BDJ: This Covered Call And Dividend Income Fund Is Solid, Just Watch The Price

One of the biggest problems that has been facing many Americans today is the pervasive inflation that is dominating the economy. Over the past year, there has not been a single month in which the consumer price index, which tracks the price of a bundle of commonly purchased consumer goods, has not increased by at least 6.4% year-over-year:

One of the biggest areas in which prices increased is food and energy. As these are generally considered to be necessities, this has had a devastating effect on people of lesser means. We have seen a surge in credit card debt along with a growing number of people obtaining second jobs. Indeed, as I have speculated, this could be one reason why the job reports remain stubbornly high in the face of mass layoffs in a few sectors, such as technology. We have also seen other evidence that the rising prices have devastated consumers, such as in a recent Prudential Pulse survey that stated that 81% of Generation Z members and 77% of Millennials are considering entering, or have already entered, the gig economy simply to get the extra money that they need to make ends meet. Thus, clearly, there are many people that are in need of extra income.

Fortunately, as investors, we can put our money to work for us to increase our incomes. This allows us to avoid some of the drastic measures that some other people have been forced to take to maintain our standard of living in the current environment. One of these measures is to purchase shares of a closed-end fund that specializes in the generation of income. These funds are somewhat underfollowed by many investors, but they provide easy access to a professionally managed portfolio that can usually deliver a higher yield than pretty much anything else in the market.

In this article, we will look at the BlackRock Enhanced Equity Dividend Trust (NYSE:BDJ), which is one fund that falls into the category of income generation. This is evident in the fact that the fund currently boasts a 7.50% yield, which is both higher than the inflation rate and considerably higher than the S&P 500 Index (SP500). As such, it could be an appealing way to improve the income generation of a portfolio and still maintain the sort of diversity that we generally like. Let us investigate and see if this fund could indeed fit into your portfolio.

About The Fund

According to the fund’s webpage, the BlackRock Enhanced Equity Dividend Trust has the stated objective of providing its investors with a high level of current income and current gains. This is somewhat unusual for an equity fund as equities are total return instruments. In fact, since the yield of the SPDR S&P 500 Trust ETF (SPY) is 1.59% at the current price, common equities deliver most of their returns via capital appreciation as opposed to dividends. The BlackRock Enhanced Equity Dividend Trust is almost entirely invested in common equities:

Thus, we would ordinarily expect it to be targeting capital gains or total returns. Although the fund does have long-term capital appreciation as a secondary objective, it is mostly aiming to provide investors with current income. The trick here lies in the words “Enhanced Equity” in the fund’s name. Generally speaking, any closed-end fund that describes itself as an enhanced equity fund will be employing options strategies to boost its yield. This one is doing exactly that as the fund states that it is writing covered calls against the equity positions in the portfolio. Thus, this fund is an option-income fund at its core.

The fact that this fund employs options is something that may concern some risk-averse investors. After all, many of us have heard horror stories about the risks of option strategies. However, covered call strategies like this fund employs are generally fairly safe. This is because the fund already has the stock that it would need to deliver if the option is exercised. Thus, the worst-case scenario for the fund is that the call option is exercised, and the fund is forced to sell the shares at a price that it has already agreed to. If the fund actually purchased the stock at a lower price than the strike price of the option, this worst-case scenario still guarantees it some capital gains. If the stock declines in price, the option is unlikely to be exercised and the fund can keep the option premium and the stock, which allows it to write another option when the current one expires. That is, of course, the ideal scenario for the fund as it provides a steady source of income when the options expire worthlessly. Overall, though, this is a reasonably safe strategy whose sole downside is that it reduces the fund’s potential for capital gains compared to what it would have if the price of a given stock skyrockets in value.

The fund does not rely solely on the option strategy to generate income, however. In fact, the fund’s webpage specifically states that the BlackRock Enhanced Equity Dividend Trust will invest at least 80% of its assets in dividend-paying stocks. A look at its largest positions reveals that it appears to be doing exactly that. Here are the largest positions in the fund:

The fact that these companies are dividend-paying stocks provides the fund with an additional source of income in the form of the dividends that it receives from these stocks. A few of these companies have fairly respectable yields, too:

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The fact that so many of these companies have high yields is nice because that reduces the amount of lifting that the company’s options strategy has to do in order to generate the income that it needs to sustain the current distribution. We will discuss that in more detail later in this article.

