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.

Highest Yield (from Kiplinger Magazine)

Where to Find Top Yields
From safe municipal bonds to risky closed-end bond funds, just about everything is on sale.

By Jeffrey R. Kosnett

From Kiplinger's Personal Finance magazine, June 2009

It's been an excruciating year for income hogs, their favorite investments obliterated by the recession and the credit crunch. Since September, high-yielding standbys such as real estate investment trusts, master limited partnerships, business-development companies, and oil-and-gas royalty trusts have lost 50% or more. Junk bonds and emerging-markets debt have improved of late, but they've still sustained double-digit losses.
From calamity, however, springs opportunity. Many income securities are now tantalizingly cheap. Moreover, issuers of high-yielding stocks and bonds are sure to benefit from reflation -- the stimulation of global economies through massive government spending and rock-bottom interest rates. Reflation, which implies higher inflation, will hurt low-yielding Treasury bonds, but it should boost the profits of energy producers, real estate operators and highly leveraged companies that need to raise prices to prosper.


The bear market in most income investments has resulted in lower cash payouts, too. With virtually all segments of the real estate sector suffering, dozens of REITs have cut their distributions, and many are paying dividends mainly in stock. Energy trusts have trimmed their disbursements because of low prices for oil, natural gas and other products. Led by financials, hundreds of companies have cut or suspended dividends on their common stock this year.

Credit-market chaos wreaked havoc with the recommendations in our previous "yieldfest" (see Earn 8% or More, July 2008). Our best picks, emerging-markets bond funds such as Fidelity New Markets Income and Pimco Emerging Markets Bond, dropped about 10% over the past year through April 9. Pipeline stocks, such as Kinder Morgan Energy, also held up reasonably well. But we had our share of disasters. For example, First Industrial Realty Trust cratered by nearly 90%, while Genco Shipping & Trading dived 73%.

As the economy begins to improve, the rest of this year and 2010 will be much more rewarding for income seekers. From the safest to the riskiest, we offer our best bets for big cash returns over the coming year (of course, you should keep money that you'll need soon in supersafe instruments, such as money-market funds and bank accounts).

Municipal bonds
The recession is putting pressure on state and local coffers, so why feel good about the prospects for municipal debt? Munis, which rarely default, are yielding far more than comparable Treasury securities. This state of affairs is an anomaly because interest from munis is generally free of federal income taxes. And because munis offer such generous yields, they should hold up far better than Treasuries when the economy and inflation pick up. Still, to be on the safe side, we recommend avoiding tax-free bonds with maturities greater than ten years. At ten years, you can still find 4% to 4.5%, tax-free. That's the equivalent of 6% or so from a taxable bond. Ten-year Treasuries, by contrast, yielded 2.9% in mid April.

Like most other sectors of the bond market, munis suffered last year, but confidence in them has improved. Despite California's budget disaster, the state sold $6.5 billion of general-obligation bonds in March, the third-largest muni issue ever. These A-rated bonds have already gained value. In mid April, a California GO maturing in 2019 with a coupon of 5.5% sold at $1,050 for each $1,000 of face value to yield 4.7% to maturity. For a Californian in the top income-tax bracket, that's like getting 8% from a taxable bond. And for the highest earners living elsewhere, it's the equivalent of 7.2% from a taxable bond.

Some discount brokers, such as Fidelity and Charles Schwab, offer scores of good-quality tax-exempt bonds supported by taxes or the revenues from water bills, highway tolls and the like. In mid April, a representative ten-year, double-A-rated, noncallable water-system bond, such as an Orlando utilities commission issue, yielded 4.8% to maturity. If you prefer a fund, Baird Intermediate Muni (symbol BMBSX) was the top medium-maturity muni fund in both 2007 and 2008. Other standouts include Fidelity Intermediate Municipal Income (FLTMX), a member of the Kiplinger 25, and Schwab Tax-Free (SWNTX).

Ironclad mortgages
Toxic mortgages are the match that lit the financial firestorm, but you can't blame government-guaranteed loans from the Veterans Administration or the Federal Housing Administration. The VA foreclosure rate is 1.7%, compared with 13.7% for adjustable-rate subprime loans.

The best way to own these loans is through a Ginnie Mae fund. Backed by the full faith and credit of the federal government, the Government National Mortgage Association guarantees packages of FHA and VA debt bundled together by private lending institutions. From the perspective of timely repayment of principal and interest, Ginnie Maes are just as safe as Treasuries but deliver significantly more yield. And although mortgage rates have fallen, many GNMA funds still own lots of older, higher-paying loans. For example, almost 40% of the loans in Vanguard GNMA (VFIIX) carry yields of more than 6%.

Vanguard's fund and other low-cost Ginnie Mae funds, such as Payden GNMA (PYGNX) and Fidelity Ginnie Mae (FGMNX), still yield about 5%. GNMA yields should decline by half a percentage point by the end of 2009 because lower mortgage rates encourage more borrowers to refinance. But these securities will generate higher cash flows after mortgage rates, like other long-term rates, start to turn up later this year.

Bank-loan funds
These funds hold slices of adjustable-rate loans and lines of credit that banks extend to companies with junk credit ratings of single-B or double-B. Adviser Mark Gleason, of Wescap Management Group, in Burbank, Cal., aptly calls a bank-loan fund "a hybrid between a junk-bond fund and a money-market fund." The bank funds currently yield 4.5% to 6%, which is far short of junk's double-digit yields. But their loans are safer because their terms are short, their interest rates float with changes in short-term rates, and they are ahead of bonds on the repayment pecking order should the borrower default. However, like stocks and junk bonds, bank loans gain value prior to or in the early stages of an economic recovery. Year-to-date through April 9, bank-loan funds returned an average of 11.1%, tops among bond-fund categories.

