Monday, October 29, 2012

Floating Rate Senior Bank Loan Closed End Funds – Still Have a Place?

Readers of this series (link) of posts know that my investing strategy has for a while focused a great deal on leveraged closed end funds (CEFs), which borrow at short-term interest rates and invest the extra dollars in more securities to generate higher returns.  As I have written before, that leverage seems modest by “financial wheeler-dealer” standards – at most, one borrowed dollar for every one of investor equity.

Of ongoing special interest are those CEFs that primarily hold floating rate bank loans, which are usually senior in the capital structure, are secured by specific assets, and are often amortized so that a little of the principal is paid back all along the life of the loan (avoiding a surprise at the end of the term).   

Bank loans are made by banks to businesses for a variety of reasons and are typically aggregated into larger pools which are then sold to funds and other institutional investors.  Typically the interest rate on such loans is tied to the 3-month Libor interest rate and resets frequently, so that as short-term interest rates rise, so does the interest rate on such loans.  Bank loans are commonly below investment grade, but since they are typically are senior and secured (hence the acronym SSBLs) the recovery on a default is high, and defaults have been unusually low for a while, perhaps reflecting the stronger balance sheets of companies that have survived the Great Recession.

A unleveraged bank loan ETF, BKLN, currently yields almost 5%.  But for every dollar of equity in such a fund, why not borrow say 35 cents at less than 1% interest and invest that into more bank loans yielding 5%?  Both your leverage and your principal are floating to the same reference index, so the spread shouldn’t change.  With such leverage one takes on more credit risk but not more interest rate risk.  Add to that professional management, which has the ability, if so desired, to add some credit default insurance, and you have a Bank Loan CEF. 

Many bank loans today have interest rate floors, so they are yielding much more than the 3-month Libor.  Now, if interest rates wind up staying low for many years, as the fed has indicated and as the market currently believes, then these loans may not be the best investment at the current time for either current yield or total return.  But to hedge my bets in case short term interest rates rise sooner than expected, these SSBL CEFs have a reasonably good-sized place in my portfolio.  I find the credit risk reasonable and the interest rate risk negligible, and I find for all that I’m getting attractive annualized yields at roughly 6.0 to 7.5%.  Not bad.

As with all debt CEFs, among other things I look for net investment income (NII) to exceed the distributions, positive undistributed net investment income (UNII), a positive or at least stable quarterly NII trend, and a low level of the riskier level 3 assets.  I also like to see a positive, acceptable, and competitive total return on net asset value in recent time periods.  Ideally I like to buy when the market price is at a discount to the fund’s net asset value, but I will buy at a modest premium if I think market conditions suggest the NAV will be stable or rise. 

Senior secured bank loan CEFs have run up in price lately, and bank loans have risen and are now trading roughly almost at par, so they are no longer real bargains.  Nevertheless, I like them as a portfolio hedge against rates rising earlier than expected and with acceptable distributions for that hedge.

My major SSBL CEF holdings right now are TLI (6.7%), JFR (7.2%), JRO (7.5%), PHD (6.6%), and EFT (6.3%), with the current annualized distribution yields noted.  I like to diversity across sponsors whenever possible, and these five funds come from four different sponsors.  At the moment all these CEFs are trading at single-digit premiums -- their attractiveness as buys to some investors may vary with the degree of discount or premium, which varies day-to-day. 

Mike Parenti

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