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One year ago, I wrote an article recommending four senior loan CEFs. The senior loan asset class performed well in 2012. But valuations have changed significantly since then. Most of these funds traded at attractive discounts last year, and are now trading at premiums or below average discounts.

Senior loan CEFs have many "moving parts," and I thought it would be interesting to analyze how they might perform if short term interest rates start rising late this year or in 2014.

First let's review last year's forecasts -

1) As expected, short term interest rates remained low throughout the year. Senior loan CEFs were able to raise their distributions by replacing traditional floating rate loans with newer loans with Libor floors.

2) Longer term interest rates traded in a sideways pattern with some ups and down, but ended the year roughly unchanged.

3) Equity markets did somewhat better than expected with a low double digit return.

4) Some fixed income sectors with outstanding double-digit performance in 2011 (e.g. Treasuries, municipals) produced reasonably good returns again.

Based on the futures market, here is what I expect for 2013:

- Short term interest rates should remain low throughout 2013, but if the economy does unexpectedly well, we may see short-term rates increase in the fourth quarter. I would keep an eye on real GDP growth. If it exceeds 3% for two consecutive quarters, the chances of an unexpected rate increase goes up.

- Longer term interest rates will likely have a slight upward bias, unless the economy unexpectedly weakens. Again, I would look at real GDP as the key. If it falls below 1% for two straight quarters, we could see lower long term interest rates.

- Equity markets will likely produce a mid-single digit return, unless real GDP varies dramatically from the current 2% level.

- I expect US Treasuries to provide sub-par returns unless real GDP weakens dramatically. High yield, mortgages and municipals should earn their coupons, but I don't expect major capital appreciation. I think emerging market fixed income may outperform next year.

Given the above forecasts, the underlying senior loan asset class will likely perform fairly well next year. But the senior loan CEFs are pricey now, and most of them sell at premiums over NAV or below average discounts. From a timing perspective, it may be best to hold off on additional purchases until more attractive discounts develop again.

There are some interesting dynamics that will affect the senior loan closed-end funds over the next few years. Some factors will enable them to raise distributions, while other factors will cause lower distributions. This can play out differently depending on the specific details of each fund:

Factor #1: Replacement of older traditional floating rate loans with newer loans with Libor floors.

Since the Fed started its zero interest rate policy, it has been difficult to market new floating rate loans without Libor floors. The percentage of senior loans with Libor floors has grown from around 10% in 2009 to the current level of nearly 70% of the senior loan market. As long as the Fed keeps short term interest rates at zero, this percentage should continue to increase.

When a closed-end fund replaces an older traditional floater with a new floater with a Libor floor, there is an immediate boost in income. That is why these funds have been able to raise distributions considerably since 2009.

When analyzing a senior loan CEF, one should try to estimate the percentage of loans with exposure to Libor floors in the portfolio. A fund with a lower exposure to floaters with Libor floors has more potential to raise its distributions when older floaters get replaced.

Factor #2: Leverage Cost

Leverage cost is always a key factor when analyzing fixed income CEFs. These funds can currently borrow at a very low variable interest rate pegged off of Libor.

Some closed-end fund managers have chosen to "lock in" interest rates at a higher fixed rate by using interest rate swaps (pay fixed, receive floating). They swap fixed payments in exchange for floating rate payments for some period of time, usually several years. The floating rate payments received from the swap are used to pay for their leverage.

This swap strategy did not work well last year. The Libor rate remained low throughout the year, so the funds that locked in the higher fixed rate with swaps lost their bet and cost their shareholders money.

Looking ahead to the future, the managers that locked in the higher fixed rate may eventually benefit when short-term rates finally exceed the fixed rate that was locked in. But it looks like this will not happen until 2014 or later, unless the economy is much stronger than expected next year.

Factor #3: What happens when the Libor rate approaches the floor rate of the floaters?

At some point, probably in late 2014, the Libor rate may finally start increasing and approach the Libor floor rate for most floating rate senior loans. At this point, leverage costs will start increasing for those funds that did not use swaps to lock in a fixed rate, and this can cause some distribution cuts.

But the cuts should be minor, since there will be a higher exposure to higher rate Libor floor floaters by that time, and this would help to compensate for the more expensive leverage. But there may also be some decreases in NAV, since the value of the floaters with Libor floors would likely drop a bit because of the higher interest rate environment.

Factor #4: What happens if/when Libor finally exceeds the floor rate of the floaters?

If the Libor rate exceeds the floor rate and continues going higher, the funds should start behaving like normal floaters, and distributions should start increasing based on the spread over the Libor rate. This will probably not occur until 2015 or later. Leverage costs will also increase, unless a fund used interest rate swaps to lock in a fixed rate.

At the current time, the valuations for senior loan CEFs are stretched. Here are the current discounts/premiums compared to last year for the four funds discussed in my article:

1. Invesco Van Kampen Senior Income Trust (NYSE:VVR)

The fund seeks high current income with capital preservation through investment in floating and variable rate senior loans.

Dist. Yield= 6.83% Leverage: 29.3% Expense Ratio= 1.69%

Jan 12, 2012 Discount to NAV= -6.07% (last year)

Current Premium over NAV= +4.68%

52-week average discount= -1.50%

Change in discount/premium in the last year= +10.75%

2. ING Prime Rate Trust (NYSE:PPR)

The fund seeks high current income with capital preservation through investment in US dollar denominated, floating rate secured senior loans.

Dist. Yield= 7.11% Leverage= 28.3% Expense Ratio= 1.67%

Jan. 12, 2012 Discount to NAV= -5.83% (last year)

Current Premium over NAV= +7.02%

52-week average discount= -0.26%

Change in discount/premium in the last year= +12.85%

3. Invesco VK Dynamic Credit Opportunities (NYSE:VTA)

Leveraged CEF seeks a high level of current income by investing primarily in senior bank loans.

Dist. Yield= 6.95% Leverage: 23% Expense Ratio= 1.86%

Jan 12, 2012 Discount to NAV= -8.48% (last year)

Current Discount to NAV= -1.22%%

52-week average discount= -4.09%

Change in discount/premium in the last year= +7.26%

4. Eaton Vance Floating Rate Income Trust (NYSE:EFT)

Leveraged closed-end fund invested in senior secured floating rate loans seeks to provide a high level of current income with preservation of capital. The fund provides individual investors access to the institutional loan market.

Dist. Yield= 6.17% Leverage= 35.9% Expense Ratio= 0.81%

Jan 12, 2012 Discount to NAV= -3.61% (last year)

Current Premium over NAV= +9.62%

52-week average premium= +2.58%

Change in discount/premium in the last year= +13.23%

If the senior loan CEF valuations come back down to earth again, I would certainly consider a purchase for the longer term. But at the current time, I prefer other fixed income asset classes that are still available at a discount to NAV.

Other fixed income CEFs like FSD or PPT can also provide a hedge against higher interest rates and are currently available at a discount.

Source: Will Senior Loan CEFs Have Another Good Year In 2013?