Why Floaters Look Attractive Despite Lowered Rate Expectations

We've discussed leveraged loans (also called floating rate or senior loans) quite a bit on this site.  At the end of the third quarter, floating rate was the best asset class in the fixed income space with a mid-single digit gain.  However, by the end of the fourth quarter, aided by some media-induced panic, the floating rate ETF was down nearly 5.50%.  

The index sits just over $94 which implies a hefty 27% default rate.  While the market itself is not small at $1.3 trillion, the defining characteristic is fund flows which tend to drive prices.  In the last two months of the year, loan funds have seen weekly outflows of $1-$4 billion. 

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A leveraged loan is simply a secured loan from a bank to a speculative-rated company.  A package of these loans bundled together, securitized and sold to investors are called CLOs (collateralized debt obligation).  You invest in these because you believe the economy is going to grow and interest rates will rise.

The key for these loans are two variables:

  • The future path of short-term interest rates

  • Corporate balance sheet health

Obviously, when you own floating rate loans, you want interest rates to rise in order for your coupon to increase.  But that is a double-edged sword as higher rates mean higher interest expense for the borrower.  Most of the issuers of levered loans are smaller private companies who do not have access to the junk bond market.  In other words, these companies are likely not even strong enough to issue in the JUNK market and lock in a fixed interest rate.

If the economy turns and corporate balance sheets sour, these companies will likely have a hard time paying them back.  

Eaton Vance recently issued a blog post with some statistics and positive points on the space.  Granted, the portfolio managers who wrote it are talking their own book as they run a floating rate mutual fund.  Still, the points are valid and worth considering:

  • Today's average dollar price of 94.5 implies a 27% default rate.         

  • Yet the actual real-world default rate is just 1.6%.                             

  • Credit conditions are stable.                                                                          

  • Volatility has been technically driven by flows.                                               

  • "Re-tail" can wag the dog in loans -- but not for long.                               

  • Rebounds tend to be quick and relatively V-shaped. 

Lower prices tend to produce lower prices as investors all flock to the exits at the same time and tax loss harvest.  The barrage of negative headlines has exacerbated the decline and the large behemoth in the space, the Invesco Senior Loan ETF (BKLN) continues to experience retail investor fund outflows.  We do think that once the selling subsides, we could see a sharp rebound.  This is especially the case as libor has continued to rise despite rate expectations for next year from the Fed plummeting to basically nothing.  

The key will be to watch default rates.  If there is no subsequent rise in defaults, outflows are likely to stop or at least decline to a trickle.  If so, we could see a rebound in price in addition to higher yields brought on by rising libor even if the Fed doesn't hike rates in 2019.  

On the closed-end fund front, NAVs have been chopped by the decline in the prices.  

Write here…

Of the 29 funds we classify in the space, only seven were up YTD on NAV through December 31th.  The worst performer was XAI Octagon Floating Rate and Alternative Income (XAI) which was down 3.7%.  The best performer was KKR Income Opportunities (KIO) which is a mix of floating rate and high yield bonds, and finished up 2.3%.  

A Closer Look At KKR Income Opportunities (KIO)

KKR is one of the premier alternative asset managers with over 40 years of history.  This is their only publicly traded closed-end fund though they operate/manage many private closed-end funds as partnerships.  

The CEF invests is not pegged to one area of the fixed income market and can allocate dynamically across credit instruments.  Some characteristics:

  • Total net assets:  $465M

  • Leverage:  28.79%

  • Average Daily Volume: 97,000

  • Management fee:  1.54% plus other expenses of 0.47% plus interest expenses of 1.03% = 3.04%.

  • Current yield:  10.53%

  • Current discount:  11.87%

The two charts below show the credit quality breakdown and composition of the holdings.  Right now, they are a 50/50 blend of high yield bonds and floating rate loans.  Most of the credits are lower quality with no investment grade holdings, and a moderate amount of CCC-rated junk.  

The fund got hit on both price and NAV since October, as most funds in the space did.  In fact, no fund on our list was up in the fourth quarter with the best still falling by 3.5% on NAV.  KIO fell right in the middle, falling by 6%.

During the week of Christmas, the discount had widened out to a massive 17.60%.  At that point, the 1-year z-score reached its nadir of -3.1 indicating that the discount was massively oversold compared to historical averages.  The chart below shows that sell off as investors likely exacerbated the decline with tax loss harvesting.  In the final week of December, the fund started to rebound.  

Over the long term, this fund has been a strong performer ranking in the top 2 or 3 over the YTD, 1-year, 3-year, and 5-year numbers. 

The fundamentals remain strong with the recently released annual report showing distribution coverage of 101% with UNII of -0.015 (please note the figures on CEFConnect.com are incorrect).  

The fund conducted a rights offering last year that increased the size of the fund and increased net investment income yoy so comparisons are not apples-to-apples.  On a per share basis, the fund earned $1.55, down slightly from last year's $1.59.  

Concluding Thoughts

This is a best-in-breed fund with expert management and a great opportunity to score a dynamically managed investment strategy.  The prospectus allows the fund managers the ability to opportunistically adjust the portfolio based on both current market conditions and the best opportunities in the below investment grade space.  

We do think the discount will tighten further from here as it remains oversold compared to historical standards.  The fundamentals of the fund remain strong and the distribution safe from being cut.  From a valuation stand point, the shares are still cheap though off their oversold lows.  

If you are looking for more timely recommendations and hand-holding in regards to constructing an income-focused portfolio, check out our community of investors at our marketplace service. We have easy-to-follow spreadsheets to mirror along with weekly and monthly commentaries to help explain our positioning and market outlook. For more information, click the link below or message us for a copy of a recent newsletter.

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