I commenced writing this article back in February 2021 with the (then) argument of:
With equity markets fresh off of record highs, one has to ask themselves, how much more upside is there for stocks? A better question might be, what event/s could mess this party up?
The bull camp dutifully notes that the drivers which had propelled equities to current levels will remain intact. One key driver is prospects of additional stimulus from Congress to get the economy jump-started until (presumably) vaccines are distributed and we pick-up where we left off.
The operating theory being that a one-two punch of stimulus and subsiding pandemic fears could help the U.S. get back to more normalized employment within a year.
A variant view to the bull thesis might include a possibility of rising inflation on top of potential for policy-driven interest rate hikes.
Fast Forward: Well, here we are more than a year later, and, as I was re-visiting the original article draft, it remains clear to me that the intended theme remains (mostly) intact.
In retrospect, the bulls had their party and stocks rallied into late December 2021. To equity markets, it had been a “punch-bowl-is-half-full” kind of bash. Fueled by an accommodative Fed and multiple fiscal handouts, the economy (for the most part) chugged along.
Pandemic issues continue to throw curve balls, but multiple-dose vaccine ramps look to be ample and available.
The Other End of Town: Meanwhile, inflation has gone bonkers (from “transitory” to parabolic), and the Fed has initiated its belt-tightening with a half-point (50 basis points) rate hike earlier this month. Fed Chairman Jerome Powell has indicated the Fed is on track for similar moves in June and July.
The ongoing Russian invasion of Ukraine and the global response via quid pro quo sanctions at/from Russia created additional volatility in the broader commodity complex. It has also added significant impairment risk to the many companies doing business in Russia.
This convergence of diverse macro issues will likely see Mr. Powell and company re-evaluate timing of said rate hikes, but it is safe to assume that rate hikes are very much still on the table.
At the other end of town, there is another party. It’s the bond market, and they are considerably less than sanguine about the economy than their equity counterparts.
Judging by a steady rise in 10-Year Treasury yields since the August 2021 trough, the bond folks are signaling the “punch-bowl is half-empty.”
It seems like an eternity since the last Fed tightening cycle, but it was in late 2015 with the peak following four quarter-point hikes in 2018.
An Unlikely Beneficiary of Rising Interest Rates: One area of the market investors might find solace during a rising rate environment is in baskets of variable rate / floating rate senior loans. Also known as loan participation funds, these types of portfolios generally invest in senior “secured” debt (bank loans, first/second lien term loans and corporate bonds).
Pros: The senior/secured aspect of these instruments provide several advantages. In the event of default, creditor preference on senior paper is generally higher on the liquidity food-chain than subordinated bondholders, preferred equity and common equity. Also, these obligations are typically secured by assets of the borrower.
The “floating-rate” aspect of senior loans can also potentially boost income streams in a rising interest rate environment. As rates rise, variable rates (resets) on the underlying note increase, resulting in rising cash-flow distributions. This is one reason I have always considered floating-rate vehicles a good proxy for rising interest rates.
Cons: Senior loan pools tend to be on the lower end of credit quality. Companies that issue these loans tend to be highly leveraged. Lien structure/priority is another consideration. For example, a second lien loan may have a claim on the same collateral pool as the first lien or be secured by a separate set of assets. Less restrictive loan (maintenance) covenants are also more frequent in recent years.
Senior loan and variable rate portfolios also employ structural leverage to enhance performance. This adds to the expense ratio of a fund.
Evolution of Senior Loan / Loan Participation Funds: Closed-end funds (“CEFs”) are an excellent vehicle for exposure to senior loan baskets. There are numerous products available and I have included a link here for your further review.
It should be noted that following the Great Financial Crisis (2007-2008), there was a frenzy of corporate refinancing activity. I discussed this in an 2012 article related to premium risk. This re-set resulted in something like $600 billion of higher yield coupons being retired/extinguished in favor of lower yield issuances.
Faced with a dwindling supply of higher yield paper, senior loan portfolio managers adapted to a new world of shorter duration and maturity spans by incorporating derivative exposure, bonds and even equities into the mix.
My Pick: One closed-end fund which I have owned for years is First Trust Senior Floating Rate Income Fund II (NYSE:FCT). In the senior loan / floating rate universe, I find FCT to be a solid fit in my income portfolio.
While I prefer to buy senior loan baskets at a discount to their underlying net-asset-values, only recently has FCT settled into a modest discount to NAV. This is due in large part to massive “risk-off” selling pressure in recent weeks in most asset classes.
The “C” word ( as in capitulation) has been discussed much in recent days, and whether or not a bottom is in place, remains a wide open topic of debate. I have been in the markets for 40+ years and have experienced numerous drawdowns. This particular volatility has the usual suspects (i.e., fear, consternation, melt-down of exuberance, etc.)
