FRA: Floating Rate Fund Worth Taking A Look At
Summary
- Debt investments with floating rates, typically funds that focus on senior loan investments, should do well when rates rise.
- We know that the next logical step for interest rates is for the Fed to increase rates, this should happen over the next couple of years.
- FRA is at an attractive discount and should benefit from increased rates as it will be among the first to start earning a higher income.
- This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »
Written by Nick Ackerman, co-produced by Stanford Chemist
BlackRock Floating Rate Income Strategies (NYSE:FRA) is a pretty straightforward fund. As its name suggests, it targets debt investments that have floating rates. Therefore, when the Fed does decide to start increasing rates as the economy expands over the next couple of years, FRA should be a beneficiary. This will happen faster for floating rate funds such as FRA because many of the underlying holdings are based on LIBOR plus a spread.
FRA's investment objective is "to provide shareholders with high current income and such preservation of capital as is consistent with investments in a diversified, leveraged portfolio consisting of floating-rate debt securities and instruments." The leverage utilization here will increase the fund's volatility, relatively speaking.
To achieve this investment objective; "at least 80% of its assets in floating rate debt securities, including floating or variable rate debt securities that pay interest at rates that adjust whenever a specified interest rate changes and/or which reset on predetermined dates." As is typical with these sorts of funds - the portfolio "invests a substantial portion of its investments in floating rate debt securities consisting of secured or unsecured senior floating rate loans that are rated below investment grade."
Typically, senior loans are issued to those types of companies with lower credit qualities. That being said, as senior loans, they are first in line to receive repayment in the event of a bankruptcy. That is, before all the other investors; common, preferred and bonds - if there are any.
The fund is a fair size at nearly $700 million in total managed assets. The percentage of leverage comes out to 29.11%. Which itself is tied to LIBOR too. At the end of 2020, they reported a daily weight average interest rate of 1.30% for FRA. That means that increased interest rates will put some pressure on their leverage expenses. Though overall it should be a net positive.
The expense ratio for this fund comes to 1.13%. With total expense, when including leverage, comes to 1.72%.
(Source)
Performance - Similar Returns To Peers
Over the longer term, FRA has come in only slightly behind some of its peers. BlackRock Floating Rate Income (BGT) over a ten-year period slightly outperforms the fund on a total return NAV basis. Additionally, Eaton Vance Floating-Rate Income (EFT) also outperforms the fund a bit over 10 years.
Of course, past performance is not indicative of future results. On the shorter term basis of YTD, we see once again FRA struggling a bit against peers on a NAV basis. On a share price basis, it has outperformed, interestingly enough.
That being said, if we look at the fund's valuation. FRA comes to a 4.85% discount, with BGT coming in at 5.37%. For EFT, however, we see a much different scenario. As the fund had to entice investors to approve the new advisory agreement, they launched a tender offer contingent upon approval. With that, EFT will look to repurchase up to 50% of the outstanding shares. That has pushed EFT's discount to a very narrow 1.44%.
Therefore, I suspect that FRA or BGT would be a much better option going forward.
Distribution - 6.04% Paid Monthly
The fund currently pays 6.04%, on a NAV basis, this works out to 5.71%. This was trimmed entering into 2021 as a result of lowered interest rates in 2020. Though prior to that, they had been increasing the distribution too as rates were rising the previous years. At this time, the Fed isn't anticipating interest rate hikes until 2023. With that being the case, we don't have to make any mad dashes to floating rates just yet. Though it is something to monitor now so we are prepared.
(Source - CEFConnect)
In terms of coverage, throughout 2020 net investment income [NII] was light for FRA. This is exactly why a cut would have needed to be implemented in the first place.
(Source - Annual Report)
With 35,335,136 shares outstanding and a new annualized distribution rate of $0.8004 - we should anticipate around $28.282 million being paid out. That is still shy of what the fund was able to produce last year.
This is consistent with BlackRock's latest UNII report that they published for the funds as well.
(Source - May 31st UNII Report)
Unfortunately - or fortunately - depending on how you want to look at it, this has been a struggle for all fixed-income funds. The unfortunate part is that most of their coverages remain weak. The fortunate part for FRA specifically, this isn't inconsistent with its peers.
Though coverage remains weak across the board, until rates rise, most funds will continue to struggle. That is until they finally cut the distributions down to a sustainable level. For now, most seem content with participating in some upside to continue to fund their distributions. Over the longer term, capital appreciation in debt portfolios will probably be less reliable. That is why we typically want to see NII distribution coverage at over 100%.
