Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on December 8th, 2022.
BlackRock Enhanced Equity Dividend Trust (NYSE:BDJ) continues to hold up well against the broader market. The combination of a value-tilted portfolio and covered call-writing strategy has generated these results. With expectations of an uncertain economy holding up next year, that could mean BDJ sees another strong year of relative performance. Even more, if investors expect a ‘lost decade‘ to develop for equities, a covered call writing fund is a fair bet.
Unfortunately, other investors seem to be thinking along the same lines. BDJ had historically traded at some significant discounts. Throughout 2022, the fund’s share price has hugged its NAV much closer than usual. At this time, a slight discount is available, which is an improvement over the slight premium we saw in our prior update.
That presents us with a situation where it’s an attractive strategy, but we can’t get overly excited about buying aggressively. More like a time when cautiously adding could be seen as more appropriate-utilizing a dollar-cost averaging approach to build up a position at various prices for the time being.
- 1-Year Z-score: 0.72
- Discount: 0.97%
- Distribution Yield: 7.35%
- Expense Ratio: 0.85%
- Leverage: N/A
- Managed Assets: $1.724 billion
- Structure: Perpetual
BDJ’s primary objective is to “provide current income and current gains.” The fund intends to achieve this by “investing in common stocks that pay dividends and have the potential for capital appreciation.” They concentrate on dividend-paying stocks with “80% of its total assets in dividend-paying equities.”
They will also utilize an option strategy on single stocks within the portfolio to “enhance distributions paid to the Trust’s shareholders.” The fund last reported being overwritten by 48.87%. This is quite an elevated level of their portfolio, considering their target is between 30 to 40% overwritten.
A more aggressive overwrite means that they could be tilted towards a more bearish outlook. This is also similar to the weighting they had overwritten on their underlying portfolio before.
In July, the fund also announced that the investment policy had changed slightly. They are now allowing up to 10% of the portfolio to be invested in private investments.
Performance – Holding Up Relatively Better, Look For Widening Discount
Since our prior update, BDJ continues to perform relatively better than the broader market. In fact, BDJ has extended its lead in terms of both total NAV return and total price return performance relative to the SPDR S&P 500 (SPY).
As is appropriately noted on every update, over the longer run, the fund does underperform. This is particularly true over the last decade when growth investments and a bull market meant that BDJ was out of favor. With a value-oriented portfolio and covered call strategy, it is disadvantaged in rapidly rising markets. The reason for this on the covered call strategy is that positions either get called away, meaning gains are given up. Or, the fund closes or rolls the position, both of which can generate a net loss on the trade.
However, given the current environment and expected muted returns over the following years, BDJ is primed for the current environment. Value-oriented positions tend to generate consistent cash flows, albeit slower growth. That’s what is attractive in an environment where overall economic growth is uncertain or expected to be flat. If that expectation comes to fruition, a flat or even downward market could continue to benefit BDJ. Writing covered calls is one way to generate gains in a flat market.
That’s exactly what we saw with BDJ’s last semi-annual report. They were able to generate $5.532 million in options premiums. Overall, they even generated significant realized gains in the first half of the year too.
We can’t completely ignore the unrealized losses the portfolio generated, though. That was enough to mean the fund was still losing ground for the year. Since that report, the fund’s NAV (and share price) have risen, which means some of those losses have been trimmed slightly.
With BDJ looking like a relatively strong consideration for the current environment, it would appear that investors have taken notice. The average closed-end fund tends to see its discount widen during times of volatility. As of 12/7/2022, the average CEF discount is touching 6.49% from the 2.28% discount reflected at the start of 2022.
Thus, we can clearly see that BDJ has done the opposite and bucked this trend.
This was a fund that traded at some significant discounts for extended periods of time. That’s saying it generously too. The fund almost never trades this high. There were some unusual periods between 2009 – 2011 that saw the fund spike up to premium levels. Over the last decade, the fund’s average discount has come closer to 8.5%.
Distribution – Special Distribution And Attractive Regular
BDJ raised its distribution earlier this year after it was one of the more conservative payers. Since the inception of the fund, the distribution had moved down many times after the GFC. However, thanks to the bull market (despite not benefiting as directly,) the distribution has been steadier in the last decade.
We can also see that the fund paid a large year-end special last year and this year. The special for this year is $0.2738835. Although that does include the regular December distribution in it is as well.
It might seem a bit unusual to see a raise and a special paid out in an environment of such uncertainty for equity funds. I know we can see that BDJ has performed relatively better, but that’s not why we see specials. When year-end specials are paid, it’s because they have a requirement to pay out a certain minimum of realized capital gains and income during the year. These specials are just them meeting those requirements and avoiding excise taxes.
For BDJ, this was a spillback, meaning it came from the preceding fiscal year too.
