Forget what your Mom told you. You can float through life. That’s the message the markets have been sending investors over the past 18 months.
Thanks to some recently introduced exchange-traded products, you can make either side of your portfolio—equity or debt—float. So to speak.
Perhaps some definitions are in order because the word “float” means something different to stock investors than it does to bondholders. On the equity side, float refers to the number of company shares held by the public. Float, on the debt side, most typically describes coupons that periodically reset to market interest rates.
Either way, there’s money to be made playing the float game, especially when you decide to float both sides of your portfolio.
Rates That Float
Earlier this year, the Federal Reserve started, um, floating test balloons to signal an increasing likelihood of higher rates. The effect on a now-spooked credit market was dramatic. Between March and June, 10-year Treasury rates backed up more than 60 basis points, knocking down bond and bond fund prices.
Floating rate notes (FRNs), however, held their ground. FRNs, also known as senior loans, leveraged loans or syndicated bank loans, represent bank credit extended to corporations with below-investment-grade ratings. These loans are often used in the financing of leveraged buyouts, mergers and acquisitions. They’re known as senior loans because investors’ rights to the payment of principal and interest is senior to any other security in the issuing corporation’s capital structure. They’re syndicated because the risk is spread around to a group of banks and institutional investors.
Interest paid by FRNs adjust to the current market by being tethered to a reference rate, typically the London Interbank Offered Rate, or LIBOR. Most often, an FRN will offer a yield at some preset margin over the reference. As an example, J.C. Penney Co., Inc. (JCP), a B2/B- credit, has an “L+500” note outstanding, meaning it pays LIBOR plus 500 basis points.
Reference rates are typically reset every 30, 60 or 90 days, keeping the FRN yield in line with changes in the corporate credit market. That’s a benefit to be especially enjoyed by noteholders in a rising rate environment. Of course, it could be a bit of a detriment when interest rates are falling, though FRNs tend to be less rate-sensitive than other segments of the bond market.
FRNs can diversify a portfolio’s fixed income allocation (though, as we’ll soon see, it may take a whole lot of them to provide a meaningful effect) because these notes commonly have very low or negative correlations to broader segments of the credit market.
More often than not, FRNs are secured by collateral such as corporate real estate property, inventory or equipment. That feature, coupled with the loan’s senior status and any embedded performance or leverage-related covenants, mitigates a holder’s risk. That makes FRNs an appealing alternative to high-yield (junk) bonds.
All this shouldn’t lead investors to ignore the inherent risks presented by FRNs. These are, after all, loans extended to low-rated companies. There’s still big credit risk here, even if it’s a notch below junk paper. Of course, improving economic conditions and strengthening corporate balance sheets will tend to narrow credit spreads and bolster FRN values, but deterioration will have the opposite effect.
Floating Rate ETPs
Investors can tap into the FRN market through a growing number of exchange-traded products. First to market was the PowerShares Senior Loan Portfolio (BKLN), launched in March 2011. The passively managed ETF tracks the S&P/LSTA U.S. Leveraged Loan 100 Index, a market-weighted benchmark of the nation’s largest institutional notes.
The $4.8 billion BKLN fund presently offers an annual yield of 4.6 percent after expenses of 66 basis points. The fund’s components average a reset cycle of 48 days.
To say that BKLN has been popular lately is a bit of an understatement. As interest rates ratcheted up, the fund raked in nearly $500 million a month making it the nation’s eighth-largest corporate bond ETP.
Dramatic asset growth also has been seen in more recently launched bank loan products, namely the passively managed Highland/Boxx Senior Loan ETF (SNLN) and two active products, the SPDR Blackstone/GSO Senior Loan ETF (SRLN) and the First Trust Senior Loan Fund (FTSL). This asset surge has come at the expense of the high yield market especially. In the first half of 2013, for example, the largest junk bond ETPs, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays High Yield Bond ETF (JNK), lost $1.7 billion and $2.9 billion, respectively.
Float vs. Junk
In its first 18 months, BKLN returned substantially more than the general bond market, proxied by the iShares Core Total U.S. Bond Market ETF (AGG), and edged out the high yield segment represented by HYG. Both HYG and BKLN are negatively correlated to AGG, though BKLN is more so. BKLN’s low volatility earns the fund a Sharpe ratio more than double that of HYG, indicating a much better reward-to-risk proposition in the FRN market versus the high-yield segment.
Public companies, flush with cash after trimming costs during the financial crisis, are now buying back their shares in record numbers. If equity floats your boat, a couple of exchange-traded funds will let you ride atop the buyback wave.
