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Floating Rates: How To Protect Your Income Stream

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Income investors are well aware of the inverse relationship between bonds and yields; as rates rise, the price of bonds declines. Floating rate loans, funds or securities can reduce or eliminate this risk. Several leading income experts and MoneyShow.com contributors suggest a variety of investment vehicles that employ a floating rate strategy.

John Bonnanzio, Fidelity Monitor & Insight

Even the casual observer of bond funds knows that 2018 has so far been tough on the wallet. On several occasions, the yield on the bellwether 10-year Treasury has briefly breached 3%.

 Fidelity Floating Rate High Income, a high-yield bond fund, is playing an increasingly important role in our model portfolio income strategies. At a time when taxable bond funds with roughly the same interest rate risk are yielding only about 2%, it’s clear that Floating Rate’s 4.36% yield is the result of additional credit risk.

In fact, it’s taking considerably more risk via its nearly 500 non-investment grade leveraged bank loans. Naturally, companies that are highly indebted (leveraged) must pay investors a higher yield because they are riskier bets. Notably, 80% of the fund’s assets are in credits rated BB and B.

With that in mind, Floating Rate has a modest wind to its back in the form of a healthy economy and strong corporate earnings — both make the risk of default less likely right now.

It also helps that Fidelity has a deep pool of credit analysts to mitigate some of the risk that’s inherent to holding leveraged bank loans. While we generally don’t encourage investors to “reach for yield,” Floating Rate currently has its risk and potential reward in the appropriate balance.

It’s clear that Floating Rate’s 4.36% yield is the result of additional credit risk. In fact, it’s taking considerably more risk via its nearly 500 non-investment-grade leveraged bank loans.

 

Jim Powell, Global Changes & Opportunities

In his most recent address to Congress, Fed chairman Jerome Powell confirmed that he plans to raise interest rates two more times this year.

As a result, we should continue to buy only short-term bonds and CDs, and roll them over each time rates move up. It’s a slam-dunk strategy for staying abreast of rising interest rates. Not everything is hard on Wall Street.

If you don’t want to make the rollovers yourself, I suggest the iShares Floating Rate Bond ETF. The exchange-traded fund has been serving investors well so far and should continue to do so.

Unlike most fixed rate bond funds that decline in value when interest rates rise (as has been the case since the Fed started to push rates up in December 2016), iShares Floating Rate rotates its bond portfolio to protect investors from losses and keep up with the increases.

Brett Owens, The Contrarian Income Report

BlackRock Floating Rate Income Strategies Fund and Eaton Vance Floating Rate Income Fund tend to deliver their promised distributions and price upside when rates rise.

These funds barely blink when stocks plummet, and they even hold steady when rates plummet. Their secret? They buy corporate bonds. These issues have higher yields and more flexibility than, say, U.S. Treasuries. As rates move higher, these money managers aren’t left with has-been pieces of paper.

BlackRock Floating Rate Income Strategies Fund is currently on sale for no good reason. The fund is a closed-end fund (CEF), a vehicle which can be prone to price whipsaws. These are opportunities we level-headed contrarians can take advantage of.

The fund’s “discount window” — the difference between the value of the bonds it holds, and the price it commands on the open market — has expanded to 5.5%.

BlackRock Floating Rate Income Strategies Fund traded at a premium to its NAV as recently as 2013. If rates keep rising and this fund swings back into favor, we’ll enjoy this “free money” window closing as price upside. We pay 94.5 cents for a dollar, plus we get the yield!

Meanwhile, Eaton Vance Floating Rate Income Fund portfolio manager Scott Page is able to cycle into higher paying investments as rates move higher. His loans, on average, reset every 48 days thanks to a portfolio that features 90% floating rate loans.

When the bonds mature, Page will simply roll the capital into new corporate bonds. He can search the public and private markets for deals (showing another advantage of bonds over stocks – the universe is larger). And if interest rates are higher when he looks, he’ll capture the higher yield.

But he doesn’t have to wait for maturity. Remember, his loans reset every seven weeks, on average. He isn’t stranded if rates spike. He simply rides the rate wave to higher payments. He doesn’t get drowned in its wake – as other lesser managers do.

Since the Fed started (slowly) hiking rates in 2015, BlackRock Floating Rate Income Strategies Fund and Eaton Vance Floating Rate Income Fund investors have enjoyed these “Fed funded” higher returns. It’s a simple formula — during rate hike periods, you want to own these funds because they steadily grind higher.