The fact that Enterprise Products Partners is listed among the fund’s largest positions is somewhat surprising. While this is a great company that I recommended earlier this month, it is not a company that is typically seen in closed-end funds. This is because it is a master limited partnership and not a corporation. American tax laws typically limit the amount of exposure that a regulated investment company can have to master limited partnerships. That is the reason that nearly all closed-end funds that invest in master limited partnerships are structured as corporations, not as pass-through entities. With that said, the fund can still include up to 25% of its assets in master limited partnerships and it is likely that it is less than that level. In fact, Enterprise Products Partners is the only master limited partnership listed in the fund’s semi-annual report, but that document is dated June 30, 2022, so it is possible that it has more exposure to partnerships today.

As my long-time readers on the topic of closed-end funds are likely well aware, I do not generally like to see any individual position in a fund account for more than 5% of the fund’s total assets. That is because this is approximately the point at which that asset begins to expose the portfolio to idiosyncratic risk. Idiosyncratic, or company-specific, risk is that risk that any asset possesses that is independent of the market as a whole. This is the risk that we aim to eliminate via diversification but if the asset accounts for too much of the portfolio, then this risk will not be completely diversified away. Thus, the concern is that some event may occur that causes the price of a given asset to decline when the market in aggregate does not, and if that asset accounts for too much of the portfolio, then it may end up dragging the entire fund down with it in such a scenario. As we can clearly see above, though, there is no single asset that accounts for more than 5% of this fund. Therefore, this does not appear to be a fund that we really need to worry about as it is reasonably well-diversified.

A look at the largest positions above likely leads one to think that the BlackRock Enhanced Equity Dividend Trust is heavily invested in the financial sector. After all, three of the ten companies on the list are financial firms. This is certainly true, although healthcare currently accounts for a slightly larger portion of the portfolio:

It is not particularly surprising to see financials featured so prominently in the largest holdings list. After all, the fund specifically states that it focuses on dividend-paying stocks and the financial sector does possess some of the highest yields in the market. However, it is worth noting that financials account for 11.73% of the S&P 500 Index so the fund is more heavily weighted to that sector than its representation in the market. The largest sector in the index is information technology, which is only third in the fund. This does make a certain amount of sense though since technology is not exactly known for being a rich source of dividends. As such, we should not really expect this fund to perform in line with the S&P 500 Index, and it certainly has not over the past twelve months. In fact, the BlackRock Enhanced Equity Dividend Trust outperformed the index over the period:

When we consider that the closed-end fund also has a higher yield, investors in this fund would have greatly outperformed investors in an index fund. This is not unusual for a covered call fund since when executed properly, the strategy can reduce losses in a declining market due to the option premiums received. However, the fact that the fund is not as weighted to technology as the index likely helped as well because the technology sector performed quite poorly in 2022.

One other thing that readers may notice from looking at the largest positions in the fund is that the BlackRock Enhanced Equity Dividend Trust includes companies from outside of the United States. This makes it a global fund. However, the overwhelming majority of the fund’s assets are still invested in American companies:

The United States accounts for less than a quarter of the global gross domestic product, so we can clearly see that the fund is substantially overweighted to that country based on its actual representation in the global economy. Then again, this fund does not specifically bill itself as a global fund and nearly all of the companies in it are ones that are prevalent enough in the United States that they could almost be confused with a domestic company, like BP and Medtronic. As such, investors should not really think of this as a fund that can really contribute to the international position that we all should have in our portfolios.

With that said, the fact that the fund does still include some exposure to foreign companies is nice because of the protection that it affords us against regime risk. Regime risk is the risk that some government or other authority will take an action that has an adverse impact on a company that we are invested in. The only real way to protect ourselves against this risk is to ensure that only a relatively small proportion of our assets is exposed to any individual nation. This fund is doing that to a very limited degree, so we need to make sure that we have sufficient exposure from either individual stocks or other funds to have sufficient international diversification across our entire portfolios.

