BDJ: Buy For Defensive Options Strategy, Stay For The Long-Term Gain

ETFS

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BlackRock Enhanced Equity Dividend Trust (BDJ) has been a solid performing fund over the years and investors have been rewarded. Paying out generous distributions to shareholders who are seeking high income, with a top fund sponsor like BlackRock. Its current discount is quite attractive to me, and I believe now is a good time to be picking up shares.



The fund utilizes an options strategy on single stock positions within the portfolio. Currently, the percentage overwritten on the fund is 52.27% of the underlying assets. BDJ states that they only intend for the fund to be overwritten by 30% to 40% of assets. This leads me to believe they are increasingly becoming more defensive.

This may be prudent as the market is hitting all-time highs. Options strategies are defensive in nature, as it helps produce potentially enhanced distributions by collecting the premium from the trade. The flip side though, is it holds funds back during times of sharp moves higher. This is because the fund gives up the upside potential that’s beyond the strike price of the options trade.

The S&P 500 is up an incredible 20.22% YTD! Which is fantastic, however, this means that most of 2019’s gains are already in and probably doesn’t have much room left to run up higher. Even considering such an accommodative U.S. Federal Reserve. This is even more evident as the S&P 500 is trading at a Price/Earnings ratio of 22.42. This is well above its average of 15.75.

At CEF/ETF Income Laboratory, we currently have BDJ rated as a “hold,” and would be looking to see an 8% discount before really loading up. However, the shares currently trade at a discount of 7.32%. I believe initiating a position now will reward a long-term shareholder. Even while it isn’t fully at our targeted discount, market conditions warrant a deeper look for investors.

Performance

As I previously mentioned, the fund has had spectacular past performance. It hasn’t beaten the SPDR S&P 500 (SPY) performance, but it shouldn’t really because of its defensive features.



(Source – CEFconnect)

BDJ currently trades at $8.99 per share, with a NAV of $9.70. This leads us to the current discount of 7.32%. The average 1-year discount for BDJ is sitting at 8.23%. So it is not grossly overvalued to its historical range by any means. In fact, the 1-year z-score comes in at 0.50. YTD the fund’s NAV is up 15.09%, and its market return is 20.23%. This has been the primary factor for the narrowing discount recently.



(Source – CEFconnect)

What I wanted to highlight in the performance mostly, is the fact that the fund’s NAV in 2008 only showed a loss of 22.63%. Of course, this isn’t ideal but shows that the options strategy helped offset the worst of the drawdown. SPY for 2008 had dropped around 37%.

Distribution

The fund currently pays out a distribution of $0.05 on a monthly basis. This is a 7.1% increase starting in the month of July, from its previous $0.0467. This gives BDJ a current distribution rate of 6.67%.

While the fund did have to make several cuts to its distribution due to the 2008 financial crisis Overall, the fund is in a much better position than that period. Consider this, the fund’s distribution rate heading into 2008 was 9.7%. If the fund dropped a similar 22.63% as it did in 2008, the yield on NAV would still only be at a manageable 8%. With that being said, BlackRock tends to be more conservative with their distributions, looking for stability rather than eroding the NAV and hoping it gets better someday.

From its last available Annual Report, we can see why the fund was able to increase its distribution this year. Keep in mind, the report is dated year-end December 31, 2018. This was a down year for almost all investments, even BDJ shows a NAV return of -7.16%. And 2018 is actually a case where BDJ deviated from our above example of expecting better performance during downturn periods.



(Source – Annual Report)

So as you can easily see, BDJ was not spared from 2018’s turbulence at year-end. However, they still felt comfortable raising the distribution. This is because even after such a significant drop the fund was sitting on considerable unrealized appreciation.

BDJ Unrealized Appreciation

(Source – Annual Report)

At the time of release for that report, BDJ had $1,651,071,132 in managed assets, which is a significant size for a CEF. Today, the fund now has $1,819,214,244 as the fund has recovered from the last December lows.

BDJ has 187,542,405 shares outstanding; this means that every month they are paying out $9,377,120 or $112,525,443 annually to shareholders. This is calculated from their new rate of $0.05. That means, even after a decline in 2018, the fund had 1.75 years to cover the distribution through capital gains at that time. This calculation didn’t even take into account the $30+ million in net investment income. This leads me to believe that the distribution is quite safe; the fact that they raised it is just added confirmation.

Holdings

BDJ is primarily invested in U.S. securities, which comprises about 80% of their underlying holdings. They also have a fund that is very similar but focuses on global securities if someone is more interested in global exposure, the BlackRock Enhanced Global Dividend Trust (BOE).



(Source – BDJ Fund Website)

This should help with the volatility of the fund because the U.S., in general, offers investors a more stable market. Even further, BDJ is invested in almost all large-cap companies. Again, this should reduce volatility going forward.



(Source – BDJ Fund Website)

This is primarily due to the fact the fund invests “at least 80% of its total assets in dividend-paying equities.” This tilts the holdings to more stable, cash-flow positive companies. All of these factors lead up to a fund that can perform well during times of uncertainty. Aside from the previously mentioned 2018, I won’t hold that against the fund indefinitely as you never know for sure exactly how a fund will hold up or not. But, this leads us to the next point. Sector allocation of the fund.



(Source – BDJ Fund Website)

This is where the fund gets a little bit uncertain, but not enough to keep me from buying. However, it can help explain last year’s poor showing.

As the economy begins to slow, this can lead companies that operate in the financial sector to be hit increasingly hard as they are cyclical businesses. When the economy is great, they do great; when the economy is performing poorly, they perform poorly. Another sector that has been an underperformer is the healthcare sector. This is because the current populist ideas in the U.S. is that they would like to see healthcare costs decrease.

The goal for the Trump administration was to get lower-priced prescriptions. However, we just recently heard that this fell through as Trump dropped the proposal that was supposed to address the drug rebate rule. We aren’t out of the woods yet, though as it isn’t certain what the current administration might go after next in this sector. It shouldn’t be ruled out completely though that the healthcare sector is generally a defensive sector to be in during times of uncertainty.

They even state in their Annual Report that for the prior 12-month period that healthcare was a contributor to its performance, while financials were an underperformer for the fund:

The largest contributor to relative performance for the 12-month period came from an overweight position and stock selection within the health care sector. Notably, stock selection within and an overweight to the pharmaceuticals industry proved beneficial, as did an overweight to the health care providers & services industry.

The largest detractor from relative performance derived from a combination of stock selection and allocation decisions within financials. In particular, stock selection in the insurance and capital markets industries detracted, as did an overweight to banks and an underweight to the diversified financial services industry.

Financials have another concern to deal with too if the Fed drops interest rates they are likely to feel the pinch. This is because of how banks operate. As interest rates drop from Fed cuts, the spreads between what the banks take in and what they pay out squeezes. This is not too much of a concern at the moment. As it is likely to start with a 25 basis point reduction, an outside possibility of being 50 basis points but unlikely, in my opinion. So, banks shouldn’t feel such a cut just yet, but worth keeping an eye on.



(Source – BDJ Fund Website)

Conclusion

BDJ is looking to be an attractive investment option right now. While the market is at all-time highs, investors really have to work to find funds worth buying. The fund’s defensive nature by writing options should prove to be worthwhile over the short term. Even better, I believe buying today at the fund’s 7.32% discount is a good long-term play. Getting paid on a monthly basis to wait for a pullback to really load up is fantastic, in my opinion. And in this case, BDJ is willing to give us a 6.67% distribution rate to wait for such an opportunity!

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Disclosure: I am/we are long BDJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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