Floating Rate Loan Funds (Morningstar)

Five Senior Loan CEFs for Your Radar

Five Senior Loan CEFs for Your Radar
By Cara Scatizzi | 08-13-10

Senior bank loans are typically extended to below-investment-grade companies, which can translate to higher interest-rate payments for banks and investors. After a bank lends the money, it sells the loan as a security to investors and passes the interest payments to investors. Such bank loans are structured to produce yields higher than comparable bonds and also to mitigate certain risks that accompany fixed-income investing.


Senior loans are often short term and have floating interest rates. This reduces interest-rate risk for investors because, as interest rates rise, the short-term floating rates on the loans can be reset quickly to reflect higher rates. Conversely, if interest rates are falling, the floating rates will reset to echo lower rates, which means investors cannot lock in high interest rates with this type of security.


In addition, these loans are secured by cash or assets and are considered "senior." This means that, in the event of bankruptcy, these obligations are the first to be repaid. There is no guarantee of any payment after a default, but because the loans are senior and secured by assets, historically, investors have received $0.75 to $0.80 per dollar in such situations.


Investing in closed-end funds, in general, has many benefits. First, CEFs can use leverage in an effort to enhance performance and distributions. CEFs are also required to distribute income to investors. In addition, CEFs often sell at discounts to net asset value, which means investors can achieve "yield enhancement." Finally, there is an added benefit of diversification. Specific to senior bank loans, CEFs hold hundreds of individual bank loans of varying credit quality and maturity. If one or a few of the companies default on their bank loans, it will most likely have a small effect on the overall portfolio. However, bankruptcy is not the only way for a senior loan to lose value. Deterioration of the individual company's credit can cause a loan to fall in value.


There are 19 senior bank CEFs and only one does not use leverage (the newly created Blackstone/GSO Senior Floating Term Rate (BSL). The remaining CEFs use leverage in the form of debt and preferred shares, which is regulated by the Investment Act of 1940. In addition to senior loans, these types of CEFs also invest in corporate bonds and cash. Ten of the 19 senior loan CEFs trade at a discount to net asset value, which offers investors a yield enhancement via their discount.


Investors seeking the higher income that senior bank loans can offer should be aware of the risks to their underlying capital. The group produced volatile returns in 2008 and 2009, as would be expected given the changes in interest rates, the inherent volatility of leverage, and the turmoil in the credit markets. The average senior loan CEF has gained 0.19% annually over a five-year period, is down 2.97% annually for the latest three-year period, and is up 6.5% in the year to date.

A Closer Look: Five Senior Loan CEFs

Discount /Premium (%)Distribution Rate at Current Price (%)1-Yr Distribution Change (%)Leverage Ratio (%)

Highland Credit Strategies (HCF) -2.1 8.68 0 23.6
Nuveen Senior Income (NSL) +2.4 6.92 19 36.5
Nuveen Fl Rate Inc Opps (JRO) -0.6 6.63 24 36.5
Nuveen Floating Rate Inc (JFR ) -3.9 5.56 24 35.6
LMP Corporate Loan Fund (TLI) -5.8 5.17 20 52.0

The table above lists five senior loan CEFs that, in our opinion, look attractive. Exclusion from the above list does not reflect our dissatisfaction with a fund. Instead, these are the five that have caught our attention at the moment. None of the listed CEFs have decreased distributions in the last year and four of the five have increased the distribution at least once over the last year. In addition, none of them uses return of capital to synthetically boost stated yields.


Highland Credit Strategies (HCF ) has a distribution rate of 8.7%. The fund has not increased the distribution in the last year, but while 13 of the 19 funds in this category decreased distributions, HCF did not. The fund came out of the gates in 2007 and performed poorly, as might have been expected given the credit-market environment at the time. The fund has lost 10.8% per year since inception. However, in early 2009, the fund replaced the portfolio-management team with two new managers, who have outperformed their peer group over the one-year (HCF gained 21.9% versus the peer group's gain of 20.2%) and year-to-date (HCF is up 7.95% versus 6.55% for the peer group) periods. HCF holds 63% in bank loans, with the remainder in low and non-investment-grade corporate bonds and equities. Its largest holding (7.3% of the portfolio) is a holding company for venture healthcare companies. Finally, HCF has a leverage ratio of 23.6%.


Nuveen Senior Income (NSL) is one of three highlighted funds from Nuveen. All three funds are managed by Gunther Stein. NSL is selling at a 2.4% premium to NAV but still offers a 6.9% distribution rate. The fund increased the distribution twice in the last year for a total increase of 19%. In 2009, the fund gained 111% in net asset value (versus the peer group, which gained 76%), during which the fund's share price jumped from a 12% discount to NAV to a 17% premium to NAV in the final four months of 2009. Since inception in 1999, the fund has gained 5.3% annually. 86% of assets are held in bank loans with the remainder in high-yield corporate bonds, convertibles, and cash. The largest sector concentration is media, at 11% of assets. The fund has a 36.5% leverage ratio.


Nuveen Floating Rate Income Opportunities (JRO) has a 6.6% distribution rate and has boosted its distribution twice in the last year for a total increase of 24%. The fund invests 87% of its assets in senior loans and the remainder in junk bonds, cash, and a very small portion in common stock. The current leverage ratio is 36.5%. The fund has performed about as well as the peer group, with the exception of 2009, when the fund outperformed with an impressive NAV gain of 113%. Since inception in 2004, the fund has gained 4.1% annually. Historically, the fund has traded at a discount to NAV (its three-year average discount is 8.04%), but 2010 has proved a volatile year for JRO's premium and discount. In April 2010, the fund shot to at a historically high 9.46% premium, only to drop to a discount of 6.75% in late May. Currently, the fund sells at a slight 0.60% discount to NAV.


Nuveen Floating Rate Income (JFR) has a current distribution rate of 5.6% and is selling at a 3.9% discount to NAV. The fund has increased its distribution twice over the last year for a total increase of 24%. JFR has a current leverage ratio of 36.5%. In 2009, JFR gained 101% and in 2008 the fund lost 50.1%, still slightly beating the peer group. Since inception in 2004 the fund has gained 3.71% annually. JFR holds 86% in bank loans of mostly low credit quality, though 7% of its holdings are bonds rated AAA.


LMP Corporate Loan Fund (TLI) has the lowest distribution rate of the highlighted CEFs, but it is still attractive on an absolute basis. In addition, the fund is selling at the largest discount (5.8%) of the funds listed, making it even more attractive. TLI has increased its distribution twice in the last year for a total increase of 20%. The fund holds 93% in bank loans, with the remainder in corporate bonds and short-term debt. TLI has a relatively high leverage ratio of 52%. Since inception, TLI has gained 4.5% annually. In 2008, when the average senior bond CEF lost 51%, TLI lost 44%.





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