 to 4 percent yielding dividend growth portfolio, I have decided to focus on a fund that incorporates several asset classes into its portfolio. While the other funds which I have covered in this series typically concentrate on only one type of asset with which to take advantage of rising interest rates, the Ares Dynamic Credit Allocation Fund ( ARDC) invests in multiple types of credit-related assets, many of which stand to deliver more income should interest rates rise and default rates remain low.

ARES, the publicly-traded alternative asset manager, started the Ares Dynamic Credit Allocation Fund in 2012. This closed-end fund trades under the symbol ARDC and manages approximately $585 million in assets. The fund has access to $212 million in leverage and currently operates with a 30% leverage ratio as of April 2018. These funds are invested in a variety of debt instruments – bonds, senior loans, and CLOs – as well as a very thin sliver of equity investments.

Let’s take a moment to delve more deeply into collateralized loan obligations, or CLOs. CLOs are securities which represent stakes in a diversified loan portfolio. Usually, these loans are below-investment grade. This portfolio, which is actively managed throughout the life of the CLO, harvests interest payments from the hundreds of loans comprising the portfolio and passes them on to investors in the various tranches of the CLO. Each tranche represents a level of priority in terms of interest payments. If an investor in a CLO holds an AAA-rated note from that CLO, they will receive interest payments from the CLO portfolio first. This process repeats itself through the various tranches of the CLO until the CLO equity holders receive any interest payments over and above those payments which are required to be paid to CLO debt holders. If this structure seems familiar, it’s probably because these securities were also used to help finance the subprime mortgage boom of the early 2000’s, in which the use of securitization allowed financial institutions to manipulate subprime mortgage loans into investment-grade securities.

ARDC seeks to offer its investors a generous 7+ percent distribution yield by investing in CLO equity and debt securities which are towards the bottom of the payment ladder. For example, the fund holds about $2 million worth of the Class E-R notes issued by a CLO sponsored by the Carlyle Group. As the chart from a preliminary S&P ratings release shows, the E-R notes, which are rated as below-investment grade, offer a generous yield of 7.51% + the 3 month LIBOR rate. On the other hand, these notes are only 8% overcollateralized, illustrating the relatively low margin of safety upon which these securities operate. At the top of the ladder, the A-R notes are 60% overcollateralized and sport an AAA rating. Of course, investors pay for this safety by accepting 6 percentage points less in interest.

ARDC holds about a fourth of its assets in various classes of CLOs. The rest of its assets are held primarily in corporate bonds and senior loans. It’s also important to note that only about half of ARDC’s portfolio is floating-rate in nature. As such, the benefits of rising interest rates (at least as far as coupon payments are concerned) will be somewhat diluted by the fixed-rate component of ARDC’s portfolio. On the other hand, the 7+ percent starting distribution yield is somewhat higher than that on the previous floating-rate funds discussed in this series of articles. Depending on your personal investment needs, this tradeoff may be one that is acceptable to you.

While analyzing the sector exposure of each CLO that ARDC holds is beyond the scope of a single article, we can gain some insight into ARDC’s sector exposure by looking at its bond and loan holdings. Sectors which are particularly well-represented in the fund include the energy, healthcare, metals/mining, and technology sectors.

ARDC pays a monthly distribution, all of which is currently being funded by investment income per CEFconnect and amounts to a 7 to 8 percent annual distribution yield. While the fund experienced distribution cuts in 2016, it has since increased its monthly distribution twice recently. As interest rates rise and the rates on ARDC’s floating-rate portfolio reset upwards, it is reasonable to assume that – absent major defaults – the distribution should continue to hold steady and will likely rise. ARDC Dividend data by YCharts

Like many closed-end funds, ARDC currently trades at a discount to its net asset value. However, the fund has done so over the vast majority of its relatively short existence and is not particularly large relative to its historic levels. Finally, the illiquidity and complexity of the assets that ARDC holds make it difficult for me to have a high degree of confidence in whatever assumptions the fund uses to calculate its NAV. As such, while the absence of a premium to NAV keeps the fund from being excluded from consideration, ARDC is not trading at such a steep discount to NAV as to be an ‘automatic buy’ on that basis alone.

Over the next few years, the Federal Reserve is expected to continue its stated goal of monetary policy normalization by gradually increasing interest rates. AS it does so, debt and other income securities with floating- or variable-rate components should see their dividend/interest payments in concert with these monetary policy actions. The funds which we’ve examined over the past week or so each represent a way for investors to gain exposure to floating-rate assets. The Ares Dynamic Credit Allocation fund, like the other high-yielding funds which we have looked at, offers a high distribution yield but achieves this by investing in below-investment-grade assets, many of which are illiquid. A rise in default rates could be catastrophic for this fund and others like it. Nonetheless, unlike many 7-8 percent yielding CEFs, ARDC is currently paying its distribution out of income, as opposed to as a return of capital. For investors who desire yield above all else and are comfortable with taking credit risk, ARDC seems like an acceptable income investment. Those who do, however, should thoroughly research the holdings of this fund and CLOs as an asset class before doing so.

Disclaimer: Use my work as a starting point for your own due diligence, not as a substitute. All investments involve the risk of loss of income as well as the principal. Consider consulting with an investment adviser before making any investment. I am not a tax professional or investment adviser. Please consider consulting with a tax professional before making any investment. Author-generated charts are subject to error due to discrepancies in source data or securities being listed on multiple international markets.