Floating rate securities, like the Nuveen Floating Rate Income (NYSE:JFR) fund, have served as a bond alternative in my portfolio. The funds typically invest in debt that have an adjustable rate feature, where the interest rate is based on a margin over LIBOR (typically a floor of 1.0%). By avoiding company or industry concentration, the funds are able to provide a high-rate, lower-risk return for investors. The securities currently yield +/- 7% in monthly, cash distributions (taxable as interest not dividends). JFR and its ilk are "Closed End funds" ((CEFs)), which can trade at a premium or discount to the underlying assets. Over the past year, JFR provided a total return of more than 20% as discounts to net asset value narrowed and monthly interest payments were made.
As shown below, investors are increasingly investing in the asset class, especially post-election when the prospect of higher LIBOR (see LIBOR Floor discussion below) made the returns increasingly attractive.
The underlying investments of floating rate bond funds are senior bank loans. The interest rates for the majority of the loans are variable and increase as interest rates rise above a floor. The adjustable feature makes these funds attractive in a rising rate environment and provide protection against inflation. The adjustable feature is derived from a contractual margin over a LIBOR floor (e.g. interest rate equals 30 day LIBOR plus 700 basis points).
A Bit About the LIBOR Floor
The LIBOR floor is most typically (but not always) 1.0%. As of this writing, 90 day LIBOR is 1.0% (bankrate.com) meaning if LIBOR rises, the adjustment feature will be triggered and affected loans will adjust payments upward by the difference between 30 day LIBOR and 1.0% (e.g. if LIBOR is 1.1% and the margin is 700 basis points, the paid rate will increase from an annualized 8.0% to 8.1%). The adjustment occurs monthly, so most loans will have their rate reset on January 1. In August, Andrew Park, writing in Forbes, noted that the average floor of floating rate bank loans was 0.985%; a unit of S&P Global Market Intelligence (lcdcomps.com) further noted 19% had a LIBOR floor of 0.75%. The 3-month LIBOR is the most typically utilized reference rate.
Every fund is different, but generally, +/- 85%-90% of the investments are loans with B, BB or BBB credit quality. JFR's portfolio mix is shown below.
Selected Floating-Rate Senior Bank Loan Funds
There are a variety of instruments providing a similar product. As I mentioned, my preferred fund is JFR (4-star rated by Morningstar). JFR is large enough ($1 billion in NAV) that in the event of rapidly changing markets, liquidation (or a large buy) should not be a problem (create a material discount to NAV); smaller funds could suffer swings in price-to-NAV in the face of material buys or sells. Other highly rated funds (Morningstar 4 or 5 star) include: BlackRock Floating Rate (NYSE:FRA), Invesco Dynamic Credit Opportunities (NYSE:VTA), Nuveen Floating Rate Income Opportunities (NYSE:JRO) and Nuveen Senior Income (NYSE:NSL). Interestingly, JRO and JFR have an almost identical portfolio but sometimes have price differentials of as much as 3% (based on discounts and premiums to NAV).
While there are mutual fund versions of many of these funds, I prefer to invest in the closed end fund versions. My preference is based on the ability to sell during the day as well as the ability to purchase the funds at a discount to net asset value (NYSE:NAV). During much of 2013, these funds carried a premium to NAV; as investors started to become concerned with rising interest rates, the premium turned to a discount. Most recently, many funds have appreciated and have minimal discounts or a slight premium.
Risk and Diversification
Risk is further mitigated through company and industry diversification, with the top ten holdings of a fund typically representing less than 20% of the funds' investable assets. Similarly, industry diversification is also maintained, with no one industry type receiving more than 20% of a fund's investable assets.
The below tables represents the top ten holdings and industry diversification of my favorite floating rate bank loan fund, JFR (Nuveen Floating Rate Income Fund) as of November 30, 2016.
Top Ten Holdings of JFR (Source: Nuveen)
Holdings by Industry of JFR (Source: Nuveen)
Investment returns are commonly enhanced by leverage, typically between 35%-40%. In the case of JFR, leverage was 38% at November 30, 2016 (Source: Nuveen).
Because of the unique nature of bank loans, there really needs to be an element of human involvement in assessing the underlying securities. Therefore, these funds typically carry hefty management fees and expenses. Paying professional management is contrary to my investing style, but given the need to assess and monitor, I make an exception in the case of floating-rate senior bank loans. As an example, JFR fees are currently running at an annualized 1.6% (on total invested including leverage, 2.5% on equity).
A Discussion of Macro Risk
Nothing in life is without risk. The underlying assets of floating-rate senior bank loans, while offering first lien position in investment grade securities, do default on occasion. According to a study by Moody's Investors Service, the average annual default rate on senior floating-rate loans has historically (including the recent recession) been 3.4% (1996-2012). The same analysis highlights a 71.1% recovery rate on these same loans over the same period. Ignoring the time to recovery, the data suggest that an annual loss rate of 1.0% is to be expected (3.4% x 28.9% non-recovered) in an average year. Logically, the loss rate would tend to be less in times of economic expansion and greater in times of economic contraction or recession.
A Discussion of Micro Risk
JFR's energy holdings represent less than 4% (in dollars) of current holdings (as of Nuveen data analyzed December 21). Any declines in these bonds are already reflected in net asset value. Further, about 90% of JFR's holdings trade for 90 or more, which given bid-ask spreads, and increases in interest rates, mean the vast majority of JFR's bonds are doing fine and trading for par (even after price drops due to rate concerns). Foreign holdings represent about 10% of total investments; however, these bonds tend to be denominated in, and pay interest in, dollars.
Potential Performance in Today's Stable-to-Rising Rate Environment
In addition to a monthly payment, which currently is an annualized 7%, there is the prospect of distribution increases. In recent months, distributions have ticked up, increasing to $0.0675/month in December 2016 from $0.06/month in January 2016.
Floating-rate securities offer an opportunity to capture premium income with modest risk compared to bonds and (on a risk adjusted basis) cash or CDs. Today's stable-to-rising rate environment bodes well for these funds as their variable rate feature offers rate protection that is absent from bonds. Historically low net loss rates on the underlying loans combined with diversification mean minimal asset risk for the investor.
Disclosure: I am/we are long JFR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.