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Bridging the Abyss with Floating-Rate Funds

These funds might be appropriate, but risk is involved.

Helen Modly, 03/12/2009

Our professional discipline says that now is the time to rebalance our clients' portfolios by replacing the 30% to 40% of equities lost to the market. Even clients that acknowledge this is the right thing to do are pleading for just a little more time. What's an advisor to do?

Revisit the Asset-Allocation Decision
Go back to your original investment policy statement or financial plan and review with your clients why they had an exposure to equities in the first place. They need to remember that they were seeking long-term growth of capital and protection from the loss of future purchasing power caused by inflation. They know that they will have to go back into the market, but many just can't bring themselves to take on any more risk right now.

Our concern is twofold. If we rebalance now, will they just experience more losses in equities? We are already at a point where we will need to see future returns in the 40% to 65% range to recover from their recent losses. Over a four- to five-year period, that would not be so far-fetched if we weren't facing such gloomy economic forecasts.

If we do nothing, our clients are going to quickly realize that the yields they are seeing on their nice, safe bonds will barely pay our fees, much less provide them with the income they need. Far too many people are just moments away from yanking everything and crawling under a rock until they can regain some sense of control. The urge to do something--anything--is becoming overwhelming for many clients--and many advisors.

A Bridging Strategy
If the risk of more equities just won't fly with your clients, perhaps taking on a bit more risk in their fixed-income allocation will. Today, the difference in yields for various types of bonds over the available yield on similar treasuries is wider than it has been in years. Currently, two-year treasuries are yielding less than 1% and 10-year treasuries are yielding less than 2%. Apply a 1% advisory fee to that and you will quickly see the problem with letting clients hunker down in cash to ride it out.

Instead, consider adding an exposure to short-term, high-yield securities such as senior floating-rate bank loans. These are bank loans to corporations that are highly leveraged and thus rated below investment grade. These loans are called senior bank loans, floating-rate loans, leveraged loans, or senior secured loans. These loans are secured by collateral such as equipment, real estate, inventory, shares of the borrower's stock, and receivables. The loan rate floats with a specified margin to a specific index, usually LIBOR, and the rate resets every 30 to 90 days. Principal is repaid over the life of the loan, generally three to seven years.

Low Correlation to Equity Assets
Senior secured loans have historically had a very low to negative correlation to most asset classes commonly used in diversified portfolios. After watching domestic and international equities sink in lockstep last year, a little negative correlation would certainly be welcome. Over the past decade, funds of senior secured loans have had remarkably stable net asset values-until 2008. Last year, some senior loan funds were down less than 15%, although the index of these loans (S&P/LSTA US Leverage Loan Index) declined by almost 40%. Today, the loans in the index are priced at 65% to 70% of par. This explains the historically high current yield of 8% to 10% with an opportunity for capital appreciation as well.

Risks
Since these borrowers are below investment grade, the risk of default is the most obvious risk. The current default rate is just under 5%, and historically defaults have ranged from 0.5% (summer of 2007) to a high of 7%-8% (1999 to 2002). There are floating-rate bond mutual funds that have never experienced a default, but most managers are anticipating a default rate in the index of 7% to 10% before the economy rebounds. A higher default rate would negatively affect the NAV. Look for funds that are avoiding the hardest-hit sectors, such as the auto industry, and hold the highest-quality loans, such as Fidelity Floating-Rate High Income FFRHX.

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