5 Leveraged Loan CEFs To Watch

Vulture investors in fixed income securities are mainly hedge funds and other institutional investors. However, there will soon be some good opportunities for retail investors in leverage loan closed end funds.

Leveraged loans are unregistered loans made by banks to lower rated non-investment grade corporate borrowers. These are typically longer term loans with floating rates spread above LIBOR. In some ways, they are similar to high yield bonds, and some non-investment grade corporate borrowers use both leveraged loans and high yield bonds. But there are some important differences:

• Leveraged loans are more senior in the capital structure and are secured. They are structured to include a lien against assets which can be sold off or operated for cash. High yield bonds are senior unsecured and are behind loans in the pecking order when there is a default.

• Leveraged loans are floating rate, high yield bonds are fixed rate.

• Effective duration of leveraged loans is shorter. Much less interest rate risk.

• Leveraged loans have strong covenants which are minimal for high yield bonds.

• Default recovery rates for leveraged loans are about 80% versus 30-40% for high yield bonds.

In spite of many advantages, leveraged loans have recently dropped significantly in price because of the credit liquidity crunch- not because of any problems with the underlying securities. Open end mutual funds that invest in leveraged loans have experienced 18 straight weeks of fund redemptions which means forced selling.

To make things worse, several hedge funds have recently been forced to unwind total return swaps [TRS] financing programs. TRS lines are used by hedge funds and market value CLO obligations to borrow from banks to buy debt instruments such as leveraged loans in the open market. Market value CLOs (unlike cash flow CLOs) must mark to market their underlying loan assets at the end of each day. As the price of leveraged loans has fallen, investors using TRS financing face repayment similar to a margin call. Some irresponsible hedge funds and CLOs have used leverage of 400% up to as high as 1000%.

Once the market stabilizes, a good way for retail investors to buy leveraged loans is to use closed end funds selling at a discount to NAV. That way you get a discount on assets that are already heavily discounted by forced selling. A few closed end funds in this space to look at are: Pioneer Floating Rate Trust (PHD), Nuveen Floating Rate Income Fund (JFR), Eaton Vance Senior Floating-Rate Trust (EFR), Eaton Vance Floating-Rate Income Trust (EFT), Nuveen Floating Rate Income Opportunity Fund (JRO).

Full Disclosure: I do not currently own any of the above funds, but have placed them on a watch list for potential future purchases.

Comments

[alfonsox:]

See also WSJ Feb 16/17 weekend issue, Green Thumb column first page of second section.

2008 Feb 17 10:30 AM

[User 142005:]

You are correct that this asset class has been crunched, it is also true that these CEF's have had great damage done to them. But do not forget that these portfolios currently hold many LL's that were issued 12-24 months ago when the spreads were skinny (unlike today) and because these are Floating rate the return falls as Gentle Ben lowers rates and keeps them there.

2008 Feb 17 12:04 PM

[mavericks:]

Author neglects to mention the other reason why floaters are falling so much...LIBOR has been falling like a rock recently...from 5.4% to 2.8% in just 6-months, with much of it very recently!! Has forced many floaters to cut dividends and will probably see continued cuts for awhile even if LIBOR has about bottomed.

2008 Feb 17 05:41 PM

[granger:]

Thanks for the ideas. I have been a holder of EFR and have slowly added in small increments (about every 7-10%). All of my dividends are being reinvested. I plan to make one large purchase and round out my position once they have stabilized. I likebuyign bewlo NAV. Note: I will be a long term holder of EFR.

2008 Feb 18 07:31 AM

[Pablo:]

I have been buying EFT as it bounced along the bottom. Now look at it. Sweet ride, plus it went X on 2/20/08. I'll take and will buy more!!!!

2008 Feb 25 03:38 PM

[Investor Man:]

This is commentary on Bank Loan Funds and Senior Bank Loan Funds - Loans issued to companies…
Senior Loans are the second most common form of financing for mid-sized public companies and for leveraged buyouts. Senior Term Debt is typically lent against the collateral value of property, plant and equipment. Senior Term Debt comes in many varieties and there are many sources of this type of financing.
Typically 50% to 70% of a firm's capital structure is comprised of senior debt. A senior loan is collateralized by a first lien on the current and long term assets of the company. Senior financing is generally made available from banks and finance companies, although privately-placed notes to institutional investors are also possible, or a public issue of bonds is occasionally the source.
Senior Term Debt typically amortizes over 4 to 7 years. These payments are generally monthly or quarterly. However, the amortization schedule can be more erratic and may be structured to conform to the company's projected cash flows. For example, amortization payments may gradually increase over time in consideration of a company's expected growth. Some lenders are willing to forego amortization payments for a number of years and allow the loan to be repaid in one or a few large payments. Typically, the longer the time to repayment, the higher the interest rate will be.
Interest rates on Senior Debt range from one-quarter percent under prime to five percent over prime, depending on the perceived risk of the company's cash flow and the quality and quantity of collateral. Interest rates may be fixed or floating. Sometimes a lender will tie the interest rate to a schedule, such that if the company becomes less leveraged, the interest rate decreases because the company's risk has also decreased.
Financial Institutions started to create instruments called Collatorized Loan Obligations or CLO's in an effort to provide a cheap and attractive way of mitigating and dispersing risk. A CLO is a special purpose vehicle (SPV) with securitization payments in the form of different tranches. Financial institutions back this security with receivables from loans, very similar to how a CMO works, except for the assets securing the obligation. CLOs allowed banks to reduce regulatory capital requirements by selling large portions of their commercial loan portfolios to international markets, reducing risks associated with lending.

Hedge funds, seeking to put on an interest rate arbitrage investment, used their investor’s assets AND borrowed funds from via their prime brokerage dealers or other lending instutions, to buy senior loans. This arbitrage portfolio may be leveraged as much as 300-400% of equity. As the credit tightened these lending institutions were no longer lending money to these hedge funds, and hedge funds are being forced to liquidate their loans.

In the past couple of months some of these SPV are being Unwound and causing severe market disruptions due to the flood of assets and lack of buyers, this is resulting in senior secured loans trading at deep discounts.

This Market for Bank Loans is typically a relatively liquid market normally, but with the unwinding of structured investments and the lack of investors/institutions... funds looking for these assets, meaning no NEW money coming into purchase these investments, these assets have been greatly depressed over the last two weeks.

The fundamental credit quality or balance sheet of the underlying company is not affected by the price of the loan traded on the secondary market. However, as the company in required to reissue this debt upon maturity, they will have to pay higher interst rates. These higher rates with then affect earnings. An alternative to paying higher interest on their debt, the company can raise addition equity, diluting shareholder ownership.

I believe that smart money (hedge funds etc) will be putting money into these assets with the potential for equity like returns

Take a look at the fidelity fund with the symbol FFRAX, finance.yahoo.com/char...;range=5y
This fidelity fund is a NON Leveraged Fund - I only show for an example -

There are many Closed End Funds that trade with these assets in them, these are funds that trade as stocks, that don't issue new shares. They can trade at a discount or premium to there value. These funds in most cases use Leverage to enhance the yield, so if they raise 500 million, they will also borrow 150 million.


These Closed end and Open End will be providing Equity like returns when stability comes back into the market, they have been painful to own, as a fixed income investment, but we will be overweighting them as an equity holding in the coming months.

2008 Feb 25 09:25 PM

[Pay me monthly:]

After being cut by half, now it's time to buy

2008 Dec 31 10:39 AM