Commonly referred to as a “spillback” distribution, this distribution of undistributed income and/or capital gains from the Fund’s preceding fiscal year is required in order for the Fund to satisfy regulated investment company related U.S. federal income tax requirements.
Taking particular note of the word “realized” capital gains, we can see BDJ had no lack of those being generated. This was especially the case in 2021, which triggered the BDJ payout. Option premium falls under realized capital gains, adding to the amount of capital gains along with the positions they sold that had appreciated.
For this year, we won’t know exactly what the realized gains were for the full year. Given this is for the first six months, anything could have happened, and there really is no way to guesstimate here. That being said, what they realized in the first half of the year is already more than enough to ‘cover’ the distribution for this year.
In fact, we may end up seeing a special next year if they realize too many more capital gains on top of this. That’s a possibility, as the fund should still see a net benefit from option writing. It will come down to if they realize losses to offset some of these gains we saw in the first part of the year.
Here’s the discussion for tax purposes that I shared in the previous article that is just as relevant in this update. There will be no tax update until we get the official tax data for 2022.
For tax purposes, the bulk of the distribution was long-term capital gains, as one would expect in 2021. We also see a hefty portion identified as qualified dividend income; and, to a small degree, some non-qualified dividend income or ordinary income. I believe that makes it appropriate for a taxable account with these types of distribution classifications. They are generally lower tax obligations for most investors.
If the earnings are any indication so far, the distribution classification could be similar for 2022. As I’d always caution, anything can happen between now and the end of the year. Something drastic could happen, and the expected tax character could shift significantly.
Overall, BDJ’s portfolio is heavily invested in U.S.-based holdings. However, in aggregate, we still have a fairly meaningful allocation in holdings outside of the states too. I think greater flexibility is a benefit when managers can invest where they believe is the best opportunity. It adds to the overall diversification of the fund.
The latest listing available on their website was for the period ending September 30, 2022. In our prior update, we were looking at July 29, 2022, data. This is noteworthy because all the other BlackRock (BLK) funds provide monthly updates.
For sector exposure, they regularly hold a large exposure to value-tilted holdings. It doesn’t tend to change drastically from quarter to quarter. However, as we noted in the last update, BDJ did have a fairly significant shift earlier this year.
The fund was running near 26% in financials at the start of the year. We still see a significant weighting to the sector, but it was passed by healthcare. The tech sector has remained relatively stable over this year, where it lands in third place in terms of weighting for BDJ. Having a relatively lower weighting to tech and consumer discretionary is where the fund benefited significantly this year. Those were poor-performing sectors on a YTD basis.
The communications sector was the worst performing, but the exposure here isn’t overly needle-moving for the fund. Real estate was also a bottom performer, but the fund doesn’t have exposure listed to that sector.
With a short period of time between providing updates on holdings, the top ten hasn’t shifted dramatically.
Despite the healthcare sector being the largest weighting in the fund’s portfolio, only one name is represented in the top ten holdings. That would be Medtronic (MDT). It was present in the last top ten updates, but it has moved up in allocation since then, up to the fourth largest position from the seventh. Elevance Health (ELV) was also in the top ten previously. As a health insurance company, that would have also been included in the healthcare sector.
MDT is a particularly interesting healthcare name, as the rest of the healthcare sector has performed well. MDT has moved in the other direction on a YTD basis.
They are in the healthcare equipment industry. They “develop, manufacture and sell device-based medical therapies to healthcare systems, physicians, clinicians and patients.” This includes many different products and software. Despite being essential, analysts are expecting earnings to drop off next year by a touch. This could be causing some of the weaknesses. For a longer-term investor, this seems like a fairly attractive entry for MDT.
This should mean that MDT being in BDJ’s portfolio should be longer-term beneficial. Not to mention that they can turn around and write covered calls while waiting for it to turn around. In fact, in their last report, they listed they did exactly that. They wrote 742 covered call contracts at a strike of $99. Those expired on July 22, 2022. So they aren’t still outstanding, but they help give us an idea of some of the covered call positions they might take.
Below is the price action of MDT from the end of the semi-annual report for BDJ to the expiration date. As we can see, these would have expired worthless. Therefore, the premium collected here would be included in the next report for realized gains under options written.
They are also collecting a healthy and growing dividend from this position.
BDJ has been holding up significantly better when compared to the broader market. The focus on value-oriented portfolio positions and writing covered calls has benefited this fund for 2022. If investors anticipate more muted returns in the coming year or two, then BDJ could present a compelling option. Unfortunately, that seems to be exactly what investors realized, as the fund has been flirting with a premium over its NAV. The shallow discount at the moment means that we should be more patient, but utilizing a dollar-cost averaging approach to invest slowly over time could be appropriate.