Distribution Analysis

As stated earlier in this article, the primary objective of the BlackRock Enhanced Equity Dividend Trust is to provide its investors with current income and gains. This is accomplished by investing in a portfolio of dividend-paying stocks and then writing call options against them in order to generate premium income and essentially provide a synthetic high yield. As such, we might assume that the fund would also have a respectable yield. This is certainly true as the fund currently pays out a monthly distribution of $0.0562 per share ($0.6744 per share annually), which gives the fund a 7.50% yield at the current price. As already mentioned, this is much better than the S&P 500 Index, which yields 1.59% at the current price. The fund has been remarkably consistent about this payout over the years, as it has increased it twice since 2014 with no cuts since that time:

This is something that will likely prove to be appealing for those investors that are seeking a consistent and reliable source of income to use to pay their bills or cover other expenses. Naturally, though, it is critical to ensure that the fund can actually afford the distribution that it pays out. After all, we do not want to find ourselves the victims of a distribution cut since such an event would both reduce our incomes and probably cause the fund’s share price to decline.

Unfortunately, we do not have a recent document that we can consult for that purpose. As of the time of writing, the fund’s most recent financial report (linked earlier) corresponds to the six-month period that ended on June 30, 2022. As such, this document will not include any information about the fund’s performance during the second half of 2022. However, the current market turbulence mostly started in March 2022 when the Federal Reserve reversed its longstanding loose monetary policy and began tightening and raising rates. Thus, the fund’s semi-annual report should still be able to provide us with a good idea of how it performed in the aftermath of that event. During the six-month period, the BlackRock Enhanced Equity Dividend Trust received a total of $23,839,020 in dividends. When we net out the fund’s foreign withholding taxes, we get a total income of $23,111,651 during the period. It used this money to cover its expenses, leaving it with $15,557,846 available for investors. That was, unfortunately, nowhere close to enough to cover the $60,413,916 that the fund actually paid out to the shareholders. At first glance, this is something that may be concerning.

However, there are other methods available that the fund can use to obtain the money that it needs to cover the distribution. As already mentioned, it sells covered calls in order to receive premium income, which would not be included in the fund’s net investment income. It could also have capital gains on the stocks in the portfolio. As might be expected from the market volatility in the first half of 2022, the fund had mixed success at this. It reported net realized capital gains of $143,357,986 but this was offset by net unrealized losses of $310,688,348 during the period. In aggregate, the fund saw its assets under management decline by $212,186,432 after accounting for all inflows and outflows. This is something that may be concerning as it is a sign that the fund overdistributed during that period. However, its net realized gains plus net investment income were easily enough to cover the distribution. The biggest concern here is that the fewer assets the fund has, the more difficult it becomes to maintain the payout. However, for now, everything seems fine. We just want to keep an eye on the fund to ensure that it can begin to increase its asset base in the near future.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate a suboptimal return on that asset. In the case of a closed-end fund like the BlackRock Enhanced Equity Dividend Trust, the usual way to value it is by looking at the fund’s net asset value. The net asset value of a fund is the total current market value of all the fund’s assets minus any outstanding debt. This is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to buy shares of a fund when we can acquire them at a price that is less than the net asset value. This is because such a scenario implies that we are purchasing the fund’s assets for less than they are actually worth. This is unfortunately not the case with this fund today. As of February 24, 2023 (the most recent date for which data is available as of the time of writing), the BlackRock Enhanced Equity Dividend Trust has a net asset value of $8.94 per share but the shares currently trade for $9.01 per share. This gives the shares a 0.78% premium to the net asset value at the current price. That is more attractive than the 1.86% premium that the shares have had over the past year, but it is still a premium. As such, buying today would be overpaying for the actual assets of the fund. It would be a good idea to wait until the shares come down a bit before making a purchase.

Conclusion

In conclusion, the BlackRock Enhanced Equity Dividend Trust appears to be a very solid covered call income fund. The fund invests primarily in dividend-paying stocks and then employs covered calls to boost their yields. It is one of the best and safest strategies available to generate high levels of income. The fund did suffer from some unrealized losses in the first half of 2022, which was disappointing, but it does not appear that this was enough to completely prevent it from maintaining the distribution. The biggest concern here is that the fund is trading at a premium valuation. It is generally not a good idea to buy any fund at a premium so it would be advisable to watch the fund and see if the shares come down to a more attractive price. Otherwise, this fund does appear to be a winner.