My Favorite Pick In The Asset Class That Benefits From Rising Rates…

Right now, the talk among Fed watchers is whether we’ll see a “pivot” in the pace of rate hikes issued by the central bank.

There’s little doubt that rates will be lifted by another 0.75% in November. But the debate is whether the pace of future rate hikes should be moderated or not.

As I’ve pointed out before, the Fed has a dual mandate, Its job is to stabilize prices and maximize employment. And right now, with near record-high inflation, stabilizing prices is taking precedence.

In this rising rate environment, it’s been tough sledding across the asset class spectrum. Everything from stocks to preferreds to bonds and municipal bonds has taken it on the chin. But remember, rule number one of income investing: prices move inversely to yields. So if yields are climbing, then prices are sinking.

That means, at some point, the yields will be too good to pass up. And investors will start to pile in.

But why wait? There’s an opportunity in one asset class that directly benefits from rising rates.

I’m talking about bank loan funds.

I wrote about bank loan funds back in the summer (here and here). But don’t just take it from me… Jeff Gundlach, CEO of investment management firm DoubleLine, has touted bank loan funds for much of this year.

Gundlach was named by Barron’s as “The New Bond King” a few years ago. And with $127 billion under management, he knows a thing or two about the markets.

There’s a lot to like about bank loan funds. I’ll tell you a little bit about my favorite in just a second. But first, let’s recap some of the benefits they offer to income investors…

These Funds Benefit From Rising Rates

You may have heard of bank loan funds referred to as senior loans, prime-rate loans, syndicated loans, or floating-rate loans.

Previously only open to hedge funds and other institutional investors, a variety of mutual funds, closed-end funds, and exchange-traded funds (ETFs) exist to hold packaged pools of bank debt.

These loans are typically made to sub-investment-grade companies with less than stellar credit. Because the borrowers don’t have the strongest balance sheets, some credit risk is involved. But that risk is mitigated by restrictive covenants, which prevent the borrowers from taking any action that the bank feels is detrimental to getting its principal back. Second, whereas most bonds are unsecured, these are backed by tangible collateral such as property, equipment, and inventory.

As the senior lender, the bank originating these loans is entitled to recover its money ahead of other creditors in the event of non-payment. So, it’s first in line. But that’s normally not an issue because defaults are pretty rare, running around 2%.

Now, here’s where we get to the good part…

The rates on these loans are variable (or floating) rather than fixed. Most are linked to a short-term benchmark such as the London inter-bank offered rate (LIBOR), plus an extra 4%.

Take a look at the chart of the 3-month LIBOR below…

In January, the LIBOR was at a paltry 0.2%. It’s risen to 4.37% in October, meaning many bank loans are now paying 8.37%. Incredible. As short-term rates continue to rise, so will bank loan yields (interest rates reset every 30 to 90 days).

Of course, the reverse is also true in a falling rate environment. But remember, the current talk is about the Fed moderating rate hikes, not reversing them. So the wind is at our backs here.

My Favorite Pick In This Unique Asset Class

Investors worried about rising interest rates and wanting to earn a solid income stream should be looking at bank loan funds. I’ve mentioned a few names to consider in previous articles, but today I’ll tell you a little about my favorite…

Launched in 2004, BlackRock Floating Rate Income Trust (NYSE: BGT) narrowly focuses 80%-95% of its $400 million in assets in this unique space.

With 450 holdings, the portfolio is well diversified across over two dozen industries, including auto parts, construction, software, healthcare equipment, and wireless telecom. The largest holding accounts for just 1.3% of assets, so there is minimal risk associated with any single issuer.

Like all floating rate funds, the bulk of BGT’s assets reside a couple rungs below investment grade on the credit-quality ladder. But most are backed by established, well-known corporate borrowers such as American Airlines, Murphy Oil, PetSmart, and Wyndham Hotels.

The average loan in the portfolio currently has a coupon of 5.3%. But remember, these loans reset every two to three months. So given the coordinated global rate tightening efforts, that figure is likely to be higher by November/December.

The variable nature of these loans means BGT has very little exposure to rate fluctuations. But that rate protection doesn’t mean you have to sacrifice income. The most recent monthly distributions was 7.8 cents per share, which provides a healthy forward yield of 8.6%. That’s double the 4% you’d get from a 10-Year Treasury – without having to tie up your money until 2032.

Now, that doesn’t mean BGT is bulletproof. While interest rate risk is nil, the fund does carry some credit quality risk. As interest rates rise, I expect to see more strain on some of the weaker issuers’ ability to pay their notes.

But BlackRock’s credit research team is highly regarded. And with the economy still broadly supportive, any downgrades (or worse, defaults) will likely be isolated cases. And management has also been overweighting higher-rated B and B+ issues and steering away from the more volatile CCC spectrum. When it sees relative value, management will even gravitate to investment-grade corporates.

Action To Take

As mentioned earlier, bank loan funds aren’t just immune to rate hikes — they actually benefit from them.

Like most closed-end funds, BGT takes full advantage of leverage, borrowing money at low rates and reinvesting the proceeds at higher rates. BGT has borrowed roughly 31.7% of the total managed assets. Remember, while this strategy pays off more often than not, it can exacerbate losses in a falling market.

Fortunately, I don’t see that on the horizon. After years of stagnating near zero, short-term rates are screaming higher at the fastest pace since the mid-90s while credit conditions remain resilient – the ideal environment.

There are cheaper bank loan funds out there, but the 1.08% yearly management fee is well-earned, in my view.

With a low correlation to traditional fixed-income groups, BGT can be an effective diversification tool. As an added bonus, the shares are currently trading at a wide 10% discount to their net asset value (NAV).

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