ARDC CEF: moving from sell to conservation status

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Thesis

In February, we wrote an article in which we analyzed Ares Dynamic Credit Allocation Fund, Inc. (NYSE: ARDC) and assigned it a To sell rating based on our analysis and view of the market. the fund is down more than -9% since our rating, or on an annualized basis, down more than -36%. If an investor had held the name rather than selling it, an entire year of dividends would have been wiped out in just three months. Unlike other writers on the platform, we constantly articulate our reasons for taking certain market views and actively monitor our performance against our ratings. We believe that a well-informed investor can make a more profitable decision by validating the authors’ historical performance in their respective fields.

We believe that the massive market sell-off driven by the Fed rate hike and the fear of a “hard landing” is slightly overdone and that all momentum must die down soon. We believe the Fed will hike another 50 basis points three times and reach a neutral rate level of 2.5%, followed by an valuation period. We think the market has already priced this in and is currently almost done with the risk aversion move. We have seen credit spreads widen significantly due to recession fears, which, coupled with higher risk-free yields, has resulted in a significant negative performance for CEF ARDC fixed income securities since the start of the year. With most of the negative movement behind us, we are now moving from To sell for Hold on this name.

Performance

The fund is down more than -9% in progress since our rating:

ARDC Award

Price performance (Looking for Alpha)

Since our February post, the ARDC is down over -9% on a price basis and over -7.86% on a total return basis, which wipes out an entire year of dividends for the fund.

The fund is down more than -18% on a total return basis since the start of the year:

ARDC ytd return

Cumulative performance since the beginning of the year (Looking for Alpha)

On a 5 year basis, which is more appropriate for a real individual buy and hold, the fund is still up around +5% on an annualized annualized return basis:

ARDC 5-year performance

Performance over 5 years (Looking for Alpha)

We believe that for buy and hold instruments, while an investor is well served to hold only the name in the portfolio, during significant macroeconomic events such as monetary and fiscal policies (tighten/loosen), it is worth trading part of the position. Namely, when identifying further weakness in the name due to higher interest rates in the market, even a true long-and-hold investor would have been well served to lighten their positioning. Taking such action does not mean liquidating the entire position, but simply adjusting to a lower ratio with the intention of buying the name later in the year at a lower price.

Assets

The fund currently holds leveraged loans, high yield bonds and CLOs:

Assets of the ARDC Fund

Wallet (Fund Fact Sheet)

Most of the CLO debt is floating rate, which, together with the fund’s large holdings of leveraged loans, explains the low duration exhibited by ARDC:

duration

Duration (Fund Fact Sheet)

CLO Equity represents an asset class in its own right since it does not have a declared interest rate per se. What do we mean by that? Let’s take a quick look at how a CLO is structured:

ARDC structure - CLO

Structure (Fund Fact Sheet)

CLOs are securitizations, which means that cash generated from a finite pool of assets is disbursed in a “cascade” or seniority of payments. The rated tranches have defined interest rates (fixed or floating) while the equity tranche captures all residual cash flows and trades on yield or IRR. Depending on the health of the collateral pool, default rates, recoveries and the business acumen of the collateral manager, CLO Equity tranches can generate substantial returns over the life of the transaction, with IRRs in excess of 12% . Conversely, in a stressed economic environment, the equity tranche is the first to be affected and absorb a loss. Therefore, equity slices can lose all their value quite quickly. Think of the Great Financial Crisis of 2008-2009 when securitizations (subordinated tranches and equity tranches) were responsible for massive violent losses on the back of slightly higher default rates.

The vehicle is heavily invested in CLOs which represent more than 30% of the portfolio and have a mixed sector allocation due to their own collateral pools:

ARDC Fund Industry Allocation

Industry (Fund Fact Sheet)

From a ratings perspective, the fund is biased towards BB names, but please keep in mind that securitized product ratings follow a different metric/stress test than pure corporate bonds/benchmark loans leverage:

Breakdown of ARDC Fund ratings

Ratings (Fund Fact Sheet)

Conclusion

ARDC is a fixed income CEF that focuses on floating rate leveraged loans, high yield bonds and CLO debt. Although it has a low duration, the fund was negatively affected by higher risk-free rates, with the curve rising significantly even at the front. Coupled with much wider credit spreads due to recession fears, the correlated factors have caused the fund to decline significantly over the past three months, which when annualized translates into a negative performance of -36%. We believe most of the rate move is behind us and, coupled with stabilizing credit spreads, will result in a carry-oriented performance for the fund going forward. We now move from To sell for Hold on this name.

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