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Floating Rate Bond Funds: 7% Income And Appreciation Potential

Summary Floating Rate CEFs like JFR are currently yielding 7% with huge 13% discounts to net asset value. Exposure to energy is only 3% (and net asset value reflects current prices). Prices fell as investors pulled funds in anticipation of Fed rate hike, leaving little downside and potential upside as any increases are likely to be moderate and investors flee equities. Floating rate securities, like the Nuveen Floating Rate Income Fund (NYSE: JFR ) fund have served as a bond alternative in my portfolio. The fund typically invests in debt that has an adjustable feature, where the interest rate is based on a margin over LIBOR. These securities have yielded 6%-7% over the past year and can provide strong returns. JFR and its ilk are ‘Closed End funds’, which can trade at a premium or discount to the underlying assets. In recent months, discounts have widened, which may signal an opportunity. The underlying investments of funds like JFR are bond-like products that provide the benefits of (relatively) high yielding senior, secured bonds with protection against rising interest rates and inflation. As mentioned above, the protection is derived from a margin over a LIBOR floor (e.g. 30 day LIBOR plus 700 basis points). Every fund is different, but generally, +/- 90% of the investments are loans with B, BB or BBB credit quality. Source: Nuveen If you are intrigued by closed end floating rate funds, there are to choose from. The four highlighted funds, all with Morningstar rankings of 4 stars or better are certainly worth closer inspection. Source: Morningstar (M* is Morningstar) While there has been a modest amount of decline in asset values (bond prices decline as interest rates rise and interest rates have been rising in anticipation of the Fed increasing interest rates), the values of the funds have fallen much more than the underlying change in asset values. The increased drop is reflected in the current discount (in the above chart). As you can see, every fund listed has seen an increase in discount to net asset value of between 220 and 460 basis points. This is a huge manifestation of these securities falling out of favor. However, they create an opportunity for buyers. (click to enlarge) Source: Morningstar As the above chart shows, net asset values are similar to those in mid-December, but the discount has widened significantly (especially in the last few weeks). The catalyst for the widening of spreads was likely a sale of JFR (in the example) in anticipation of the Fed increasing rates. Please consider these points: Any Fed increase is already “baked into” the market. Most observers expect the Fed to either delay or be very cautious with respect to raising rates due to low inflation and the negative impact of a strong dollar on the U.S. economy (higher interest rates will likely to cause the U.S. Dollar to further appreciate, making exports less competitive). Current volatility in the stock markets may cause a subset of investors to look for alternate investments; the same supply/demand equation which has driven the current high discount can reverse. Risk is mitigated through company and industry diversification, with the top ten holdings of a fund typically representing less than 20% of the funds investable assets. Similarly, industry diversification is also maintained, with no one industry type receiving more than 20% of a fund’s investable assets. The below tables represents the top ten holdings and industry diversification of my favorite floating rate bank loan fund, JFR ( Nuveen Floating Rate Income Fund ) as of July 31, 2015. Top Ten Holdings of JFR (Source: Nuveen) Holdings by Industry of JFR (Source: Nuveen) Investment returns are commonly enhanced by leverage, typically between 25%-40%. In the case of JFR, leverage was 38.1% at July 31, 2015 (Source: Nuveen). Fees Because of the unique nature of bank loans, there really needs to be an element of human involvement in assessing the underlying securities. Therefore, these funds typically carry hefty management fees and expenses. Paying professional management is contrary to my investing style, but given the need to assess and monitor, I make an exception in the case of floating- rate senior bank loans. As an example, JFR fees are currently running at an annualized 2.05% (including leverage costs). A Discussion on Risk- Macro Nothing in life is without risk. The underlying assets of floating-rate senior bank loans, while offering first lien position in investment grade securities do default on occasion. According to a study by Moody’s Investors Service, the average annual default rate on senior floating-rate loans has historically (including the recent recession) been 3.4% (1996-2012). The same analysis highlights a 71.1% recovery rate on these same loans over the same period. Ignoring the time to recovery, the data suggest that an annual loss rate of 1.0% is to be expected (3.4% x 28.9% non-recovered) in an average year. Logically, the loss rate would tend to be less in times of economic expansion and greater in times of economic contraction or recession. A Discussion on Risk- Micro JFR’s energy holdings represent less than 3% (in dollars) of current holdings (as of Nuveen data analyzed August 21). Any declines in these bonds are already reflected in net asset value. Further, about 90% of JFR’s holdings trade for 99 or more, which given bid-ask spreads mean the vast majority of JFR’s bonds are doing fine and trading for par (even after price drops due to rate concerns). Foreign holdings represent about 14% of total investments; however these bonds tend to be denominated in, and pay interest in, dollars. Potential Performance in Today’s Stable-to-Rising Rate Environment In addition to a monthly payment, which currently is an annualized 7%, there is the prospect of appreciation (on the closed end funds) as discounts decline from today’s 12%-13% to a more moderate 5%-7% or even a more normalized 3%-4%. Further, according to a study by Vanguard, the performance of floating-rate products during a period of rising rates outperforms the bond market by 4.3% (see an excellent discussion from Vanguard on floating-rate bond funds). Summary Floating-rate securities offer an opportunity to capture income, with appreciation potential and modest risk compared to bonds. The floating rate feature of the securities provides protection in the event interest rates do rise materially which the yield and opportunity to close the discount-to-net asset value provides income and appreciation potential. Disclosure: I am/we are long JFR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Between Chinese Slowdown And Falling Dollar, SLV Remains Up

