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The Search for Income: Floating-Rate Senior Loans

Investors should not ignore floating-rate funds despite the current low-interest-rate environment. 

Cara Esser, 05/11/2012

Floating-rate securities were a hot commodity in the early part of 2011 as investors feared inflationary pressures were mounting. Monthly flows into the open-end bank-loan category reached a multiyear high of $5.5 billion in January 2011. But by August, after the Fed made clear its intention to keep interest rates low into the foreseeable future, flows quickly turned negative. The bank-loan category lost $7.2 billion in August alone. During the first quarter of 2012, the category saw a net inflow of $353 million. All of these sudden inflows and outflows can hurt a fund's long-term performance as managers must contend with generating or investing cash on short notice. 

Closed-end funds, or CEFs, do not have this issue. However, CEF investors do contend with discounts and premiums widening as the ever-changing winds of the market dislocate share prices from underlying net asset values. The senior-loan CEF category, as a whole, followed a similar path as the open-end bank-loan category when considering discounts and premium movements. Many of the funds were selling at higher-than-average premiums in the early part of 2011 only to plummet to lower-than-average discounts after the Fed's announcement. These funds' discounts have narrowed since their lows in late 2011, but investors are still wary of floating-rate loans in a low-interest-rate environment. Given the market's ups and downs, investors may be surprised to learn the average distribution rate paid by senior-loan CEFs is over 6%. Distribution rates aside, there are many reasons investors should consider adding floating-rate CEFs to their portfolios now, despite the expectation of low rates through 2014.

Senior Loans in Brief
Senior loans, also called bank loan and floating-rate loans, are issued by firms with below-investment-grade credit ratings. The loans are generally backed by assets from the firm and are "senior" in terms of payment and recovery after bankruptcy. Senior debt holders will receive interest payments and, in the event of default, final payments before investors holding bonds, preferred shares, or common stock. Within senior loans, an issue can be first lien, second lien, or unsecured. This dictates the order in which senior bondholders are paid.

Because the loans are issued by low-rated or nonrated firms, there is credit risk. Similar to any bond, credit risk is the risk that the company will default and be unable to make its promised interest and principal payments. Investors receive higher interest payments to compensate for this higher credit risk. While credit risk is a real concern, according to a report put out by ING Investment Management, default rates for the S&P/LSTA Leveraged Loan Index (an index that represents the bank-loan market) have reached historically low levels since peaking in 2009 at nearly 10%. For 2011, the index's default rate was 0.17%, and for the year-to-date, defaults are running about 0.21%. Fund managers believe the default rates will remain low into the near future as firms have cleaned up their balance sheets.

In the event of default, senior-loan investors generally receive at least a portion of what is owed to them. ING also reported that between 1995 and 2011, recovery rates for first lien loans averaged 71%, meaning investors in defaulted loans received $0.71 for every $1.00 invested. Not bad compared with the average recovery rate for high-yield bonds of 44%. (High-yield bonds are also issued by firms with less-than-stellar credit rating but make fixed payments over the life of the bond and are not senior credits. Because of these added risks, high-yield bonds generally have higher interest rates than senior loans issued by the same firm.)

Unlike traditional, fixed-rate bonds, interest payments on senior loans are based on a floating rate that is generally reset quarterly. The rate is based on a reference index or rate (usually Libor) plus a spread. The spread is linked to credit risk: The higher the spread over the reference rate, the larger the risk of default. Interest-rate risk is a big issue for bond investors, especially when interest rates are low. Because interest rates and bond prices move in opposite directions, investors can get hurt when interest rates rise and the value of their bonds falls. Of course, investors holding bonds until maturity are not exposed to this risk and will receive the bond's full principal at maturity; instead, they are exposed to inflation risk. Because senior loans have floating (not fixed) payments that are reset regularly, they are less exposed to interest-rate risk. If interest rates quickly rise when a reset date is months away, these securities will likely see a price drop. But because the reset date is never too far off, the securities will be somewhat protected.

Senior Loans vs. High-Yield CEFs
The Fed has promised to keep interest rates low through 2014, and no one doubts that the Fed does have that intention today. But some pundits and fund managers argue that an "intention" is not a promise, and even promises can be broken. Investors will likely be caught by surprise if the Fed does break this promise, and many believe it's better to be prepared today than caught unaware tomorrow.
While it's clear that interest rates will rise at some point in the future, no one can predict when that will happen. Many income-oriented investors in search of "yield" have turned to fixed-income securities with higher risk than U.S. Treasuries, such as high-yield bonds. Many of the fund managers we speak with believe that current spreads on high-yield bonds are large relative to the real risk of default. This means that high-yield investors are being compensated for taking risks that, in reality, may not be as large as the market believes. This is good for high-yield investors, but it's not a secret. High-yield CEFs have produced strong returns since the 2008 market downturn, which has since attracted investors. Table 1 compares the senior-loan and high-yield CEF peer groups using the average of all CEFs in each universe.



Cara Esser is a closed-end fund analyst at Morningstar.
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