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A 7.6% Yield Contrarian Bet On Interest Rates, Trading at a Big Discount

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There’s been plenty of discussion lately about where the Fed should be setting interest rates, especially considering over the last year expectations have changed from anticipating increases to cuts. The economy remains strong by many measures (e.g. strong GDP, low unemployment), yet the Twitter in Chief wants rate cuts to better compete internationally. And whilst this dramatic change in expectations has been occurring, one interesting 7.6% yield (paid monthly) floating rate closed end fund (“CEF”) has fallen very hard—perhaps significantly too hard. Specifically, not only have sinking rate expectations punished its floating interest rate holdings, but the pure selling pressure has caused the shares to trade at a very wide discount to the actual market value of its underlying holdings (it trades at an 11.6% discount to NAV). If you are an income-focused contrarian investor that likes to buy things at widely discounted prices—this one is worth considering.

Overview: Nuveen Floating Rate Income Fund (JFR)

Nuveen Floating Rate Income Fund (JFR), newly formed in 2014, is a diversified, closed-end management investment fund which seeks to achieve a high level of current income by investing in a portfolio of adjustable rate senior loans and other debt instruments. The fund seeks to invest at least 80% of its managed assets in adjustable rate loans, of which at least 65% of must be senior loans secured by specific collateral. Other loans may include unsecured senior loans and secured and unsecured subordinated loans.

Some of the potential benefits of the company’s investment philosophy are as follows:

Reduced volatility risk: The fund primarily invests in fixed income securities whose prices are relatively less volatile compared to common stocks

Reduced interest rate risk: The fund invests in adjustable rate loans, which are less sensitive to interest rates than most fixed income securities, providing a potential hedge against rising short-term rates

High income potential: The fund offers a potential for high monthly income by maintaining a well-diversified portfolio of primarily higher yielding loans

Floating Rate Funds:

A floating rate fund is a fund that invests in financial instruments paying a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest rate level. In the case of JFR, the underlying interest rate is predominantly limited to the 1 month or 3 month LIBOR rate.

Typically, a fixed-rate investment will have a stable, predictable income. However, as interest rates rise, fixed-rate investments lag behind the market since their returns remain fixed. Floating rate funds aim to provide investors with a flexible interest income in a rising rate environment.

Floating rate funds can include corporate bonds as well as loans made by banks to companies. These loans are sometimes repackaged and included in a fund for investors. Whilst such loans often carry a certain amount of default risk but they are considered senior debt, meaning they have a higher claim on a company's assets in the event of default. And the overall portfolio is well-diversified.

JFR’s Portfolio Characteristics:

JFR primarily invests in fixed income securities of companies based in the US, with 82% of the investments being in US-based companies, followed by 5% in the UK and 4% in Canada. The fund’s preferred choice of instrument is senior loans which account for 89% of the portfolio as seen in the table below[2].

Worth noting, bank loans can be attractive for their floating rate characteristics, but they are also not accessible to most individual investors because of the extensive legal documents and size of the loans. Therefore larger investment funds/strategies (such as JFR) invest in them thereby giving unique access to these often attractive securities to individual investors.

The fund is currently invested in a total of 360 holdings which are spread across various industries. Top 5 industries account for 42% of the total portfolio while diversification across issuers is even more spread out, with the top 10 issuers accounting for only 18% of the total portfolio[3]. Not being over-reliant on the performance of a particular industry or the performance of a few companies is beneficial as it helps in spreading out the risk component.

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Since, the company targets higher returns from its portfolio, investments are focused on higher yielding, below investment-grade loans. Only 14.6% of the company’s portfolio consists of investment grade bonds (BBB rated) while the remaining is below investment grade, considered to have a low credit quality. However, it is worth noting that 80% of the portfolio is just below investment grade which indicates that the firm is betting on slightly riskier assets for higher yields rather than being speculative with inferior assets.

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The Management Team:

JFR is run by Nuveen Fund Advisors, LLC which operates a diverse portfolio of closed end funds including four other floating rate funds - Nuveen Credit Strategies Income Fund (JQC), Nuveen Floating Rate Income Opportunity Fund (JRO), Nuveen Senior Income Fund (NSL) and Nuveen Short Duration Credit Opportunites Fund (JSD)[4]. The funds’ investment portfolios are managed by Symphony Asset Management, LLC (Symphony), a hedge fund manager which is an affiliate of Nuveen, LLC ($973 billion in assets under management as of 06/30/18).

