Floating Rate Bond Funds: 7% Income And Appreciation Potential
Summary Floating Rate CEFs like JFR are currently yielding 7% with huge 13% discounts to net asset value. Exposure to energy is only 3% (and net asset value reflects current prices). Prices fell as investors pulled funds in anticipation of Fed rate hike, leaving little downside and potential upside as any increases are likely to be moderate and investors flee equities. Floating rate securities, like the Nuveen Floating Rate Income Fund (NYSE: JFR ) fund have served as a bond alternative in my portfolio. The fund typically invests in debt that has an adjustable feature, where the interest rate is based on a margin over LIBOR. These securities have yielded 6%-7% over the past year and can provide strong returns. JFR and its ilk are ‘Closed End funds’, which can trade at a premium or discount to the underlying assets. In recent months, discounts have widened, which may signal an opportunity. The underlying investments of funds like JFR are bond-like products that provide the benefits of (relatively) high yielding senior, secured bonds with protection against rising interest rates and inflation. As mentioned above, the protection is derived from a margin over a LIBOR floor (e.g. 30 day LIBOR plus 700 basis points). Every fund is different, but generally, +/- 90% of the investments are loans with B, BB or BBB credit quality. Source: Nuveen If you are intrigued by closed end floating rate funds, there are to choose from. The four highlighted funds, all with Morningstar rankings of 4 stars or better are certainly worth closer inspection. Source: Morningstar (M* is Morningstar) While there has been a modest amount of decline in asset values (bond prices decline as interest rates rise and interest rates have been rising in anticipation of the Fed increasing interest rates), the values of the funds have fallen much more than the underlying change in asset values. The increased drop is reflected in the current discount (in the above chart). As you can see, every fund listed has seen an increase in discount to net asset value of between 220 and 460 basis points. This is a huge manifestation of these securities falling out of favor. However, they create an opportunity for buyers. (click to enlarge) Source: Morningstar As the above chart shows, net asset values are similar to those in mid-December, but the discount has widened significantly (especially in the last few weeks). The catalyst for the widening of spreads was likely a sale of JFR (in the example) in anticipation of the Fed increasing rates. Please consider these points: Any Fed increase is already “baked into” the market. Most observers expect the Fed to either delay or be very cautious with respect to raising rates due to low inflation and the negative impact of a strong dollar on the U.S. economy (higher interest rates will likely to cause the U.S. Dollar to further appreciate, making exports less competitive). Current volatility in the stock markets may cause a subset of investors to look for alternate investments; the same supply/demand equation which has driven the current high discount can reverse. Risk is 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 July 31, 2015. Top Ten Holdings of JFR (Source: Nuveen) Holdings by Industry of JFR (Source: Nuveen) Investment returns are commonly enhanced by leverage, typically between 25%-40%. In the case of JFR, leverage was 38.1% at July 31, 2015 (Source: Nuveen). Fees 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 2.05% (including leverage costs). A Discussion on Risk- Macro 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 on Risk- Micro JFR’s energy holdings represent less than 3% (in dollars) of current holdings (as of Nuveen data analyzed August 21). Any declines in these bonds are already reflected in net asset value. Further, about 90% of JFR’s holdings trade for 99 or more, which given bid-ask spreads 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 14% 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 appreciation (on the closed end funds) as discounts decline from today’s 12%-13% to a more moderate 5%-7% or even a more normalized 3%-4%. Further, according to a study by Vanguard, the performance of floating-rate products during a period of rising rates outperforms the bond market by 4.3% (see an excellent discussion from Vanguard on floating-rate bond funds). Summary Floating-rate securities offer an opportunity to capture income, with appreciation potential and modest risk compared to bonds. The floating rate feature of the securities provides protection in the event interest rates do rise materially which the yield and opportunity to close the discount-to-net asset value provides income and appreciation potential. Disclosure: I am/we are long JFR. (More…) 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.