As a retiree, I am always searching for sources of high income but lately I have worried about rising interest rates. Floating rate loans Closed End Funds appeared to offer the best of both worlds, providing over 6% income plus a hedge against increased rates. In August 2013, I wrote an article on Seeking Alpha that analyzed the performance of this asset class and postulated that these CEFs might be good portfolio additions for risk-tolerant investors. It has been about 9 months since my previous article and during that time, interest rates have unexpectedly dropped and the yield curve has flattened. Thus I decided to revisit my analysis to see if my views on floating rate loans were still valid.
The characteristics of floating rate loans (also called senior loans) are not that well know so I will provide a quick tutorial. First off, these are loans made to below investment grade companies to support business purposes, such as expansion. The loans are typically large, with sizes in the $50 million to over a billion dollar range. They are called "senior" loans because they are backed by real assets and are the first to be paid when a company pays its debts.
The loans are also known as "floating rate" because the rate of interest is adjustable and moves higher or lower based on a benchmark, usually the London Interbank Offer Rate (Libor). The Libor is the rate banks pay one another to borrow funds and the rate depends on when the loan is due, either 30, 60, or 90 days. The interest rate paid by a floating rate loan is calculated as a "spread" over the Libor. The spread on the loan does not change but the Libor can change daily in response to market conditions. Floating rate loans have a "reset period" that determines how frequently the interest rates are synced with the Libor. The reset varies from loan to loan but a diversified portfolio of loans will typically have a reset period that averages about 60 days. Thus, the interest earned on floating rate loans is responsive to changes in short term interest rates.
Floating rate loans are different than high yield bonds. When interest rates go up, the price of a high yield bond go down but the amount of interest paid is always the same. The opposite happens to a floating rate loan. When interest rates change, the interest on this type of loan is adjusted but it seldom impacts the price of the loan. Also since these loans are secured by assets of the company, senior loans recover an average of about 70% of face value if the company files for bankruptcy. This is much better than the 44% average recovered by high yield bonds.
The bottom line is that floating rate loans have a number of characteristics that make then well suited if interest rates are expected to rise. However, the following are some observations investors should think about before investing.
- Floating rate loans are tied to short term rates, usually the 3 month Libor, which has barely moved over the past year. Today the Libor is 0.22% which is only slightly below the rate 0.27% a year ago. The Libor will likely not rise until the Fed begins to actively raise rates, not likely until 2015 or later.
- Even when rates begin to rise, floating rate loans may not immediately follow suit. The reason is that many floating rate loans have a floor, for example the rate may be stated as 2% above the Libor but with a floor of 3%. In this case, if the Libor increases from 0.22% to 1%, the 3% floor will still be in effect at and the interest paid of the floating rate note would not have changed.
- Because of the floor discussed above, short term treasury rates could rise faster than floating rates, which could depress the price of floating rate by providing lower risk alternatives.
- In recessionary environments, floating rate loans funds can lose significant value. For example, floating rate loans funds had a terrible year (along with most other assets) in 2008, with Net Asset Values (NAVs) falling on average by about 50%. (Note: The group rebounded strongly in 2009, gaining over 75 %.)
- In 2013, the NAV of floating rate CEFs remained relatively stable but the fear of tapering spooked the market, caused the prices to fall. This resulted in wiping out premiums and increasing discounts associated with these funds. Many of the funds that were selling at premiums in early 2013 are now selling at substantial discounts.
With these caveats in mind, let's look at the performance of floating rate loans. The easiest way to invest in floating rate loans is by either a closed end fund (NYSEMKT:CEF) or an exchange traded fund (ETF). Floating rate loans ETFs have a relatively short history (the first was launched in 2011) so I will focus primarily on CEFs. The website www.cefconnect.com lists 26 CEFs that invest primarily in senior loans. To reduce the number of funds to be analyzed, I selected candidates based on the following criteria:
- At least 6 years of history (since I wanted to include the bear market of 2008 in the analysis)
- Market Cap greater than $300 million
- The CEF sells at a discount
- Average trading volume greater than 50,000 shares per day.
- Distributions of at least 6%.
