In my recent articles concerning the upward directional change in interest rate (Data Shows Interest Rates will Continue Higher In 2013 - What to Do Now) I have described strategies which are intended to hedge or deaden the blow of basis loss in an investment portfolio as the market trades lower in price, higher in yield on fixed income investments. One of the strategies that many investors assume should work is the purchase of variable rate bank loans, either through a Closed End Fund, [CEF] or a Business Development Corporation [BDC]. But when you look at the market trading data since the beginning of May across the board on these companies, there is a definite under performance in the issues. It is an under performance which in relative magnitude equals the decline in the highest duration Treasury ETFs.
A bank loan which is variable is supposed to be a low duration, not high duration security. So, there must be something else going on which is driving the trading pattern across an entire market sector; and, I will explain what it is in this article.
During the month of May 2013, the term structure of interest rates turned higher for the first time in a considerable period of time. There was a general 50 basis point rise in all maturities ranging from 5 to 30 year. The underlying asset values lost value as rates rose as can be seen in the table below. Particularly hard hit were the 10-30 year duration ETFs which lost 3-7%:
To get a sense of the relative impact of the rate increase on the CEFs and BDCs which hold a high percentage of variable bank loans, I have pulled together unit price performance on a wide range of CEFs and BDCs for the month of May and the first week of June.
In the table below I have listed the fund name and ticker symbol so you can do your own research if you desire. I have shown the performance of the securities over the last 30 days, 1 year and 5 year periods along with the current yield and price level of the shares when the data was captured. In addition, I have added additional information associated with the BDCs, the recently IPOed exchange traded debt issues of each one shown in the table. I will let you know I have included this piece of information after explaining why the CEFs and BDCs are not performing as one might expect as interest rates have begun to rise.
After reviewing the information for the month of May, it is useful to look at the continued performance into the first week of June. During this past week, the S&P500 did a mini-correction for the first three trading days. The market fell through Wednesday during the week to a point where its 30 day return was at break-even. During that time, many of the interest sensitive areas rebounded from the drubbing they took in May. Some issues in the large cap dividend, telecom and REIT space made some comebacks. But the leveraged loan sector, as shown in the chart below by and large did not bounce.
As you can see from the data, most of the CEFs and BDCs continued lower during the week of June 7th. This is even more telling since it a week prior to when many of the CEFs go ex-dividend, which means that there is selling prior to getting the dividend which is a bearish signal. The share price levels at the end of May were typically higher than the price level of the shares after 5 days of trading June. And the performance level is still worse than the negative performance of the 10-20 year duration Treasury bonds.
There are several factors which are inter-working to create a security which is suppose to hedge interest rate risk, but instead acts to magnify the problem when rates begin to rise. They involve the high leverage carried by funds and BDCs which hold the bank loan assets as well as the changing market assessment of the underlying asset quality held by the entities after an extended period of very low interest rates.
I can say this with a fair amount of certainty because this has happened before. The time period was 2005 as Alan Greenspan, Federal Reserve Chairman at the time, was in the process of raising interest rates from near zero levels. You can examine the change in the Fed Funds rate level relative to the rise and fall in market price of and (ETF) in the graph below:
During the year 2004 and early 2005 many new issue variable loan CEFs were introduced in the market. At the time of the IPO, the new funds were sold to the public at the high point for the Net Asset Value of the loans in the funds. As the interest rate policy to move rates up was implemented in 2004, the leveraged loan index began to weaken. Why? Because in a rising rate environment, business loans as a group get riskier. And, the low interest rate level that the loans were issued would not fully begin to actually "float" higher until the LIBOR rate moved higher by at least 1% from the point the assets were valued at IPO. Whack - say good-bye to a portion of the net asset value. Additionally, these funds are highly leveraged, usually close to the statutory maximum of 2:1 or 40% effective leverage. If the underlying net asset value declines, some assets will have to be sold. This causes a downward cascade in asset value across the entire sector. And, to magnify the earnings problem, the expense level of the fund or BDC rises as the leverage debt interest rate increases.
