PHD: Leverage Rising Interest Rates With This High-Yield Floating-Rate Fund

As the year 2022 nears its conclusion and investors attempt to navigate the constantly changing economic conditions and expectations for next year, some trends have become apparent and inevitable. One of those trends that we have witnessed this year that influences investment decisions is that of rising interest rates to combat inflation.

The Federal Reserve has raised the base interest rate from near 0 after the Covid-19 pandemic to rates approaching 4.5% as we look to 2023. And although the pace of rate increases is slowing slightly, the Fed still expects to raise the rates again next year. According to the latest “dot plot” from the December 14 Fed meeting, the target rate for 2023 is expected to be in the range of 5 to 5.5%.

For many equities, including those of growth stocks in industry sectors like technology, the rising rate paradigm poses a significant negative impact on corporate profit margins, causing investors to mark down the prices of those businesses. This is one primary cause of the bear market that growth investors have been witnessing this year. It has also created excess volatility in credit markets, which has caused high yield fixed income investments that are tied to interest rates to struggle as well.

For those investors who are interested in passive income from their investments in retirement, or who are preparing for retirement in the coming years, this has presented both a challenge and an opportunity. The challenge is in timing purchases of fixed income funds that have been seeing their market price decline even as the income streams that they generate continue to provide monthly distributions to shareholders. The opportunity is to be able to take advantage of market mispricing by buying those funds at currently depressed prices to collect high yield income streams in the future.

In the case of several high-yield fixed income closed-end funds (“CEFs”) that I follow, and which offer monthly distributions, the discount to the NAV (net asset value) is one measure of the fund’s affordability and can be evaluated against historical trends to determine whether the fund is a good buy at the current price. I have recently covered several of those funds, including Ares Dynamic Credit Allocation Fund (ARDC) here, and Nuveen Floating Rate Income Opportunity Fund (JRO) here.

In this review, I would like to introduce readers to a relatively small (with net assets of $180 million as of 10/31/22) leveraged loan fund that gets very little coverage on Seeking Alpha, offers a monthly distribution that has been increased 5 times in 2022 and now yields more than 11.5% annually, and currently trades at a discount to NAV of -11%. The Pioneer Floating Rate Trust (NYSE:PHD) offers attractive current income with relatively low volatility, along with portfolio diversification and greater performance potential in a rising interest rate environment.

Fund Overview

From the fund’s October fact sheet:

The Fund seeks a high level of current income by investing primarily in floating-rate loans. It also seeks capital preservation as a secondary objective to the extent consistent with its primary goal.

The fund’s inception date was 12/23/2004 and the total return based on NAV since inception is 4.29% (as of October 31, 2022), which is largely skewed downward by the negative performance over the past year, which amounts to -9.75% based on NAV. The fund’s holdings are largely comprised of below investment grade senior secured floating rate loans (~84%) and roughly 10% corporate bonds and other fixed income debt with primarily B-rated credit quality (BB and higher are considered investment grade).

The loan durations are mostly short-duration loans, with most of them maturing in the next 2 to 7 years and a weighted average loan life of 4.68 years. The fund holds about $121 million in common assets with total assets from borrowings of $57M and leverage at 32.6%. The fund expense ratio is 2.0% with 1% of that representing management fees.

The top 5 sectors as of 10/31/22 according to the fund fact sheet include:

The fund manager is Amundi S.A. (OTCPK:AMDUF), a large European asset manager based in Paris, France. Amundi has 5,400 employees and more than €1.8T in assets under management (“AUM”) serving more than 100M clients worldwide. The breadth and scope of their investments are global in nature, with less than 10% of the holdings in PHD coming from US companies.

From the December 19, 2022, press release announcing the December dividend:

Amundi US is the US business of Amundi, Europe’s largest asset manager by assets under management and ranked among the ten largest globally. Boston is one of Amundi’s six main global investment hubs and offers a broad range of fixed-income, equity, and multi-asset investment solutions in close partnership with wealth management firms, distribution platforms, and institutional investors across the Americas, Europe, and Asia-Pacific.

The top 10 holdings as of 10/31/22 indicate the level of diversification, with only a handful of holdings concentrated with more than 1.0% of the total portfolio value.

