ARDC: A Lot To Offer Income Investors, Regardless Of Interest Rate Direction (NYSE:ARDC)

The Ares Dynamic Credit Allocation Fund, Inc. (NYSE:ARDC) is a very popular closed-end fund, or CEF, that is frequently purchased by those individuals who are seeking to earn a very high level of income from the assets in their portfolios. As of the time of writing, the fund boasts an impressive 11.02% distribution yield, which is easily competitive with most other fixed-income funds on the market. For example, here is how this fund’s yield compares to that of some of its peers:

Fund	Current Yield
Ares Dynamic Credit Allocation Fund	11.02%
Apollo Tactical Income Fund (AIF)	11.72%
Nuveen Credit Strategies Income Fund (JQC)	12.83%
PIMCO Dynamic Income Fund (PDI)	15.02%
Allspring Income Opportunities Fund (EAD)	9.92%

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For the most part, these funds all employ a combination of traditional fixed-rate bonds and floating-rate loans in their attempts to provide a degree of income for their investors. This is something that could prove to be very attractive right now considering that various data points to both rising and falling rates over the next twelve months or so. In addition, nobody can really predict the direction of interest rates, particularly as the United States will go through a major election next year and may or may not enter a recession. In addition, some people may simply prefer to use a dynamic credit fund in their portfolio simply because they do not wish to go through the hassle of constantly changing their positions in reaction to a given change in interest rates.

As regular readers can no doubt recall, we last discussed the Ares Dynamic Credit Allocation Fund back in August. The fund’s performance since that time has been very reasonable, but nothing that will cause the eyes of most readers to turn. In short, the shares of the fund have been almost perfectly flat, just like the Bloomberg U.S. Aggregate Bond Index:

However, as I have pointed out in numerous previous articles, closed-end funds typically aim to maintain a relatively stable net asset value and pay out all of their investment profits in the form of direct payments to the shareholders. This is different from an index exchange-traded fund, which rarely realizes capital gains and simply sees its share price change along with the share price of the underlying assets. As such, it is important that we consider the distributions that the fund paid out in order to determine how well investors in the fund actually did. In this case, the investors in this fund who purchased on the date that my prior article was published have substantially outperformed the Bloomberg U.S. Aggregate Bond Index:

As we can see, investors in the Ares Dynamic Credit Allocation Fund are up 3.28% over the past three months. This compares to only a 0.52% gain in the broader bond index. That is something that is undoubtedly going to appeal to any income-focused investor. However, as is always the case, past performance is no guarantee of future results.

The Ares Dynamic Credit Allocation Fund also trades at a very attractive valuation right now, which when combined with its strong recent performance results in a very appealing investment proposition. Let us investigate and see if purchasing this fund potentially makes sense today.

About The Fund

According to the fund’s website, the Ares Dynamic Credit Allocation Fund has the primary objective of providing its investors with a very high level of total return. Specifically, the website states:

Ares Dynamic Credit Allocation Fund, Inc. is a closed-end management investment company. The Fund’s investment objective is to provide an attractive level of total return, primarily through current income and, secondarily, through capital appreciation. There can be no assurance that the Fund will be able to achieve its investment objective or structure its investment portfolio as anticipated.

The website states that the fund seeks to achieve this objective by investing at least 80% of its assets into senior floating-rate loans or fixed-rate high-yield bonds (“junk bonds”). CEF Connect confirms that this general strategy is indeed being followed by the fund:

As I have pointed out in numerous previous articles, it is somewhat surprising that any fund that invests primarily in debt securities will have an objective of the provision of total return as opposed to current income. This is because bonds by their very nature are current income vehicles. After all, an investor purchases a bond for its face value when it is first issued. The investor then receives a regular monthly payment from the bond’s issuer in the form of interest and then receives the face value back from the fund’s issuer upon the maturity of the bond. There are no net capital gains over the bond’s lifestyle.

However, this fund does not employ a buy-and-hold strategy with respect to the securities in the portfolio. We can see this in the simple fact that this fund has a 51.20% annual turnover, which is quite a bit higher than most fixed-income funds. As was mentioned earlier, this fund is actively changing its portfolio based on the direction of interest rates and debt security prices in the economy. As bond prices go up when interest rates go down and vice versa, we can expect that this fund will be selling bonds in order to realize the profits from the changes in security prices. Thus, despite the fact that bonds (or any other debt security) do not have any net capital gains over their lifetime, this fund is receiving them since it does not hold most of its securities to maturity.

As everyone reading this is no doubt well aware, the Federal Reserve has been aggressively raising interest rates since early 2022 in an attempt to combat the incredibly high inflation rate in the broader economy. As we can see here, the effective federal funds rate is currently at 5.33%, which is the highest level that has been seen since February of 2001:

The federal funds rate typically dictates short-term rates, and indeed LIBOR frequently correlates to the federal funds rate. However, long-term interest rates have been much more volatile than the federal funds rate recently. For example, this chart shows the yield of the ten-year U.S. Treasury over the past year:

The price of traditional fixed-rate bonds typically inversely correlates to the yield of the ten-year U.S. Treasury. As such, when the yield goes up, bond prices go down, and vice versa. As we can see, the ten-year U.S. Treasury yield has generally been trending down since the middle of October, following a period of increase during the third quarter of this year. There was a similar period of volatility with respect to the yield of this security during the first quarter of this year. Thus, we can see that there have definitely been some opportunities for profit by trading bonds over the past year despite the fact that the federal funds rate has not changed over the period.