As you can see in the graph, the CEFs across the board in 2005 declined in value until reaching an intermediate term bottom at the end of 2005. From 2006 to mid-2007, the variable bank loan CEFs actually began to hedge the upward movement in market interest rates, and underlying net asset values [NAV] improved. But as we know from history, the underlying economy was unstable and over-leveraged. It is interesting how these securities signaled the eventual stock market collapse in September of 2008 and early 2009 so far in advance. The value of the variable bank loan funds collapsed right in synch with the drop in the Fed Funds rate from mid-2007 through 2008.
I do not believe the current poor performance of the CEFs and BDCs is a signal of an impending market collapse. But then again, the Fed has not as yet begun to actually raise the Fed Funds rate and the sell-off is significant. However, the Fed Funds rate may not be a good indicator of rate increases in this upcoming rate increase cycle. The Federal Reserve is committed to keeping the short end of the term structure of interest rates "artificially" low by paying interest rates on reserves to banks. LIBOR, which the loans are tied to, is the rate that will have to be monitored in this cycle.
Back in early April of this year, I published research articles on three separate BDCs warning that this is not the time to be buying these type of companies at market prices above net asset value. You can access these reports on my website in my article archive or on my website (Financial Calculus). The declining asset quality was the primary warning that I was issuing, as the extreme market competition for loans in the middle market has lead to a decline in lending standards. The worst abuse is first lien loans which are being packaged which are comprised of the older 1st, 2nd and subordinated note loan. It is similar to the 100% loan to value mortgages in the mid-2000s. The market, in my opinion, has not yet fully adjusted to the over-valuation of these loans in the net asset value reporting.
Most CEFs and BDCs that are in the tables in this article have suffered in excess of 5% corrections. This is the first stage of the adjustment to the changing Federal Reserve policy. There is likely to be a continuation of this decline over the intermediate term all the way until the Fed actually does begin to raise short-term rates. If a CEF or BDC has not corrected yet, then it is likely they will fall more than other funds in the near term. As a group, these securities all trade with a very high degree of correlation. There is one outlier right now. It is the Blackstone Fund . I do not have a rationale as to why it is an outlier over the last 5 weeks. It is, based on historical analysis, trading at only 80% of its original IPO price level, while many of the CEFs are much closer to the original issue price 8 years later. This may mean they have non-performing loans on the balance sheet which there is an expectation will become performing again, and therefore the distribution rate will be increased. If nothing materializes, I would expect FRA to correct soon.
One Last Point - Potential Actionable Trade
As a last point, I will explain why I included the exchange traded debt of Fifth Street Finance, Pennant Park and Prospect Capital in the tables above. The debt in these companies makes up a portion of the almost 40% leverage that each of these companies hold on their balance sheet. It is in a sense a margin loan at a high relative interest rate. The debt in all three cases is investment grade (BBB-), albeit low investment grade. The issues are in the 10-15 year maturity window, which you would expect makes them a high duration issue. However, they are trading with very little down-side volatility at the present time. If there was a run on these issues, it would be a definite signal of a 2008 event, but there is not.
In a rising rate environment, lower duration assets which are non-correlated to a rise in rates are what you need in your portfolio. On this measure, the exchange traded debt of the BDCs is actually a better investment than the CEFs and BDCs at the present time which are undergoing valuation pressure as rates just begin to rise. And the interest rate received is almost the same in the case of the CEFs - it is below the BDCs distribution level in all cases - but fairly close in the case of . This creates the possibility of a good strategic trade opportunity to hedge downside risk on this portion of your income portfolio:
- Swap some portion of your current variable rate loan asset holdings for the exchange traded debt of the BDCs. [There are additional offering s than the ones listed in this article, including issues by (MSCA), and also issues by Prospect Capital that can be found as non-exchange traded bonds].
- Once the short-end of the curve begins to move higher, and the variable loan funds have returned to a position where distribution increases are expected, swap back into the variable rate loan CEF or BDC.
I remain a bear on the BDC and leveraged CEFs for the intermediate time period until the correction is complete. This will not happen until the loans in the portfolios reach a point where rates can be increased, and the distribution levels of the CEFs are on the verge of increasing distributions. This may be a year or more away. ETFs without leverage such as in the variable rate sector should perform better than the leveraged funds during this time period.