The actively managed AdvisorShares TrimTabs Float Shrink ETF (TTFS) is the newest float-playing entrant to market. TTFS portfolio runners look for companies actively engaged in float reduction through buybacks rather than reverse stock splits or spin-offs. Specifically, TTFS managers want issuers generating free cash flow from operations and shun those using leverage to shrink their share base.
The fund’s bogey is the Russell 3000 Index which is used as the universe from which purchase candidates are culled. First, the index is screened for float reducers, then the illiquid issues—stocks with low trading volumes or exceptionally high bid/ask spreads—are tossed. Finally, capital is allocated equally to each of the 100 top-ranked companies passing the screens.
TTFS is a young fund but, as its track record shows, it’s managed to reach its objective. Over the past 18 months, TTFS earned enough excess return to overcome its higher volatility and edge out the low-cost Vanguard Russell 3000 Index ETF (VTHR).
A more passive approach is taken by the PowerShares Buyback Achievers Portfolio (PKW). PKW tracks a modified capitalization-weighted benchmark comprised of companies that have repurchased five percent or more of their common stock in the past 12 months.
The fund aims to outperform the S&P 500 and charges an expense ratio of 70 basis points, a cheaper alternative to the 99-basis point TTFS portfolio. Cheap isn’t necessarily better, however. Because of its lower volatility, PKW earns a better Sharpe ratio than TTFS but, at the same time, is more highly correlated to the broad market. PKW posted a .96 correlation coefficient versus the SPDR S&P 500 (SPY) for the past year and a half, making the PowerShares fund less desirable as a portfolio diversifier compared to TTFS.
Two Better Than One
Recent punditry has extolled the virtues of FRN funds as fixed income portfolio diversifiers. Float reduction ETFs have been less visible among market observers and investors but are still advertised as risk management tools.
You’ve got to add heavy spoonfuls of these products, however, for optimum results. Yes, small doses boost overall returns, but they also crank up portfolio volatility. Still, there is a sweet spot, where returns justify the risk undertaken.
Let’s look at what a portfolio might look like if it were allowed to totally “float.” If you swapped out index funds in the classic 60/40 (equity/fixed income) model with float products, returns would have been boosted by a third over the past 18 months.
The total replacement of broad market exposure with float products, in this case TTFS and BKLN, would have increased returns with just a modest goose-up in overall volatility. The incremental gains, of course, are cyclical which is to say that market conditions favored both products over the sample period. Why? Because TTFS and BKLN are positively correlated, a synergy that magnified returns. A more traditional portfolio made up of the SPDR S&P Mid-Cap 400 (MDY)—the “best fit” market proxy for the medium capitalization-tilted TTFS—and the iShares AGG fund is more disparate. MDY and AGG are negatively correlated, a condition that may yield more portfolio risk diversification over the long term.
An investor taking the total replacement approach would have to be gutsy and perhaps a bit speculative. The portfolio isn’t a buy-and-forget proposition. Sooner or later, the recovery bloom’s bound to fade and interest rates will stabilize, all of which may chip away at the float products’ present advantage. For not-so-sanguine investors, giving over less portfolio real estate to float products may be more comfortable. But what’s the optimum allocation? What mix of float products produces the best risk-adjusted return?
If we use the Sharpe ratio as our yardstick and the past 18 months as our market environment, you’d need a substantial dollop of float products to get out to the fringe of the efficient frontier. A very substantial dollop.
True, allocating small amounts to TTFS and BKLN in a 60/40 portfolio has an ameliorative effect on returns, but the overarching step-up in volatility dampens Sharpe ratios. A 10 percent allocation to each, for example, produced a 14.5 percent annual return but only a 1.61 Sharpe ratio. Doubling the allocations to 20 percent yields an annual return of 15.4 percent together with a 1.74 Sharpe ratio. It’s only when the debt side of the portfolio (40 percent) is given over totally to BKLN and the TTFS apportionment cranked up to 30 percent or more that we see Sharpe ratios exceeding that full-float portfolio’s. As it turns out, that sweet spot is hit with a mix of 40 percent TTFS, 20 percent MDY and 40 percent BKLN.
Few investors or financial advisors may be interested in building portfolios of such limited scope, but the foregoing examples do illustrate the utility of float products. At least in the current environment. The biggest exogenous risk to a float portfolio is an economic downturn in which buyback cash dwindles and credit quality nosedives. At that point, float products would likely need to be swapped out of portfolio for more defensive issues.
At least, that’s what Mom would say if she were your advisor.