The following 10 funds satisfied all of these conditions:
Voya Prime Rate Trust (NYSE:PPR). This CEF sells for a discount of 6%, which is below the 52 week average premium of 1%. It has a distribution of 6.3%, none of which was from Return of Capital (NYSE:ROC). The fund has 393 holdings, virtually all in senior loans and from U.S. companies. PPR utilizes 31% leverage and has an expense ratio of 2.1%, including interest payments.
Invesco VK Dynamic Credit Opportunities (NYSE:VTA). This CEF sells for a discount of 7%, which is below the average discount of 5%. It has a distribution of 7%, none of which was ROC. The fund has 552 holdings, with 78% in floating rate loans. About 30% of the holdings are from non-U.S. companies. VTA utilizes 30% leverage and has expense ratio of 2.1%, including interest payments.
Invesco VK Senior Income (NYSE:VVR). This CEF sells for a discount of 5%, which is below the average discount of 1%. It has a distribution of 6.7%, with only a small amount (10%) coming from ROC. The fund has over 515 holdings, with 87% in floating rate loans. Almost all the securities are from U.S. companies. VTR utilizes 30% leverage and has an expense ratio of 2.2%, including interest payments.
Nuveen Credit Strategy Income (NYSE:JQC). This CEF sells for a discount of 9%, which is below the average discount of 5%. It has a distribution of 6.7%, none of which was from ROC. The fund has 487 holdings, with 72% in floating rate loans and 16% in high yield bonds. All securities are from U.S. based companies. JQC utilizes 29% leverage and has an expense ratio of 1.8%, including interest payments.
Nuveen Floating Rate Income Opportunities (NYSE:JRO). This CEF sells for a discount of 4%, which is below the average premium of 2%. It has a distribution of 6.3%, none of which was from ROC. The fund has 284 holdings, with 78% in floating rate loans and 14% in high yield bonds. All the securities are from U.S, based companies. JRO utilizes a high 44% leverage but has a relatively low expense ratio of 1.7%, including interest payments.
Nuveen Floating Rate Income (NYSE:JFR). This CEF sells for a discount of 8%, which is below the average premium of 4%. It has a distribution of 6.3%, none of which was ROC. The fund has about 300 holdings, with 78% in floating rate loans and 12% in high yield bonds. About 66% of the securities are from U.S. based companies with 24% being from the Cayman Islands. JFR utilizes a high 44% leverage and has an expense ratio of 1.7%, including interest payments.
Pioneer Floating Rate Trust (NYSE:PHD). This CEF sells for a discount of 5%, which is below the average discount of 1%. It has a distribution of 6.1%, none of which was from ROC. The fund has 364 holdings, with 87% in floating rate loans. All of the securities are from U.S. based companies. PHD utilizes 36% leverage and has a low expense ratio of 1.5%, including interest payments.
Eaton Vance Floating Rate (NYSE:EFR). This CEF sells at a 6% discount, which is low compared to an average premium of 5% over the past year. The distribution is 6.2%, none of which was from ROC. The fund holds 864 securities, with 89% in floating rate loans. All of the securities are from U.S. companies. EFR utilizes 37% leverage and has an expense ratio of 1.8% including interest payments.
First Trust Senior FR Income II (NYSE:FCT). This CEF sells at a discount of 7%, which is below the average discount of 2%. The distribution is 6.1%, with only a small portion (5%) being from ROC. The fund holds 286 securities with all invested in floating rate loans and all from U.S. companies. FCT utilizes 31% leverage and has an expense ratio of 1.9%.
BlackRock Floating Rate Income Trust (NYSE:BGT). This CEF sells at a discount of 7%, which is below the average discount of 3%. The distribution is 6.0%, with only a small portion (5%) being from ROC. The fund holds 478 securities, with 83% in floating rate loans and 14% in high yield bonds. All the holdings are from U.S. companies. BGT utilizes 30% leverage and has an expense ratio of 1.6%.
For comparison with bonds, I also included the following ETF in the analysis:
iShares iBoxx $ High Yield Corporate Bonds (NYSEARCA:HYG). This ETF tracks the performance of high yield corporate bonds. It yields 5.9%.