This is important because the Ares Dynamic Credit Allocation Fund invests in both traditional fixed-rate bonds and floating-rate debt securities. The website states that 37.8% of the fund’s assets are currently invested in traditional bonds:

This represents a decline from the 42.1% bond allocation that the fund had the last time that we discussed it. However, it still gives the fund the potential to capitalize on rising bond prices that should accompany falling ten-year U.S. Treasury yields (US10Y). That could be one reason why this fund’s share price has been increasing since the start of November. After all, rising bond prices increase the fund’s net asset value and the fund’s share price usually correlates with the net asset value. We can see this correlation here:

As shown, the fund’s net asset value has indeed been increasing since around the start of this month, although not nearly as sharply as the share price increase that was witnessed over the same period. Regardless, this shows the advantage that a fund like this could have in an environment where long-term rates decline but short-term rates do not. A fund that was solely invested in floating-rate securities could not take advantage of the recent decline in long-term rates.

We do still see that only the minority of the fund’s assets are invested in traditional fixed-rate bonds. The fund currently has a 31.5% allocation to senior loans and a 30.8% allocation to collateralized loan obligations. These securities tend to be floating-rate debt securities that pay a variable coupon that gives the security an annualized yield that corresponds to some interest rate benchmark plus a spread. A few common benchmarks are LIBOR, the federal funds rate, or the three-month U.S. Treasury yield (US3M). As such, the coupon payments that the fund receives from these securities have generally been going up with interest rates over the past two years or so. However, the federal funds rate has been stable since July, although LIBOR has increased slightly:

Thus, the fund’s income from these securities has probably only increased very slightly, if at all, since the last time that we discussed this fund. This is not necessarily a problem for many investors though, since these are among the only securities in the debt space that have delivered a relatively respectable performance since early 2022. I pointed this out in a few recent articles on other funds that contain floating-rate securities, such as this one.

As such, this fund could be in a pretty good position right now considering that the forward trajectory of interest rates is somewhat uncertain. As I discussed last week, the market currently believes that the Federal Reserve will cut interest rates by a substantial amount next year. This has caused financial conditions to loosen, which is exactly the opposite of what the central bank currently wants to see. In fact, there could be some reasons to believe that the market’s current expectations of a near-term interest rate cut will cause the Federal Reserve to raise interest rates. This fund is positioned to take advantage of the situation to generate profits in either scenario. That is something that could be very appealing right now, especially to those investors who are fairly risk-averse and are simply looking to earn some income from the money that they already have without needing to spend a substantial amount of time following the bond markets.

Leverage

In my previous article on the Ares Dynamic Credit Allocation Fund, I pointed out that the fund employs leverage as a means of boosting the effective yield that it receives from the assets in its portfolio. We can see this in the fund’s asset allocation shown earlier in this article as well, as the negative allocation to “other” reflects the fund’s use of leverage. I explained how this works in my previous article on the fund:

In short, the fund is borrowing money and using that borrowed money to purchase various debt securities. This is the reason why the asset allocation chart above shows the fund’s bond holdings to exceed 100% of its assets. The strategy works pretty well to boost the effective portfolio yield though, as long as the purchased securities have a higher yield than the interest rate that the fund has to pay on the borrowed money. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, so this will usually be the case.

However, it is important to note that this strategy is not nearly as effective today with rates at 6% as it was eighteen months ago when rates were at 0%. This is because the difference between the fund’s borrowing rate and what it can get from the purchased securities is much smaller than it once was.

Unfortunately, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not employing too much leverage because that would expose us to too much risk. I generally do not like a fund’s leverage to exceed a third as a percentage of its assets for this reason.

As of the time of writing, the Ares Dynamic Credit Allocation Fund has leveraged assets comprising 38.02% of its portfolio. This is a substantial increase from the 34.13% that the fund had the last time that we discussed it, which is somewhat disappointing. This is a sign that the fund has actually been increasing its leverage over the past three months since its net asset value is at a pretty similar level to the last time that we discussed it.

With that said, the fund’s current leverage might be acceptable. As I have pointed out in various previous articles, floating-rate securities do not tend to vary much in terms of price. In fact, these assets are almost always perfectly stable regardless of interest rate movements. As floating-rate securities comprise the majority of the fund’s assets, it should be able to carry a higher level of leverage than an equity fund or some other fund that invests in more volatile securities. We probably do not have to worry too much about this fund’s leverage right now, but admittedly we do not want its leverage to keep increasing from its current levels.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the Ares Dynamic Credit Allocation Fund is to provide its investors with a very high level of total return. In order to achieve this objective, the fund invests in a portfolio that consists of both fixed-rate and floating-rate debt securities, and such securities tend to deliver essentially all of their lifetime total investment returns in the form of direct payments to their investors. The yields on these securities tend to be fairly high too, especially in today’s environment. As of the time of writing, the Bloomberg High Yield Very Liquid Index (JNK) has a yield-to-maturity of 8.72% and many senior loans and collateralized loan obligations have comparable annualized yields right now.