Summary The Fed remains on the fence about whether it plans to raise rates next month. China’s economic concerns work as a double-edged sword for the silver market. The recent fall of the U.S. dollar has also helped pull up SLV. Will this rally last? In the past couple of weeks, iShares Silver Trust (NYSEARCA: SLV ) has slightly rallied. And even though concerns over China may bring down the price of SLV , on account of potential lower growth in demand for silver, the Fed is still likely to lead the way in moving SLV. The recent weakness of the U.S. dollar and the low chances of a rate hike in September are keeping up SLV. Will this recent rally last long? The Fed remains on the fence I think that if the FOMC was trying all along to keep us guessing on whether it plans to raise rates in September, then mission accomplished. The minutes of the July meeting only added more uncertainty with respect to the rate hike, which is still on the table for the September meeting. The minutes showed that members are mostly positive about the outlook of the labor market: “The pace of job gains had been solid and the unemployment rate had declined, with a range of labor market indicators suggesting that underutilization of labor resources had continued to diminish.” But it was noted that there are also remaining concerns over what the progress of wages: “In addition, it was noted that considerable uncertainty remained about when wages might begin to accelerate and whether that development might translate into increased price inflation.” For the silver market, a weaker Chinese economy — the recent news was that manufacturing PMI fell to its lowest level since 2009 — may also translate to lower demand for silver. But the recent changes due to these concerns, e.g. devaluation of its currency, may have also pulled down the U.S. dollar. Moreover, the latest news from China along with the moves towards devaluing the Yuan have kept the market guessing about the Fed’s rate hike. Currently, the implied probabilities of a September rate hike are at only 28% — still much higher than where they were after the release of the July FOMC meeting statement. The odds of a rate hike in October and December reached 34% and 60%, respectively. Not much higher than where they were earlier this month. This week, the second estimate for the second quarter GDP will come out. A stronger-than-expected growth rate – the current estimates are for 3.2% — could strengthen the U.S. dollar and slightly raise the odds a rate hike. Thus, a positive report could bring back down the price of SLV. But the big report will be released next week: the non-farm payrolls for August. Another strong report, especially when it comes to wages, could raise again the odds of a Fed considering raising rates sooner rather than later. I still think, it won’t behoove the U.S. economy at this point to have even such a modest rate raise, considering the latest developments in China, the lack of growth in wages, the low core inflation – which is still well below the FOMC target, the downward pressure of oil prices on inflation and the jobs growth in the energy industry. In total the FOMC may be better off to delay liftoff until 2016. But for now, the market remains confused. In such times, SLV slightly benefits, even for a short time, as it has rallied in the past couple of months. Moreover, the recent fall in the U.S. dollar has also provided back-wind for SLV. As you can see below, the price of SLV is still strongly correlated with the major currencies pairs, mainly the Euro/USD. (click to enlarge) Source: Bloomberg and Google finance On a broader scale, i.e. over a course of a year and not just over the past few weeks, the U.S. dollar has strengthened against other currencies, as presented in the chart below. (click to enlarge) Source: FRED and Google finance The rally of the U.S. dollar in the past year may have also contributed to the weakness of SLV. Only in the past few weeks, SLV bounced back as the U.S. dollar changed direction. Albeit the general direction in the past year for both of these items was reverse. Despite the weakness in the silver market, at first glance, the demand for the SLV ETF has only slightly diminished in the past several months. (click to enlarge) Source: SLV and Google finance This could suggest that even though the price of silver is going down, investors aren’t backing out of this precious metal. The recent devaluation of the U.S. dollar in part due to the weakness in China and possible delay in first rate hike in years has also provided a bit of relief in the silver market. I don’t think this rally will last long and could change course especially if the upcoming economic reports mainly GDP, to come out this week, and non-farm payroll, to be released next week, show stronger-than-expected numbers. But in any case, if the FOMC were to delay the historic liftoff to a later date (perhaps December), this could also provide another short-term boost to SLV. (For more please see: ” Will Higher Physical Demand for Silver Drive Up SLV? “) Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

An Exceptional Bond Fund For Improving Risk-Adjusted Portfolio Performance

