Floating Rate Loans Look Attractive

By Aaron Levitt | April 02, 2012 AAA

Finding strong sources of income remains a top priority for investors these days as the Federal Reserve continues to keep interest rates low. Traditional sources of income, like CD's, money markets and other short-term instruments, continue to provide paltry payouts. To get any sort of real yield, investors have been forced to get out of the maturity ladder and funds like the iShares Barclays 7-10 Year Treasury (ARCA:IEF) have become popular portfolio choices. However, when the Fed finally begins to raise rates, investors in these longer dated bond funds could see capital losses. Income seekers are certainly in a tight spot. Luckily, there's an often-ignored bond type that could offer the best of both worlds: a high yield and interest rate protection.

SEE: Dividend Yield For The Downturn.
Finding Protection in Floaters
For investors looking for potentially higher income and protection from Bernanke, floating rate bank loans could be an answer. At their core, these types of funds invest in the loans that banks make to corporations. Oftentimes, these companies fall below the investment grade debt ratings of BBB or lower on the S&P, and Baa or lower on Moody's. Therefore, they offer higher starting yields than treasuries. However, unlike standard junk bond funds such as the SPDR Barclays Capital High Yield Bond (ARCA:JNK), floaters do have some unique advantages. First, these styles of bank loans adjust rates every 30 to 90 days, making them quite attractive in rising rate environments. Second, these debt instruments usually are secured by a company's physical assets, such as a pipeline, warehouses or equipment. Thus, floating rate loans are a preferred funding method for telecoms, utilities and smaller energy companies.

Thirdly, and perhaps the most important feature of these loans, is seniority in instances of default or bankruptcy. Many of these loans come as first lien or senior debt, which take precedence over all other claims (save for those initiated by Uncle Sam). This gives loan holders the number one spot in bankruptcy proceedings, jumping both preferred stocks and even junk bonds issued by the same company.

SEE: Junk Bonds: Everything You Need To Know.

So far, investors have put more than $71.7 billion into floating rate funds, reaching a seven-month high. However, analysts predict that the sector still could hold value for investors. Many loans are currently trading at discounts to par at nearly 94 cents on the dollar. This leaves room for principal appreciation as well as yield.

Betting on the Bonds
Floating rate bond's high yields and effective zero duration rates make them an ideal candidate for the current low interest environment. There are a number of floating rate bond ETFs, including the iShares Floating Rate Note Fund (ARCA:FLOT) and SPDR Barclays Cap Inv Gr Floating Rate ETF (ARCA:FLRN). However, the only one to gain traction with investors has been the PowerShares Senior Loan Portfolio (ARCA:BKLN). The fund tracks 120 different senior floating rate loans and currently yields 4.97%. Expenses run a high 0.79%, but could be worth it as the fund offers protection against rising interest rates.

Some of the more interesting choices in the floating rate loan sector can be had via closed ended funds. The ING Prime Rate Trust (NYSE:PPR) is one of the oldest closed end funds (CEF) operating in category and holds 275 different loans. Likewise, the First Trust Senior Floating Rate (NYSE:FCT) and Pioneer Floating Rate Trust (NYSE:PHD) offer broad exposure as well. The funds currently yield 6.23%, 6.25% and 7.03%, respectively. In addition, investors may be able to snag these funds at discounts to their net asset values. All three are trading very close or slightly under their NAVs.

The Bottom Line
The search for income continues to remain a major priority for investors as interest rates still sit at historically low levels. In order to get yield, many have moved up the maturity ladder. However, that could be a bad thing when the Fed begins tightening. For those seeking high income and interest rate protection, floating rate loan funds could be the answer. The previous picks, along with the Market Vectors Floating Rate ETF (ARCA:FLTR), make ideal selections to play the asset class.

SEE: How Safe Are US Bonds?

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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