Written by Nick Ackerman, co-produced by Stanford Chemist
BlackRock Floating Rate Income Strategies (FRA) has made some big moves lately. In the past month alone, the fund’s discount has fallen from 5.42% to just 1.11%. A considerable drop from the 10% discount he was flirting with a year ago. It seems like all investors got the same memo this time around; higher rates will arrive in 2022.
This puts senior loans and funds that invest in senior loans in a particularly favorable position. They can benefit from the higher rates as a way to get more yield once they break through the rate “floor”. Stanford Chemist went into more depth on the subject of soil previously.
At the same time, the sister fund, BlackRock Floating Rate Income Trust (BGT), is trading a bit richer than FRA itself. BGT was last trading at a premium of 3.76%, but had recently breached the 5% mark several times. While she also flirted with the 10% discount just a year ago. It really shows how much capital has been pushed into these types of names.
Still, FRA is still a pretty compelling option to enjoy higher rates despite its lower discount. The attractive distribution yield it currently offers also makes it an attractive option.
- Z-score over 1 year: 1.93
- Discount: 1.11%
- Distribution yield: 5.8%
- Expense ratio: 1.13%
- Leverage: 31.35%
- Assets under management: $723.6 million
- Structure: Perpetual
FRA’s investment objective is “to provide shareholders with high current income and capital preservation consistent with investments in a diversified leveraged portfolio of debt securities and floating rate instruments”.
To achieve this investment objective, “at least 80% of its assets in floating rate debt securities, including floating or variable rate debt securities which pay interest at rates which adjust each time ‘a specified interest rate changes and/or resets on predetermined dates’. As is generally the case with these types of funds, the portfolio “invests a substantial portion of its investments in floating rate debt securities consisting of lower rated secured or unsecured floating rate senior loans. to investment quality.
The weighting to below investment grade securities will depend on the type of investments they make. Junk-rated companies dominate the senior loan fund space. They wouldn’t issue floating rate debt if they could. This means that it may be more sensitive to economic conditions.
The fund is a good size, but high leverage contributes significantly to it. Net assets are just under $500 million while borrowing $223 million. A leverage ratio of 31.35% is something to watch out for, but not uncommon in this type of fund. Senior loan funds often have higher leverage amounts.
The fund’s leverage comes from a floating rate credit facility. This means that the positive effects of higher rates will be offset by higher interest rate costs to some extent. The fund’s expense ratio is 1.13% but rises to 1.54% if leverage fees are included.
At the end of their six-month reporting period ending June 30, 2021, the interest rate was 0.95%. Quite low but will increase with rates. In some context, at the end of August 31, 2018, FRA’s weighted average interest rate was 2.4% on borrowings of $238 million.
Performance – Reasonable Results
That’s generally what I say about most senior loan funds. As I say again, senior loan funds were indeed not a very attractive place to stay invested over the past decade and now. With rates so low, their returns have been relatively lower than those of other asset classes. If you expect returns from the S&P 500, this is definitely not the right place to invest.
Instead, I think it is more appropriate to compare the fund to other senior loan funds. Such as its sister fund, BGT; we will also include Blackstone Strategic Credit Fund (BGB) and Invesco Senior Income Trust (VVR). These two, in particular, simply because I hold them in my own wallet as part of my senior loan. It makes sense to include BGT to try to determine why it is trading at a richer valuation.
Below are the latest 5-year total return figures. We can see that based on the total NAV return, FRA is coming in at the bottom and BGB is coming in at the top. Overall, the returns are pretty similar considering it’s a 5-year time frame.
We can also take a look at 10-year returns. In this case we have BGB carrying the bottom but FRA not too far behind. This could explain some of the valuation differences between FRA and BGT.
During both periods, BGT had outperformed its sister fund. In the grand scheme of things, however, it hadn’t been to any significant degree in terms of total NAV return. Instead, it was mostly thanks to the total stock price return. This reinforces why one might want to switch from BGT and FRA.
However, they are both still highly regarded compared to their historical lineups. This puts them in a difficult situation where they can benefit from higher rates, but rich valuations mean that some of the positives could be canceled out.
Distribution – Frequent Adjustments
Another area that income-oriented investors focus on a lot is the consistency of distributions. For FRA they have been adjusted a considerable number of times over the years compared to other CEFs. This seems to go hand in hand with the territory, as senior loan funds always have to adjust to interest rate levels. Rates have been falling for decades, which has put pressure on all Senior Loan fund distributions.
That being said, the 5.8% payout yield is quite attractive at the current level. The ANAV rate stands at 5.74%.
Distribution coverage will primarily come from net investment income. This is typical of most fixed income funds, so nothing special here.
The NII’s coverage has increased to 99% with the latest earnings data from their semi-annual report. That being said, at the end of November 30, 2021, we received an update on 3-month revenue coverage. It showed that coverage had dropped to around 81%.
This will be something to keep an eye on constantly. 3 month coverage, in my opinion, is less important than 6 months, or even better 1 year coverage levels. We should see an updated report from the FRA in about a month to get a better idea of the coverage. At least for now, they seem content to maintain the same payout rate, despite the lack of coverage. However, they announce distributions every month, so a change can happen at any time.
As mentioned earlier, the fund is dominated by investments in Senior Loans; in this case, BlackRock calls them “term loans”. Due to these floating rate investments, the effective term of the FRA is only 0.32 years.
Where we are starting to see diversification is in the fund’s sector allocations. Technical positions make up the majority of the fund. That being said, it is relatively diversified with a significant allocation to various sectors outside of technology as well.
From there, we can take a look at FRA’s credit quality breakdown. As warned above, the fund is invested primarily in companies rated as junk, as this comes with the territory of investing in Senior Loans. In this case, B-rated debt constitutes the bulk of this fund.
For some investors, that will be enough to scare them off. Certainly, it takes a strong economy to keep these types of investments continuing to repay their loans.
However, in addition to the industry diversification we touched on above – FRA also holds 456 different holdings. This greatly increases the chances that a position will not weigh too heavily on the portfolio.
The fund’s ten main allocations reinforce this observation. The top ten of FRA represent 12.03%. That’s a reasonably thin slice compared to some of the other funds we cover.
FRA has gotten a little richer lately, but is still a better deal than its sister fund BGT. This could provide quite an attractive moment to switch from BGT to FRA. However, both funds are highly valued relative to their own historical range. BGT has outperformed FRA over time, but that was mostly in the form of total stock price returns. Net asset value total returns had been quite similar otherwise.
Senior Loans and the funds that invest in them will be relatively more insulated from rising interest rates. The real question then is how high interest rates evolve and how long they might stay there.
I confess that I have no answer to these two crucial questions. This will depend on a multitude of factors beyond a single person’s control. This is why I invest in an essentially diversified portfolio. In my opinion, however, adding some exposure to something like Senior Loans isn’t a bad idea – a way to protect yourself a bit or take advantage of current market expectations.