Summary The Vanguard Short-Term Corporate Bond Index ETF is everything I would hope for in a short-term corporate debt exposure. The ETF has low volatility and low correlation with other important investments. The credit quality is respectable without being so high that it eliminates most of the yield. Using this fund as part of a diversified portfolio makes it shine. The Vanguard Short-Term Corporate Bond Index ETF (NASDAQ: VCSH ) is simply a great fund. I wish I could start more articles out with comments that are this positive. This fund is simply great. The yields are severely limited since this is short term debt with respectable credit quality, but the ETF on the whole is just exceptional when it comes to being part of an effective portfolio. Credit The following chart shows the credit quality breakdown. When it comes to a corporate bond fund there are two ways that I like to see the weightings. Either I would want a junk bond fund or I would want one with a credit breakdown similar to this. Personally, favor combining a fund like this with quite a few other bond funds to create a more complex group of bond holdings. Duration The following chart breaks down the duration of the funds. Holdings are almost all less than 5 years and usually more than 1 year. Again, this is a solid choice. If an investor wants to load up on even shorter term bonds, there are funds designed specifically for that. It is difficult to find a useful yield level on those ultra-short bonds so this is a reasonable portfolio composition. Sector The following chart breaks down the sector allocation: This sector allocation may seem absurd if an investor looks at numbers without reading the names. The names of the sectors indicate that rather than breaking down the market into all the corporate sectors, Vanguard is containing several other bond sectors that are not relevant to corporate debt. It wouldn’t make sense for this fund to have an allocation to foreign debt issues or MBS. My hypothetical portfolio, shown lower in the article, picks up those allocations through other ETFs. A Hypothetical Portfolio I put together a very simple sample portfolio using Invest Spy. Due to some of the ETFs being newer the sample period is limited to a little over two years. (click to enlarge) This hypothetical portfolio is weighted to 60% equity and 40% bonds. To break that down the weights from the equity section are 30% total market index (NYSEARCA: VTI ), 10% equity REITs (NYSEARCA: VNQ ), 5% Utilities, 5% Consumer Staples (NYSEARCA: VDC ), 10% International Equity. The bond section is holding 10% in junk bonds (NYSEARCA: JNK ), 5% in extended duration treasuries (NYSEARCA: EDV ), 5% in emerging market government bonds (NASDAQ: VWOB ), 5% short term corporate debt , 5% in short term government debt (NASDAQ: VGSH ), 5% in mortgage backed securities (NASDAQ: VMBS ), and 5% in intermediate-term corporate bonds (NYSEARCA: BIV ). This portfolio won’t be perfect for hitting the efficient frontier, but it should beat the vast majority of real portfolios investors are using on a risk adjusted basis. If long term rates were higher I would have used a higher weighting for long duration bonds due to their exceptionally correlation to major equity classes. My disclosure already states it, but I’ll reiterate that I am long VTI and VNQ. Annualized Volatility When measuring risk adjusted returns for a portfolio the most efficient method is usually to use the Sharpe ratio. For that ratio we are taking the total return annualized return and subtracting the risk free rate. Then we divide the resulting number by the annualized volatility. The problem is that this metric is only really known after the fact. Predicting the level of returns in advance is problematic but correlations and relative volatility are more reliable over time than returns. Within the chart investors can see the annualized volatility of each holding as well as the resulting annualized volatility for the portfolio. While some holdings have higher annualized volatility scores, such as EDV, the ETF makes up for that by having negative correlation to a few of the equity holdings. As a result, the ETF only contributes .6% of the total risk in the portfolio. VCSH has an annualized volatility of 1.8%, which is not bad at all. Once we adjust for correlation the risk contribution is extremely low. That means VCSH fits extremely well in this kind of hypothetical portfolio. The expected returns are not going to be very strong since this is short term corporate debt, but for an investor trying to achieve superior risk adjusted returns relative to the SPDR S&P 500 Trust ETF ( SPY), this is a great holding. It will usually underperform SPY, but it will result in material reduction in total portfolio risk. Correlation I want to dive a little deeper into the correlation statistics. The table below provides the correlation across each of those ETFs which should make it very quick to see which ones are work very well together. When a correlation is shown in the tan color it indicates a negative correlation which is very attractive for reaching the efficient frontier. You’ll notice that quite a few of the bond funds have negative correlations to VTI and the S&P 500. Since VTI and SPY have a correlation ranging between 99% and 99.9% depending on the measurement period, it should not be surprising that those two funds have very similar correlations to other holdings. Here is the correlation table: (click to enlarge) Conclusion When the ETF is placed within the context of a portfolio that is heavy on U.S. equities it looks like an intelligent way to reduce the overall risk of the portfolio. When it comes to generating alpha, I’ve often told investors that the secret to reaching alpha is to focus on reducing risk. Most other investors are already focused on trying to maximize their returns and many will take on more risk than they can handle. Focusing on risk reduction reduces the incentives for an investor to sell off after a big loss and makes it easier to generate alpha relative to the S&P 500 because it is easier to reduce risk through superior diversification. Disclosure: I am/we are long VTI, VNQ. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.