Loan-Based Closed-End Funds: Current Income And Inflation Protection

Includes: EFT, FRA, PHD
by: Rubicon Associates

As many may know, I have been writing a series on preferred stock closed-end funds. As the objective is high and sustainable current income (as well as prospective income) many responders leaving comments have asked what will happen in a period of rising rates (an inflationary environment) - which is a matter of when, not if.

In response to these concerns, I have looked into senior loan-based closed-end funds as these funds have a high current income that should be sustainable and are floating rate based. The floating rate feature of loans provides some protection from increasing rates. Below are my three top picks for loan-based CEFs.

Let me first address the concern many have with high-yield investments. Unlike high-yield (non-investment grade) bonds, loans are typically secured by mission critical assets of an issuing entity, which provides for higher recovery rates in the event of bankruptcy. This can be seen in the following chart from Moodys 2011 Annual Default Study:

(Click chart to expand)

As you can see, the average recovery rate on loans is significantly higher than on either senior secured bonds or senior unsecured bonds. This margin of safety accrues to the benefit of the fund investor.

The following funds are my top three choices for loan-based CEFs:

  • Pioneer Floating Rate Trust (NYSE:PHD),
  • BlackRock Floating Rate Income Strategies Fund Inc (NYSE:FRA), and
  • Eaton Vance Floating-Rate Income Trust (NYSE:EFT).

A brief snapshot of the funds is as follows:

Returns for the funds is as follows:

I have focused on the NAV return based on a suggestion from a reader who astutely pointed out that the NAV returns are the returns that are controlled by the manager.

Fund Descriptions and Characteristics

Pioneer Floating Rate Trust :

Objective: The Fund seeks high current income with capital preservation through investment in senior floating rate loans, emerging market issuers and hedging transactions.

The following are portfolio characteristics:

Source CEFConnect

Source: PHD fund filings

Source: PHD fund filings

Bottom line: The fund's holdings are in the sweet spot in terms of ratings (BB/B) and do not hold an inordinate amount of CCC rated loans. The portfolio is sufficiently diversified so as to mitigate any issuer losses without significantly diminishing the fund's returns.

BlackRock Floating Rate Income Strategies Fund Inc. :

The Fund seeks high current income and preservation of capital by investing at least 80% of its net assets in a leveraged portfolio of floating-rate debt securities and instruments.

The following are portfolio characteristics:

Source: FRA Fund reports.

The turnover (as per CEFConnect) was 91% as of 8/31/2011. I view this as kind of high.

Source: FRA Fund reports

Source: FRA Fund reports

Bottom line: 20 percent of the fund's holdings are outside the bank loan market, which alters the risk profile of the fund. As well, the fund has higher exposure to B rated debt, rather than the more balanced BB/B.

Eaton Vance Floating-Rate Income Trust :

The Fund seeks to provide a high level of current income. As a secondary objective, it will also seek preservation of capital to the extent consistent with its primary goal of high current income.

Source: EFT fund filing

Turnover (via CEFConnect 5/11) was 50%.

Source: EFT fund filing

Bottom line: 10 percent of the fund's holdings are outside the bank loan market, which isn't too outsized. Credit quality being weighted to BB, but generally split between BB/B.

Conclusion: Of the three closed-end funds, my top pick is the Eaton Vance Floating Rate Income Trust. The reasons for this selection are as follows:

  1. the weighting of the fund is pretty well split between BB/B which is a sweet spot in the market right now and has credit cushion should there be downgrades,
  2. The expense ratio is the lowest of the three, which comes in handy should the market turn lower.
  3. the fund has performed well over time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.