BlackRock Floating Rate Income Fund is too cheap as well. If you’re worried about rising rates, then this is a timely buy. Its price, for whatever reason, has declined in recent months. Meanwhile, the value of its floating rate bonds has stayed steady (and the fund boosted its distribution in July!)

BlackRock Floating Rate Income Fund traded at a premium to its NAV as recently as 2013. Rates weren’t rising then! They are now, and BlackRock Floating Rate Income Fund is trading for just 93 cents on the dollar. So I suggest swooping up this bargain before irrational income investors come to their senses.

Bryan Perry, Cash Machine

Business Development Companies (BDCs) are involved in helping grow small companies in the initial stages of their development. Like REITs, they are Regulated Investment Companies, which have to pay out 90% of net income to shareholders.

What makes BDCs uniquely different from REITs is that BDCs can use leverage to fatten up returns, employ the use of derivatives like equity warrants and management also can charge a performance fee.

The ideal BDC is focused on long-term value and making investments that will perform well over several years and can withstand different business cycles. That same focus continues to be on companies and structures that are more defensive, have low leverage, strong covenants and high returns.

If a business development company can generate a current yield of 8.0% or higher from a portfolio of floating-rate loans while paying a monthly dividend, I’m very interested in getting involved while short-term rates are still artificially low.

To that end, PennantPark Floating Rate Capital is, in my view, a fantastic way to increase one’s weighting in what should be an excellent place to ride the eventual rise in interest rates on the short end of the yield curve. Shares sport a current yield of 8.3%

PennantPark’s investment objective is to seek current income and capital appreciation by investing primarily in floating-rate loans and other investments made to U.S. middle-market private companies whose debt is rated below investment grade.

The current portfolio is valued at $834 million and made up of loans to 86 companies across 23 industries. The average investment size is $10 million. Of those loans, 100% of them are structured as the floating-rate variety.

Key weighted investment sectors include aerospace and defense, healthcare and pharmaceuticals, information technology, business services, chemicals and plastics, capital equipment, food and beverage and environmental industries.

Most of the floating-rate loans carry an average maturity of three to 10 years. In addition, PennantPark owns secured interests on $758 million of the assets of its portfolio companies to serve as collateral in support of the repayment of these loans. This collateral takes the form of first lien secured debt on the assets of a portfolio holding.

For many high-yield investors, 8% might not sound as tantalizing as the yield on other BDCs, but it would be hard to locate another BDC that has such a solid loan portfolio and sound management that will provide decent share price stability as interest rates rise.

For my high-yield advisory Cash Machine, PennantPark Floating Rate Capital is a core holding with an ideal monthly dividend payout that makes it a prime income investment in the present market environment.

John Freund, BullMarket.com

Apollo Commercial Real Estate Finance acts as a lender, which means management members take an active role in sourcing and actively monitoring the portfolio in direct contrast to many REITs that simply purchase a pool of mortgage debt and hope for the best.

By performing in-house due diligence and underwriting credit risk, Apollo can better hedge its overall profile over the long-term. Consider Apollo’s strategy of hedging against rising interest rates. The company maintains floating-rate loans on individual properties and performs the due diligence on those properties itself, thus saving external research fees.

Floating rates rise with every Federal Reserve tightening move, which means that while the entire REIT sector took a big hit from the current climate of rising rates, Apollo’s bottom line actually benefited.

The company made a record $2 billion in Commercial Real Estate loans during the first half of 2018 alone. Those loan originations include forays into new markets such as Seattle and San Francisco, where the company issued first mortgage and mezzanine financing to an office campus and high-end condo project, respectively.

The company also has major investments in arguably the best real estate market on earth, Manhattan and Brooklyn (40% of Apollo’s portfolio is located there). The famous Steinway Building at W. 57th St., which is on its way to becoming part of the third-tallest skyscraper in the city, is but one example of Apollo’s expanding CRE universe.

Apollo, yielding 9.8%, is a fundamentally sound company with excellent leadership and tremendous growth prospects on the horizon. Additionally, the mortgage REIT sector is much more secure today than it has been at any time since the Great Recession, which means the company is expanding at just the right time. Now is a perfect time to invest and capture close to a double-digit dividend.