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Income Investing

Income Investors, Get a Boost From a Floating-Rate Fund

In the first nine months of 2016, the average bank loan mutual fund earned 7.1%, as the loan market benefited from signs that things are improving for U.S. consumers.

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This may be a good time to move some money from cash and short-term bonds into floating-rate bank loans. By doing so, you may well boost your income and hedge against potential losses in your bond portfolio should interest rates climb in the coming year.

See Also: Investors, Don't Fear Higher Rates

After returning essentially nothing over 2014 and 2015, floating-rate bank loans are having a banner 2016. In the first nine months of the year, a Standard & Poor’s index of the 100 largest floating-rate bank loans gained 8.5%, and the average bank loan mutual fund returned 7.1%. Current yields for bank loan mutual funds range from 3% to 5%.

Floating-rate loans are typically made to borrowers with low credit ratings. Although the loans are called floating-rate, the interest rate that borrowers pay banks doesn’t adjust daily. Rather, rates typically change every 90 days, but not until market rates exceed a certain floor. So it’s possible that the next Federal Reserve rate hike, which many analysts expect to come in December, may not result in higher rates for borrowers with floating-rate loans.

Whether or not borrowing charges adjust upward soon, the bank loan market is benefiting from signs that things are improving for U.S. consumers. That matters because many floating-rate loans are made to retailers, casinos, cruise lines, hotel chains and other businesses whose fortunes depend on Americans spending freely. And because borrowers usually have subpar balance sheets, bank loans tend to perform poorly during periods of economic stress. For example, in 2008, in the depths of the financial crisis, the average bank loan mutual fund tumbled by nearly 30%.

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There are few no-load bank loan mutual funds. My longtime favorite is Fidelity Floating Rate High Income Fund (symbol FFRHX, yield 4.1%). It is the oldest and largest no-load bank loan fund and charges below-average annual fees of 0.70%. The fund has been a reliable place to keep money since 2008 (a 16.5% loss that year put it in the top 1% of its category). Fidelity Floating Rate lost 1.2% in 2015 and gained 7.9% in 2016 through September 30. The only other no-load fund I’d consider is T. Rowe Price Floating Rate Fund (PRFRX, 4.0%). The fund, which charges 0.82% for expenses, gained 1.2% last year and 6.0% in the first nine months of 2016.

For fans of exchange-traded funds, the most seasoned choice is PowerShares Senior Loan Portfolio (BKLN, price $23, 4.6%). The fund, a member of the Kiplinger ETF 20, lost 3.1% last year and returned 7.4% in the first nine months of 2016. Its expense ratio is 0.65%.

Then there are the 37 closed-end funds that specialize in floating-rate loans. But closed-ends, which, like ETFs, trade on exchanges, are much more complex than their cousins. Share prices of ETFs tend to closely track the value of their underlying assets, but prices of closed-end funds can vary widely from their net asset value (NAV) per share. Moreover, all of the closed-end bank loan funds borrow money—up to 35% of their assets—to boost payouts. The use of leverage adds too much price risk for me to call these closed-ends a substitute for cash. That said, most are selling for wide discounts to their NAVs. For instance, Voya Prime Rate Trust (PPR, $5, 6.0%), the oldest bank loan closed-end fund, traded at an 8% discount to its NAV on September 30.

Putting aside the structure of the funds, in the end they are more alike than different. The same names crop up on lists of holdings whether you’re looking at a fund sponsored by Fidelity, T. Rowe Price, BlackRock or Nuveen. Figure on lending your money (indirectly) to Albertsons supermarkets, Caesars casinos, Hilton hotels and a handful of technology companies. The important task is to choose a fund with hundreds of positions, in case any of them default. Fidelity Floating Rate and the PowerShares ETF both easily qualify.

See Also: Kiplinger's Interest Rate Outlook