Floating Rate Review - February 2019

Executive Summary

  • Floating rate loan funds are one of the few areas that haven't seen the sharp discount closing

  • We think that will change as spreads come in further and investors seek value.

Top Trades:

  • Apollo Senior Floating Rate (AFT)

  • THL Credit Senior Loan (TSLF)

  • Highland Floating Rate (HFRO)

  • Blackrock Floating Rate (BGT)

Leveraged loans continue to show a slow rebound from the lows in mid-December and in the last two trading days, have accelerated that rebound.  The leveraged loan index rose 2.55% in January, one of the best monthly increases on record.  The index is still below par at ~$97.  The chart below shows the last year in the Invesco Senior Loan ETF (BKLN) fund which fell off a cliff in December and has since mostly recovered.  

The default rate in January on a 12-month trailing basis was 1.42%, a 17-month low.  If you recall, in our prior write up in early January, we noted that the price of the index implied a ~27% default rate.  We clearly saw something else other than credit risks precipitating the fall in loan prices.

Of all the CEF subsectors, floating rate is currently the most attractive from a discount perspective.  The average floater is now at a -10.1% discount, only about 130 bps tighter than where the sector started the year.  As you know, most sectors have seen significant discount tightening in 2019 (the so called "January effect").  Floating rate has not really participated in that rally.

The last bastion of opportunity in this market is the floating rate.  In the chart below, we highlight the funds that we think have the best convergence opportunity going forward.  We used the 52-week average as the bogey and compared to the current discount.  

A few of the big movers (and expensive) are:

  • Blackstone/GSO LS Credit (BGX)

  • Eagle Point Credit Company (ECC)

  • Nuveen Credit Strategies Income (JQC)

ECC now trades at a very high valuation and assumes that the NAV rebounds fully from what it lost in the fourth quarter. It is certainly possible that the NAV jumps back to $17 but that is not something I would want to gamble on. Remember, this should really be classified as an equity-based fund so it will ebb-and-flow with the S&P 500.

We commented on Nuveen Credit Strat Income (JQC) a few weeks ago noting that it was likely to see interest given the new capital return program. That program (which is essentially a managed distribution program) means the fund pays a whopping 15.5% annual distribution yield. The total amount is $0.1015 of which approximately half is ROC. This is fine (and sustainable) so long as the NAV is flat or increasing.

In the Core, Blackstone/GSO LS Credit (BGX) has rebounded strongly in the last week. The price has almost moved straight up in the last few trading days. The sell flag on the sheet was flipped and we are considering making a swap. I'm debating whether to hold for a bit (like in PDI which also has a sell rating) but in this case, there are many alternatives in the floating rate space that are far cheaper and can offer similar yields/total return. In addition, the NAV is only marginally moving higher.

4.png

Nuveen Short Duration (JSD) is also finally making its move. We've held this one less than a year but are down total return on it. I added to it in October which was far too early. The discount is back under 52-week average at 5.4% (vs. 6.7%). This NAV has a little bit better of a slope than BGX so I think there could be more room to run.

5.png

On the other side of the list (sorted by lowest 1-year z-score), we've seen movement higher but not enough to move away from negative values.

Cheapest funds:

  • THL Credit Senior Loan (TSLF)

  • Blackrock Debt Strategies (DSU)

  • Highland Floating Rate Opps (HFRO)

THL Credit Senior Loan (TSLF) has been a top pick of ours for a couple of months and it's just starting to move. The discount closed under 11% but is still about 150 bps above the 52-week average and is nearly 7 points above the 52-week high. From a quality (read fundamental) standpoint, the fund is strong with coverage around 100% and 8 cents of UNII (they recently raised the distribution).

Blackrock Debt Strategies (DSU) has been a bit of a disappointment to us as the discount fails to close like other funds. I would note that the floating rate space has seen the least amount of discount closure. In addition, fundamentals are weakening a bit but not to the point where I would run out and sell because of an imminent cut. I think there may be a short-term opportunity as Saba sells out of their position. As of the 15th, they owned 2.87M shares or 5.4% of the fund's outstanding.

Lastly, we've commented on Highland Floating Rates Opps (HFRO) and even made it one of our top picks in the last two letters. At a 5% discount, the fund is likely to run a bit more though don't expect it to get back to a premium where it was for most of its existence prior to November. The yield is too low for that to occur and that was also a function of the initial public offering.

------------------------