JFR - Leveraged Loan CEF, 6.9% Yield

Summary

• Closed-end fund that invests in the leveraged loan asset class.
• The fund has a 0.40 Sharpe ratio and 10.46 standard deviation vs 0.56 Sharpe and 3.31 standard deviation for the Bloomberg US Aggregate Bond Index.
• The fund has a very low duration of 0.21, which makes it fairly immune to a rising interest rate environment.

anyaberkut/iStock via Getty Images

Thesis

Nuveen Floating Rate Income Fund (NYSE:JFR) is a closed-end fund that invests in the leveraged loan asset class. From a fundamental perspective, the leveraged loan market has been improving steadily, with issuer leverage ratios coming down and interest coverage improving. It is JRO's sister fund, with very similar metrics, albeit much smaller AUM ($0.9 bil vs $6.5 bil for JRO). The fund has a 0.40 Sharpe ratio and 10.46 standard deviation vs 0.56 Sharpe and 3.31 standard deviation for the Bloomberg US Aggregate Bond Index. It employs 36% leverage which is on the high side but appropriate for the asset class to generate a 6.9% yield. From a credit and market risks perspective, the fund is well set up, with a very low duration and overweight B/BB credit positioning. Please find the full credit profile analysis in the "Portfolio Composition - Credit Risk" section below. While overall quite robust timing is important for JFR, unless you have a 3 years+ investment window. When looking at past performance for a similar historic period (Fed taper, rising interest rates), we noticed that from Jan 2013 to Dec 2014, the fund had a zero total return (i.e. after dividends were factored in). If you have the fund already, we rate it as a "Hold", while new investors should only look to buy a dip given the past performance during rising interest rates. We establish a "Buy Under" target of $9.62/share.

CEF Metrics

This section details some CEF metrics and overall fund analytics:

Leverage Ratio: 36%

• On the high side for the CEF space.

Expense Ratio: 1.42%

• On the low side.
• Shows ability to fund cheaply.

Manager: Nuveen

• Premier asset manager with a solid track record.

Yield: 6.9%

• Average for the asset class.

Discount/Z-Spread: -4.19%/1.25

• The fund is trading at a discount.
• The discount is not large enough based on historical statistics.

Libor vs SOFR

One less known aspect for retail investors in respect to leveraged loans is the tentative transition away from Libor and into SOFR. Libor (London Interbank Offer Rate) is a rate that was tainted by manipulation and fixing that came to light post the great financial crisis of 2008-2009. The regulators set about to create more transparent floating rates, hence the genesis of SOFR (Secured Overnight Financing Rate). The leveraged loan market has been extremely slow in terms of transitioning from Libor into SOFR and the reason for that is a lack of term structure for SOFR. The main differences between the two rates are as follows:Source: pensford.com

One very important aspect to keep in mind as an investor into the leveraged loan market is that SOFR is usually lower than Libor, because it is a secured rate. Below you will find a graph from Reuters outlining the difference between the 2 rates during 2019:

Source: Reuters

For an investor into the leveraged loan market, SOFR means a lower rate paid to you, hence a lower yield. This market transformation will eventually happen and ultimately will result in overall lower all-in yields for BKLN.

Portfolio Composition - Credit Risk

The fund has an average credit distribution, with most underlying credit names falling into the BB and B buckets:

Source: Nuveen

The fund invests mostly in senior loans, which is a positive. Some leveraged loan funds have larger than normal buckets for high-yield bonds, which makes them more volatile and a higher risk from a credit perspective:

Source: Nuveen

From an industry perspective, the fund seems fairly well diversified, with no industry bucket representing more than 15% of the fund:

Source: Nuveen

From a macro credit risk perspective, we are still on a benign credit environment for leveraged loans, with the forecasted default rate to remain very low by historical standards:

Source: KDPAM

The fund, therefore, has an average credit risk composition with nothing in its portfolio standing out as credit negative.

Portfolio Composition - Market Risk

In this section, I will discuss in more detail the aspects of the JFR portfolio that relate to market risk - i.e. fluctuations in risk-free rates and credit spreads that can cause upward or downward pressure on the JFR portfolio NAV.

Given the floating nature of the underlying leveraged loans, the fund has a very low duration of 0.21. This means that the price of the loans and the NAV of JFR will be only slightly affected negatively by a rise in interest rates as the Fed starts tapering asset purchases and starts raising interest rates.

Source: Nuveen

The main risk in this fund is the credit spread risk. As we can see from the below graph, underlying leveraged loans credit spreads are at historical lows:

Source: KDPAM

As we have seen in prior risk-off instances, as the market sells off, credit spreads widen and we see a drawdown in JFR. Given we are starting from a very low base here (historically tight spreads), one can argue there is more downside than upside.

Returns

Given Fed taper discussions and imminent higher rates, let us have a look at how the fund performed during a similar period of Fed balance sheet taper and rising interest rates, namely 2013-2014:

Source: Seeking Alpha

From Jan 2013 to December 2014, the fund was flat on a total return basis, meaning after dividends, the total return to an investor was zero. Although the fund has a quasi-zero duration, meaning it should not be influenced by rising rates, the fixed spread on the underlying loans does get affected by prevailing risk-free interest rates. From that perspective, history tells us that the fund will tread water during the next 1-2 years if it mirrors its past performance.

Conclusion

Coming from a premier asset manager, JFR offers investors exposure to the leveraged loan asset class. The fund has a very well-balanced credit exposure profile. From a market risk perspective, the fund has a very short duration given the floating rate nature of the collateral, but be mindful of credit spreads being at historic lows for this asset class. The one aspect to keep in mind given the Fed taper is that the fund posted a zero total return from January 2013 to December 2014, a similar period with Fed tapering and rising rates. If you own the fund already, we rate it as a "Hold", while new investors should only look to buy a dip given the past performance during a similar environment. We establish a "Buy Under" target of $9.62/share.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Comments

[mmarek evans]

good article sold 25% of JFR long position as discount to nav nears multiyear low of -1%..the jfr/nav leveraged pair has seen jfr outperform since march 2020 ...on 1year horizon it tested trendline support and 3 sigma cheap in late december and is now near fair value
1/13 sold additional 25% at approximately same discount