When interest rates are low and rising, floating-rate mutual funds are vehicles that may provide fixed-income investors with a way to achieve potentially significant higher returns, albeit by taking on more credit risk. The debt securities in these funds periodically adjust based on the prevailing interest rates, most often tied to a well-known benchmark such as the London Interbank Offered Rate (LIBOR). These funds typically have yields between those generated by investment-grade and high-yield bond funds.
Floating-rate loans are generally of lower credit quality versus investment-grade bonds, but interest paid generally adjusts every 30 to 90 days. The rate is based on an accepted standard, such as LIBOR, and a spread based on the creditworthiness of the borrower, the value of the collateral and associated loan covenants. Also known as senior bank loans, prime rate funds or syndicated debt, the loans are secured by inventory, hard assets or accounts receivables. These loans are generally senior to bonds, preferred stock and common equity within a company’s capital structure. This seniority compensates investors for the lower credit quality of the loans. After banks originate the loans, they are sold as collateralized loan obligations to hedge funds and mutual funds.
Aside from the potential for rising income, floating-rate bonds also have lower interest rate risk. Duration is used to measure this rate risk and a simple rule of thumb is that for every year of duration, a fund will fall 1 percent for every 1 percent increase in market interest rates. Most floating-rate funds have a duration below 1 year, indicating very low risk from rising interest rates.
Fund Overview
Investors seeking to increase the yield on the income-generating portions of their portfolios should consider the 5-star Morningstar rated RidgeWorth Seix Floating Rate High Income Fund (SAMBX). Managed by an experienced team led by George Goudelias, the fund seeks a high level of current income. Portfolio managers normally invest at least 80 percent of AUM in short-duration, fixed-income securities. In addition to certain hedging strategies, the fund may invest in loans to non-U.S. borrowers, including non-dollar-denominated credit. Supported by three co-portfolio managers, Goudelias has led the team since the fund’s inception in 2006. SAMBX still holds an overall five-star Morningstar rating.
Portfolio managers search for securities they believe are improperly graded by various ratings agencies. The team looks for securities with improving credit metrics, favors securities with strong underlying asset value, and prefers ratings of BB and B. The team will add securities with a lower credit rating if they meet the fund’s overall investment criteria. Managers avoid service industry-related firms with minimal assets and concentrate holdings in asset-rich organizations such as hospitals, broadcasting companies and energy firms. The team also prefers companies with improving cash flows, access to liquidity, strong management and attractive competitive advantages.
The fund generally eschews second-lien financing and other loans positioned lower in a company’s capital structure. Managers avoid loans with small deal sizes, shunning those valued at less than $300 million. The fund has less than a 3 percent stake in these smaller deals, which compares with the 11 percent allocation of the benchmark Credit Suisse Leveraged Loan Index.
Composition and Holdings
With 356 individual holdings, the portfolio features a 6.2 percent yield-to-maturity. SAMBX has an average maturity of 4.5 years and an average duration of 0.3 years. The 30-day SEC yield is 5.00 percent. Slightly more than 86 percent of AUM are allocated toward bank loans. The fund also has a 5.4 percent exposure to corporate bonds, a 5.7 allocation to government bonds and a 2.2 percent cash position. The credit distribution is heavily weighted toward B- and BB-rated loans. The top five holdings account for 12.28 percent of assets. The positions include SSC Government GVMXX, Fortescue Metals, Level 3 Financing, Hilton Worldwide Finance and Clear Channel Communications. SAMBX has a 33 percent turnover ratio.
Historical Performance
The portfolio’s slight overweighting toward the energy and commodity sectors detracted from last year’s performance as energy and commodity prices sold off. This was somewhat offset by the shift toward higher-quality BB-rated loans and a smaller exposure to lower-quality B-rated paper. Although the fund experienced a decline during the last financial crisis, it outperformed 85 percent of its peers. As of the end of August 2016, SAMBX has generated 1-, 3- and 5-year returns of 4.11, 3.14 and 4.97 percent, respectively. These compare with the benchmark returns over the same periods of 3.74, 3.41 and 5.32 percent, for the same periods
Risks, Fees and Distributions
The fund has a 3-year beta of 1.18 and a standard deviation of 3.47. Although SAMBX has an above average Morningstar risk rating, it features a low 0.62 percent expense ratio. It also has an above-average Morningstar return rating.
Suitability
The current low-interest-rate environment may encourage investors to search for financial instruments that deliver additional yield. In the case of bonds, investors can choose to add credit or interest rate risk, but as soon as rates rise, interest rate risk will bite into returns. Floating-rate funds provide a good compromise. SAMBX should perform similarly to high-yield bonds but with less risk. There is the opportunity to earn additional income from the price appreciation during a period of economic growth and anticipated higher interest rates. If the rise in interest rates this year continues into 2017, investors can look forward to rising dividends as the loans in the fund adjust higher.