This fund collects all of the payments that it receives from the securities in the portfolio into a pool of money. It adds a layer of leverage to this that allows it to purchase more securities than it otherwise could with its net assets, which results in the portfolio generally having a higher effective yield than this when measured as a percentage of the fund’s actual net assets.

Finally, the fund can realize capital gains by trading the fixed-rate bonds during favorable (falling) interest rate environments. The fund then pays out the money that it receives from these various operations to the investors, net of its own expenses. It can be expected that this would result in the fund’s shares boasting a very high yield.

This is certainly the case, as the Ares Dynamic Credit Allocation Fund pays a monthly distribution of $0.1175 per share ($1.41 per share annually), which gives it an 11.02% yield at the current price. That is easily comparable to most other dynamic income funds, as we already saw in the introduction to this article. It is also substantially above the yields of most American bond indices. Unfortunately, this fund’s distribution history has not been as consistent as some income-focused investors might like, although it has not really been too bad:

This may not be the most attractive distribution history for anyone who is seeking a safe and secure source of income that can be used to pay their bills or finance their lifestyles. However, it is not nearly as variable as the history that many other debt closed-end funds tend to possess. This is probably due to this fund’s ability to profit from both rising and falling interest rate environments. The fact that the fund has increased its distribution three times over the past year could prove attractive though, as very few other closed-end funds have managed to accomplish the same feat and the larger distributions make it easier for retirees and similar investors to maintain their purchasing power in the face of the worst inflation that we have seen in decades.

As is always the case though, it is important that we ensure that the fund can actually afford the distribution that it pays out. After all, we do not want to be the victims of a distribution cut that reduces our incomes and probably causes the fund’s share price to decline.

Fortunately, we do have a fairly recent document that we can consult for the purpose of our analysis. As of the time of writing, the fund’s most recent financial report corresponds to the six-month period that ended on June 30, 2023. This is a much newer report than the one that we had available to us the last time that we discussed this fund, which is very good to see. This is because the market environment during the first half of this year was quite different from the one that we encountered in 2022. During the first half of 2023, the market was fairly optimistic that the Federal Reserve would shortly reduce interest rates and it began to bid up bond prices in accordance with this belief. This could have provided the fund with the opportunity to earn some trading profits as bond prices went up. In addition, as we saw earlier in this article, the ten-year U.S. Treasury experienced some substantial volatility during this period. That is generally a good situation for bond traders, as it provides the potential for capital gains.

During the six-month period, the Ares Dynamic Credit Allocation Fund received $23.983 million in interest from the assets in its portfolio. The fund received no income from any other sources, and it paid no foreign withholding taxes, so its total investment income was the same amount. The fund paid its expenses out of this amount, which left it with $16.406 million available for the fund’s shareholders. This was enough to cover the $15.124 million that the fund paid out in distributions during the period.

Thus, as was the case the last time that we looked at the fund, it appears that the Ares Dynamic Credit Allocation Fund is simply paying out its net investment income to its shareholders. This is a situation that we like to see with any debt fund, as it indicates that the fund’s distribution is not unnecessarily destructive to its net assets. The fund’s net assets did actually increase during the period though, as it had net unrealized gains of $17.496 million that offset net realized losses of $9.403 million. The fund’s net assets went up by $9.375 million after accounting for all inflows and outflows during the period.

While it is certainly possible that some of these unrealized gains could be erased by an unfriendly market, the fund’s net assets have generally been reasonably stable over the past year and it has just been paying out its net investment income so overall the fund’s distribution should prove to be stable as long as it can maintain its net investment income.

Valuation

As of November 27, 2023 (the most recent date for which data is currently available), the Ares Dynamic Credit Allocation Fund has a net asset value of $14.07 per share but the shares currently trade for $12.79 each. This gives the fund’s shares a 9.10% discount on net asset value at the current price. This is not nearly as attractive as the 11.40% discount that the shares have had on average over the past month. As such, it might be possible to get a better price if you are willing to wait a bit, but the current price is not especially terrible if you like the fund.

Conclusion

In conclusion, the Ares Dynamic Credit Allocation Fund is a closed-end fund that is quite well-suited for any investor who is seeking to earn a high level of income from the assets in their portfolios. The fund’s current 11.02% yield is certainly attractive and competitive with similar funds, and this is one of the few closed-end funds that has managed to increase its distributions over the past year.

The Ares Dynamic Credit Allocation Fund, Inc. is well-suited to perform in both a rising and a falling interest rate environment too, which adds to its overall appeal. When we combine this with a reasonably attractive current price, we can clearly see that this fund has a lot to offer to any income-focused investor.