Yet, it also exhibits the umbrage of forced selling (due in large part to liberal use of leverage) and the arrogance of those behind the bad bets. I would cite the problems at Citadel and the “Tiger Cubs” as an example of how the fewmet-hits-the-windmill in the hedge fund community. But. I would submit that we have yet to see a full-blown exhaustive sell-into-the-close type situation, which would (in my view), mark the “last gasp” presence of a market bottom.
Indeed, many other senior-loan / floating-rate CEF’s are trading at discounts to their NAV’s, but the recent broad market selling pressure has provided investors a compelling opportunity to consider FCT.
For comparison, I have provided a one month change in premium / discount to NAV for some of FCT’s peers in the closed-end spectrum (below).
The Appeal: What I admire most about FCT is how it is managed. First Trust’s Leveraged Finance Team has done a good job of evaluating existing and new investment opportunities in changing credit environments.
Current top ten portfolio weightings (by industry) for FCT are:
|Health Care Providers & Services||13.92%|
|Hotels, Restaurants & Leisure||7.55%|
|Health Care Technology||7.01%|
|Diversified Telecommunication Services||3.99%|
|Diversified Consumer Services||2.48%|
Note: as of 01/31/2022
Performance wise, FCT has held up pretty well compared to the Morningstar US CEF Senior Loans Category over the years. More impressive, is FCT’s very low default exposure.
The Fund experienced zero defaults in the quarter and zero defaults during the last twelve-month (“LTM”) period compared to 5 defaults within the LLI* during the LTM period. Since inception, the Fund has experienced twelve defaults compared to 165 within the LLI* during the same period. As we anticipated, the LLI* default rate has declined to 0.29% as the economic recovery proceeded. The current default rate is well below the long-term average default rate of 2.84% dating back to March 1999. *S&P/ LSTA Leveraged Loan Index (the “benchmark” or “LLI”) Source: Fund Commentary
Distributions: As of this writing, FCT’s distribution rate is a handsome 7.80%, paid monthly. It should be noted that monthly distributions declined from $0.1050 (March 2021) to $0.0720 (April/May 2022). Assuming distributions have floored, a 7% kicker seems worth the risk.
Risks: Speaking of risk, loan participation funds have several for investors to consider. The use of leverage is one. FCT’s effective leverage (as a % of total adjusted net assets) is 30.17%. A tailwind if risk asset prices generate positive returns and a headwind when risk asset prices generate negative returns.
A decline in underlying portfolio credit quality and the previously mentioned default exposure are other risks to consider. Also, a rising trend of weaker covenant issues coming to market pose challenges for portfolio managers.
And, a portion of FCT’s monthly distributions include a return-of-capital (or ROC). Some critics will argue that ROC is simply getting your money back, but ROC is a tax concept, not an economic concept. Closed-end fund provider Eaton Vance put out a sheet which goes in to more detail about ROC. You can read it here.
Closing Thoughts: Loan participation funds such as FCT can be a wonderful income producing vehicle within a diversified income portfolio. From a yield standpoint, 7% plus pays you well for the risk/s assumed. Monthly distributions are a plus. There is also a certain comfort knowing you are high on the totem pole regarding liquidity preference in the event of default.
I hold FCT in retirement accounts. There are many loan participation funds to choose from, but FCT has worked well for me over the years. For an investor wanting to put some cash to work, laddering in at current price, might be a good place to start.
FCT’s portfolio characteristics are also appealing to me. It is refreshing not to see names like ClearChannel, Veritas, Petsmart and RealPage in the top holdings.
As of 2/28/2022
|Hub International Ltd Hbgcn Tl B 1l Usd||$13.67M||3.05%|
|Verscend Holding Corp Vcvhho Tl B 1l Usd||$9.32M||2.08%|
|Endo Luxembourg Finance Endp Tl 1l Usd||$9.19M||2.05%|
|Mallinckrodt International Mnk Tl B 1l Usd||$9.04M||2.02%|
|Hyland Software Inc Hsi Tl 1l Usd||$8.76M||1.95%|
|Fertitta Entertainment L Nugget Tl B 1l Usd||$7.94M||1.77%|
|Mh Sub I Llc Inet Tl 1l Usd||$7.81M||1.74%|
|Solarwinds Holdings Inc Swi Tl 1l Usd||$7.70M||1.72%|
|Bausch Health Cos Inc Bhccn Tl B 1l Usd||$6.74M||1.51%|
|Applied Systems Inc Appsys Tl B 1l Usd||$6.58M||1.47%|
In the event of another big market decline, take advantage of any weakness to add to positions. One anecdotal observation about senior loan CEF’s, is that during big market drawdowns (particularly forced selling), these types of investments are usually the last to be sold.
More information on FCT can be found here (along with links to the First Trust website).