By contrast, in the three-month period that ended last November, the average bank-loan fund lost 29% as the credit crunch and selling by hedge funds slashed the value of bank debt. But defaults didn't get out of hand, so funds such as Fidelity Floating-Rate High Income (FFRHX) and the closed-end PIMCO Floating Rate Strategy (PFN) kept up decent monthly distributions even as their share prices dropped. These payouts are sliding because short-term interest rates are near zero, but bank-loan funds still offer better yields than short-term-bond funds. Gleason sees annual total returns of 9% to 11% through 2012.

Triple-B corporate bonds
This is the sweet spot in taxable bonds. In 2008, the gap between yields of a basket of triple-B-rated bonds and Treasuries exploded from two percentage points to six and a half. In mid April, the gap was almost five points, which is attractive when you consider that bonds rated triple-B are still considered investment-grade. Moreover, the category harbors a bunch of recession-hit companies that traditionally have carried single-A ratings. Today's triple-B roster includes Altria, Burlington Northern, Johnson Controls, Kraft Foods, Black & Decker, Sunoco and XTO Energy. All will thrive in better times.

For safety's sake, choose bonds from across several industries. Noncallable bonds are nice, but as rates rise, you won't see many redeemed early anyway. In mid April, an Altria bond maturing in 2018 and carrying a 9.7% interest coupon was priced to yield 8% to maturity. Bank and insurance bonds offer high yields because financial issuers are riskier than industrials, despite government efforts to keep them afloat without nationalizing them.

Pipelines
Energy prices will rise as industry expands and people drive more. So you can buy energy-income investments at sale prices and hold on for what should be higher future dividends. If you think oil prices will zoom or if you just want to hedge against inflation, buy BP Prudhoe Bay (BPT), a royalty trust that passes through cash from the sale of crude oil. BPT crashed last summer and has cut dividends two times since, but it's back to $68 from a low of $50, and it yields 6%.



If you don't want to gamble on energy prices, pipelines and storage facilities are the ticket. Their dividends depend on the amount, not the price, of the products that move through these systems. Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP) and Magellan Midstream Partners (MMP) all have long histories of delivering dividends reliably, and they currently yield from 8.8% to 9.2%. Because these firms are set up as master limited partnerships, they'll send you a Form K-1 at tax time, rather than a Form 1099, and that could mean extra work filling out your returns.

Preferred stocks
It wasn't just common stocks that went on a tear after bottoming on March 9. Preferred stocks, which act a lot more like bonds than stocks, also rallied strongly. From March 9 through April 9, iShares U.S. Preferred Stock Index (PFF), an exchange-traded fund, rocketed 66%, although it remains 45% below its 12-month high. Tom Taylor, of Thoma Capital Management, in Towson, Md., notes that a preferred stock from Bank of America (BAC.H) yields 14% to maturity in 2013 and cannot be called or exchanged. The stock surged from $5 to $15 between February 19 and April 9. But its face value is $25, so it can still go higher.

Preferreds, despite the reassuring name, are not risk-free. Issuers can cut or suspend preferred dividends, as a handful of REITs have done during the financial crisis. And if a company files for bankruptcy, bondholders take precedence over preferred investors. You can spread your risk with a fund that focuses on preferreds. John Hancock Preferred Income (HPI), a closed-end fund, owns far fewer financials than does the iShares ETF. At its April 9 close of $12, the fund traded at a 4% premium to its net asset value and yielded 15%. It would be better if the fund traded at a discount to NAV, but the modest premium is acceptable.

Junk corporate bonds
Let's face it: Recessions are not good for junk bonds and their issuers. Junk-rated companies are young, troubled, highly leveraged, or some combination of the three. So it's not surprising that they suffer when sales sink and questions about their ability to service their debt mount.

But the current recession has been less discriminating than most. Previous junk-bond routs involved "bad companies with bad balance sheets," says Mark Durbiano, a manager at Federated Investors who has seen the good, the bad and the ugly during a 25-year career investing in high-yield bonds. This time, he says, investors pummeled bonds of essentially good companies, such as First Data and SunGard, whose high debt loads earn them junk ratings. The average junk bond recently yielded 18%, a near-record 15 percentage points more than Treasury bonds.

But now, with signs that the economy is thawing and bargain hunters nibbling, things are starting to look up. The average junk-bond fund, which lost 26% last year, returned 6% in 2009 through April 9. The indexes -- but not the whole sector -- will take a temporary hit if General Motors, a huge junk-bond issuer, defaults. But the three primary junk ETFs -- SPDR Barclays Capital (JNK), iShares iBoxx $ High Yield (HYG) and PowerShares High Yield (PHB) -- hold few or no GM bonds (but plenty of health and technology issues). Each yields 10% or higher.

Wild closed-ends
We've saved our lottery tickets for last. Scott Leonard, of Trovena, an advisory firm in Redondo Beach, Cal., seeks out income-oriented closed-end funds in struggling but improving sectors that are leveraged, selling at big discounts to NAV. Dozens qualify. Consider, for example, Cohen & Steers REIT and Utility Income (RTU). At its April 9 close of $5.28, the fund sold at a whopping 25% discount to NAV and yielded a similarly massive 26%. Or look at BlackRock California Municipal Income Trust II (BCL). At a price of $10.18, it traded at a 19% discount to NAV and yielded 6% tax-free. Don't put more than 5% of your income assets into these kinds of funds because when they're bad, they're really, really bad.



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