To analyze the risks and return of floating rate CEFs, I used the Smartfolio 3 program (www.smartfolio.com), using data over the past 6 years. The results are shown in Figure 1, which plots the rate of return in excess of the risk free rate of return (called Excess Mu on the charts) against the historical volatility.
Figure 1. Risk versus reward over past 6 years
As is evident from the figure, floating rate funds had a wide range of returns and a relatively narrow range of volatilities between 20% and 30%. JQC is the exception with both a very high return coupled with a very high volatility. Are the returns associated with floating rate funds commensurate with the risk? To answer this question, I calculated the Sharpe Ratio.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with HYG to facilitate comparing floating rate funds with high yield bonds. If an asset is above the line, it has a higher Sharpe Ratio than HYG. Conversely, if an asset is below the line, the reward-to-risk is worse than HYG.
Some interesting observations are apparent from Figure 1. Over the turbulent times between 2008 and today, floating rate loans were more volatile than high yield bonds. Generally, the returns from floating rate loans were as good as or higher than high yield bonds but when volatility was considered, the floating rate loans had poorer risk-adjusted returns. The only exception was JRO, which had a risk adjusted return equal to HYG. Among the floating rate CEFs, JRO had the best performance with JSR and NSL close behind. The worst performances were booked by FCT and VVR.
Floating rate loans have also been touted as providing portfolio diversification. To be "diversified," you would choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. To assess the diversification potential of floating rate loans, I calculated the pair-wise correlations associated with these funds. I also added the SPDR S&P 500 (SPY) ETF to assess the correlation of the funds with the S&P 500. The results are shown in Figure 2.
Figure 2. Correlation matrix over past 6 years
As shown in the figure, none of the assets were highly correlated with each other or with high yield bonds. . Most of the senior loan funds had correlations with each other in the 50% to 70% range. This range was also indicative of the correlations of floating rate CEFs with high yield bonds and with the overall stock market. So overall, floating rate loans funds did provide a good but not a great level of diversification.
I next looked at the past 2 year period to see if the performance had changed during the more placid years after 2008 and 2009. For completeness, I also added the following floating rate ETF that was launched in March, 2011.
PowerShares Senior Loan Portfolio (NYSEARCA:BKLN). This ETF tracks S&P/LSTA U.S. Leveraged Loan 100 Index, which is an index designed to mirror the market-weighted performance of the largest institutional leveraged loans. The portfolio consists of the 100 largest loans in the senior loan space. This fund has a yield of 4.2% and a very low expense ratio of 0.65%.
The results of the analysis are shown in Figure 3. As you might expect, the volatilities during the past 2 years were much smaller than those over the 6 year period. Most of the floating rate loans CEFs had relatively low volatilities in the 10% to 18% range, but this was still about double the volatility of high yield bonds. In contrast to the CEFs, BKLN had an exceedingly small volatility that was significantly less than that of high yield bonds. The return from BKLN was commensurately smaller so the risk-adjusted performance of the BKLN was the same as that of HYG.
Figure 3. Risk versus Reward over past 2 years
On an absolute return basis, the CEFs beat BKLN but the risk-adjusted performance of the CEFs was substantially worse than both BKLN and HYG. This implies that the potential increased return from the CEFs was not commensurate with the increased risk. Among the CEFs, VTA broke away from the pack and recorded the best risk-adjusted performance. JRO also turned in a good relative performance but the other leaders from the 6 year period did not fare as well in recent times. FCT continued to lag during this period but VVR redeemed itself and had relatively good performance.
In summary, floating rate CEFs are a unique asset class that provides investors with current income and diversification. However, over the last 6 years, these floating rate CEFs have not provided rewards commensurate with risk. In fact, high yield bonds have outperformed floating rate loans on a risk-adjusted basis. The new kid on the block, the floating rate ETF, has also outperformed CEFs over the past two years. Thus, caution is advised if you are considering investing in these CEFs.
On the plus side, floating rate CEFs have experienced a sell off over the last year and discounts have expanded. If you believe this is a buying opportunity, I would recommend looking at JRO. But make no mistake, these are highly volatile assets and if you decide to add them to your portfolio, they will need to be managed carefully.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.