Comparing High Yield Leveraged Loan Income Funds

Since July of this year, the high yield leveraged loan funds that I follow, including ARDC, JRO, PHD, and two others including Invesco Senior Income Trust (VVR) and Apollo Tactical Income Fund (AIF), have all performed about the same, with total returns in the range of about 3 to 5% (VVR slightly better at 8%) and trending up as shown in this total return comparison chart from SA. All 5 of those funds have raised the distribution multiple times this year as well, and VVR also declared a special dividend due to excess undistributed investment income.

Yet the prices of each have continued to decline and each of those funds is trading at a wider than typical discount to NAV. The current discount for PHD is the widest it has been in nearly 3 years as shown in this pricing chart from CEFConnect, yet the fund holdings actually benefit from rising interest rates.

From the Fund Summary in the May 31, 2022, semi-annual report:

The outlook for continued below average loan-default rates is supported, in our opinion, by interest-coverage ratios for borrowers that have been more favorable than when the economy was entering the 2008-2009 financial crisis, or at the onset of the COVID-19 pandemic in the spring of 2020. And thus, under most scenarios, we think those factors should be sufficient for the loan market to absorb increases in the bank-loan reference rate likely to result from the Fed’s steps to normalize short-term rates.

Beyond 2022, we anticipate default rates could remain below average, as historical trends suggest that loan defaults typically have not peaked for nine to 12 months after the Fed has finished raising interest rates. Of course, historical precedent does not guarantee future outcomes. The outlook for Fed interest-rate increases should be supportive of loans, in our view, due to their floating-rate feature and low interest-rate sensitivity, especially as loan interest payments have continued to rise above their floors.

Thus, even though the secondary market prices of the underlying loans fall, unless the default rate rises substantially from the near record low levels that they have experienced in 2022, the loan payments continue to be paid, and bond coupons are covered so the net investment income is steady if not rising. Therefore, the NAV of the fund declines due to lower loan values, but the income available for distribution remains steady and even increases as the loans that mature are replaced with higher yielding loans financed at higher interest rates. The loan quality is a key consideration in the current market environment as explained in the semi-annual report:

In addition, the loan market has continued to trade at a discount to par (FACE) value, which has created the potential for capital appreciation. We will continue to maintain a focus on quality and careful evaluation of individual loans when choosing investments for the portfolio, especially if the Fed’s rate-raising cycle becomes more accelerated than anticipated and, at the same time, economic growth turns negative.

This pattern is reflected in the long-term total return performance of the fund as illustrated by Morningstar, which gives the fund a 3-star rating. The fund suffered a major decline in NAV in 2008/2009, again in March 2020, and has declined again in the past year. Still, an investor who bought $10,000 worth of PHD shares in 2004 would have nearly doubled that now with dividends reinvested.

Fund Distributions

On December 19, the fund manager announced the latest distribution payable on January 9 with an ex-div date of December 29. The distribution amount is $.0850, which is a $.0050 increase from the previous distribution and the 5th consecutive monthly increase. The distribution history for the past 12 months is shown in this chart from CEFConnect.

At the current market price of $8.70, as of 12/27/22, the annual yield works out to 11.7% based on that same monthly dividend going forward and assuming no changes in the next 11 months. As mentioned at the beginning of this article, PHD is a fund that is intended for long-term income-oriented investors. The fund generally has low volatility with a standard deviation of about 14 according to Morningstar, compared to the category average of 17.

For those investors who wish to further grow their income stream, the fund offers a DRIP option as explained in the semi-annual report:

When NAV is lower than market price, dividends are assumed to be reinvested at the greater of NAV or 95% of the market price. When NAV is higher, dividends are assumed to be reinvested at prices obtained through open-market purchases under the Fund’s dividend reinvestment plan.

That means that at the current discount to NAV of -11%, reinvested shares that are obtained through open market purchases will be reinvested at the 11% discount, giving investors yet more incentive to reinvest and buy more shares.

Summary and Recommendation

My belief is that the PHD fund will benefit from the continued increase in interest rates that the Fed is suggesting are likely to take place in 2023. As the price of the fund remains low and trades at a substantial discount to NAV, there is an excellent opportunity for long-term income investors to benefit from the combination of low market prices and an increasing distribution from the floating rate holdings. Some capital appreciation is certainly a possibility as well, especially if the economy begins to recover in 2023 and the overall market turns bullish again.

In the meanwhile, current investors in Pioneer Floating Rate Trust can reinvest shares at a discount each month and continue to grow the future income stream, which is exactly what I intend to do in my own tax-deferred retirement portfolio. It does not take a PhD to recognize the investment potential in the fund, PHD.