Inflation Protection: 3 Funds for Bond Portfolio Diversification

Includes: BHL, FRB, PPR
by: Old Trader

I recently wrote that TIPS may not be all that they're cracked up to be, in terms of offering bondholders a safe haven from inflation (click here for article). As inflation rises, bonds decline in value by way of compensating for below current market rates, leading to loss of capital for holders (unless they're holding individual bonds, and plan on andare capable of holding to maturity).

The fixed income (bond) investors have 2 other options open to them. The first is to stay with short duration bond funds. Typically, the short end of the yield curve suffers notably less than the long end of the curve, as short term bonds mature and the proceeds are rolled over into new ones paying higher interest.

The other option is to invest in "floating rate" bonds (aka "floaters"). Bonds of this type can be considered as being similar to adjustable rate mortgages (ARMs), in that the interest paid on the bonds is tied to a metric such as the London Interbank Overnight Rate (LIBOR) or in some cases, Treasuries, plus a fixed percentage over that rate. The rate paid is adjusted periodically. It should be noted that, just as with ARMs, the rate paid can go down as well as up. However, for bond investors concerned with being protected against the damage done to their positions by climbing interest rates floaters are another way of at least minimizing the damage.

For smaller investors that have portfolios too small to maintain a sufficiently diversified assortment of individual bonds, there's a number of ETF/CEFs available to pick from.

Three of these are:

ING Prime Rate Trust (NYSE:PPR) manages a portfolio of USD denominated floating rate secured senior loans. Current distribution rate is 4.98%, payable monthly. PPR is presently trading at a slight premium to NAV (+1.86%). Over the last 52 weeks it has traded at a premium as high as 4.54%, and at a discount as low as -6.52%. It does employ some leverage (26.40%), but not an inordinate amount.

BlackRock Defined Opportunity Credit Trust (NYSE:BHL) is also primarily a holder of senior debt, but adds some high yield corporate debt to the mix as well as a smattering of asset backed bonds. Current distribution rate is 5.62% also payable monthly. BHL is trading at a very slight discount to NAV (-0.14%). The 52 week range goes from a discount as low as -5.84% to a premium as high as +8.08%. It too, employs some leverage (21.08%).

BlackRock Float Rate Strategy II (NYSE:FRB) is the newest of the 3, having debuted in Sept. of 2006. The portfolio is comprised of non-investment grade senior floating rate securities. While the portfolio is fairly similar to that of BHL a somewhat higher percentage is held in high yield debt (13.7%, as opposed to 9.7% in the case of BHL). FRB's current distribution rate is the highest of the 3 at 6.34% payable monthly. It is also trading at a discount to NAV (-0.36%), with a 52 week range going from as low as -3..30% to as high as a premium of of +9.86%. Very possibly because of a somewhat lower credit quality, the amount of leverage employed by FRB is also the lowest at 19.91%.

In terms of "safety", I'd rank these in the same order as they appear here. It should always be kept in mind that invariably, higher yield is the handmaiden of higher risk.


Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PPR over the next 72 hours.

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