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Scott Caraher took over as the senior portfolio manager for the fund from Gunther Stein, who departed at the end of 2018. Mr. Caraher is the co-head of investments, a member of the risk committee and responsible for Symphony’s retail and institutional bank loan-focused portfolios, including credit trading related to bank loans. Mr. Caraher has served more than 15 years at Symphony. Prior to joining the firm in 2002, he was an investment banking analyst in the industrial group at Deutsche Banc Alex Brown in New York. Mr. Caraher received a BS in finance from Georgetown University.

Expenses and Leverage:

JFR’s annualized operating expenses (including advisory fees) relative to average net assets were 3.41% as of 06/28/19. This is comprised of 1.35% of fund management and administration expenses, and 2.06% of interest expense. As of 06/28/19, the fund had total debt of $379.5 million, including $264.5 million of debt and $115.0 of term preferred shares, which equates to leverage of 37.75% to net assets.

Though the expense ratio seems to be on the higher side, it is worth pointing out that this is primarily attributable to the component of interest expense which is a direct consequence of the use of leverage. In our view, the management fees being paid to Symphony are reasonable, especially considering Symphony is an attractive boutique investment manager with deep expertise across a range of traditional and alternative investments through an array of vehicles and customized strategies.

And whilst the leverage ratio is significant, it’s not unreasonable considering the lower volatility of the asset class and the well-diversified nature of the portfolio. Further, the management team’s experience and discipline give us an added level of confidence. And worth noting, due to the large scale of Nuveen, LLC’s operations, this fund gets much lower institutional borrowing rates compared to the average individual investor.

Distribution Yield:

JFR has been following a policy of paying monthly distributions since inception, and the fund’s distribution yield is currently at 7.58%. Since the fund primarily invests in floating rate securities, it receives income as interest and in turn, the distribution is completely in the form of current income. On one hand, receiving distributions in the form of current income may have higher tax implications for investors as the tax rate for ordinary income is usually higher than the tax rate for long-term capital gains. However, from a sustainability standpoint, income distributions are usually more attractive than short-term capital gains and/or a return of capital (which can create some undesirable tax consequences related to lowering your investment cost basis). We’re comfortable with how this fund generates the income for its distribution payments.

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Discount to NAV:

JFR is currently trading at an attractive discount of 11.63% to its NAV. As seen in the chart below[5], this is considerably higher than the historical discount to NAV over the last 5 years, and this is attractive in our view.

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The level of discount/premium at which floating rate closed-end funds trade varies as per individual investors’ expectations (i.e. supply and demand for the shares). And considering the recent change in interest expectations from higher to lower, there has been a large amount of selling pressure on this floating rate fund—thereby causing the discount to get too wide (an attractive time to invest, in our view). Remember, the underlying securities in the fund are generally much more efficiently priced than the shares of a closed-end fund. And in this case, it has created an attractive opportunity to access the income stream of the underlying holdings at an attractively discounted price.

Risks:

One of the biggest risks associated with investing in this fund is the floating rate characteristics of the fund. However, considering the fact that rates are already quite low, the interest rate floor on many of the bank loans protects the interest rates from declining significantly. Another risk is the credit risk associated with below investment-grade loans as these loans carry a relatively higher risk of default (however, recall that the majority of the loans are “senior” loans thereby given them priority in the capital structure to subordinated debt tranches). And although corporate loan default rates are low, averaging around 3% in 2018, the level of corporate indebtedness is rising, not just in the US but around the world. However, some of the credit risk involved with investing in the debt of low-credit-quality companies is offset by a floating-rate loan's capital structure "seniority" and the collateral backing it. Historically, default recovery rates on floating-rate loans have been higher than that of high-yield bonds, which has meant lower potential credit losses for investors[6]. Not to mention, the diversified holdings of this portfolio (JFR holds a lot of securities) also helps to reduce risk.

Conclusion:

If you are an income-focused contrarian investor, JFR is attractive not only because of its big yield (+7.6%, payments are monthly), and not only because the market may be expecting more interest rate cuts than will actually happen, but also because the fund trades at a very attractive discount to its net asset value (to a large extent, JFR allows you to access the underlying income stream at a widely discounted price). Further still, the fund is able to access an asset class that is generally not available to individual investors (i.e. floating rate bank loans). And regardless of interest rate changes, this fund is extremely likely to continue paying big income distribution payments to investors. And if/when interest rate expectations start moving higher again (or at least less lower), this fund will perform particularly well thanks to its floating interest rate payments. We currently own shares of the Nuveen Floating Rate Income Fund (JFR) within our high yielding well-diversified Blue Harbinger Alternative Fixed Income (“AIF”) Portfolio.


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