For the tax character of the distributions - we would typically see the bulk attributed to as ordinary income. Though last year we saw some return of capital [ROC]. This ROC was the result of realized losses on the portfolio and a shortfall in NII.
(Source - Annual Report)
Holdings - Mostly B Rated Issues
One area that we hone in on for debt funds at this time is the effective duration. Since this is a floating rate fund, the duration of the portfolio is extremely low at just 0.41 years. This is because the fund will benefit from increased rates for the most part - not get negatively impacted as it would with a fixed-rate portfolio.
As we noted above, senior loans are typically issued by junk-rated companies. For FRA, a majority of their portfolio is in B-rated debt. It is almost the same exact allocation for BGT, too.
(Source - Fund Website)
Maturity typically has the greatest impact on a fund's duration. However, in the case of floating rate since the interest rate impact is minimal, maturities don't matter as much. Still, we can see that the overwhelming majority is 7 years or less. This is quite consistent with junk-rated debt that carries lower maturities. The longer the maturities for below-investment-grade companies, the more that can go wrong and the potential that investors wouldn't get their money back.
(Source - Fund Website)
Finally, we can take a look at the fund's top ten issuers. Most of these names I wouldn't know of offhand. Which can present an opportunity to gain exposure where you wouldn't otherwise have if you are looking for more diversification.
Though it should be noted that FRA can be quite active at times. Turnover for the last 5 years has averaged 57.4%. This means a meaningful portion of their assets can be bought and sold over the course of 12 months.
(Source - Fund Website)
Amongst the top ten, all are private or issuers that don't have common shares trading on exchanges. That gives us fewer insights and transparency into the holdings. Zayo Group Holdings was bought out earlier in 2020. RealPage was taken out at the end of 2020.
That leaves us with more of a reliance on the team at BlackRock that manages FRA to make the right calls. Though we can peak into some maturity and last reported interest rates in their last Annual Report. For example, we can see that Zayo Group Holdings is in two different positions. One maturing in 2027 and another in 2028. The interest rates reported were 4 and 6.13%. We can also see that it is classified as a "diversified telecommunication service."
(Source - Annual Report)
From there, we can take a look at Sophia LP. There we see a bit more detail as it is one of their floating rate positions.
(Source - Annual Report)
However, UKG Inc. didn't appear to be a position at the time. So we don't have even that limited information to go on in their report for the terms of the holding.
Conclusion
At some point, the Fed should begin raising rates. Today we took a look at FRA as one potential way to play the rate increases when it happens. We have several years before rates should actually increase. However, it doesn't hurt taking a look now and potentially finding something worth holding on to until then. Of course, we will likely see discounts gradually disappear on these funds as well in anticipation. Which is another reason enough to start monitoring floating rate funds for potential opportunities.
For FRA, it offers an attractive discount that is similar to its BGT peer. The yield for both of these funds is exactly the same at this time as well. That being said, FRA also over the long and short term slightly underperformed. Probably not enough to write the fund off completely, but something to consider.
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This article was written by
Nick Ackerman is a former financial advisor using his experience to provide coverage on closed-end funds and exchange-traded funds. Nick has previously held Series 7 and Series 66 licenses and has been investing personally for over 14 years.
He contributes to the investing group CEF/ETF Income Laboratory along with leader Stanford Chemist, and Juan de la Hoz and Dividend Seeker. They help members benefit from income and arbitrage strategies in CEFs and ETFs by providing expert-level research. The service includes: managed portfolios targeting safe 8%+ yields, actionable income and arbitrage recommendations, in-depth analysis of CEFs and ETFs, and a friendly community of over a thousand members looking for the best income ideas. These are geared towards both active and passive investors. The vast majority of their holdings are also monthly-payers, which is great for faster compounding as well as smoothing income streams. Learn More.
Analyst’s Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
This article was originally published to the members of the CEF/ETF Income Laboratory July 1st, 2021.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (33)
I am up 12.88% on FRA (1/4 POSITION purchased mostly 09/28/2020 & later)
I am up 6.88% on BGT (FULL POSITION purchased 2019 or earlier).
Probably I don't need to hold both, but I do.
Steady variable income but not as much growth as some other CEFs I own.
I'll keep them for income and diversification.