How Some High-Yielding Closed-End Funds Are Benefiting From Rising Rates

The Fed's decision to steadily jack up interest rates has spooked investors in some closed-end funds.

Rising rates make it more difficult for managers of closed-end funds to employ one of their main advantages and boost distributions by borrowing cheaply to buy stocks and bonds.

But there are closed-end funds that are benefiting from the rise in rates. They focus on "senior loans," bank loans made to companies that have credit challenges.

Not only is the interest rate on these loans higher -- you pay more when your credit isn't sterling -- but they also are floating rather than fixed.

While many other closed-end funds are feeling the pinch from all the rate increases, CEF's that specialized in senior loans are seeing a bump in returns because the already high rates these businesses are paying are rising higher still.

And that trend is only likely to continue, with the Fed signaling plans to continue raising rates amid a now strong economy and low unemployment.

"We are going to get at least two more bumps," says Tom Roseen, head of research services at Thomson Reuters Lipper, pointing to minutes from the latest Fed meeting that he says signal a "hawkish" stance on interest rates.

That brings up the second major attraction of closed-end funds that focus on senior loans. Since these are bank loans, there is a greater probability of recovering the money lent out should things turn south.

Banks are typically first in line when the push comes to shove and a company declares bankruptcy, with senior loans typically backed by real estate or other assets.

Closed-end loan participation funds, another term for this type of investment, have the highest one-year returns of any sector on the closed-end side that focuses on fix-income investments.

The average, one-year return of 4.9% is shade higher than general bonds (4.8%), U.S. mortgage funds (4.2%), and high-yield municipal debt funds (3.8%), according to a survey by Roseen and Thomson Reuters Lipper.

Like most closed-end funds, those specializing in senior loans also come with a potential bonus, with closed-end senior loan funds selling at a median discount of 7.67%.

That means you can get $92.33 worth of business loans for a dollar. If the spread narrows, then you can earn a nice bonus.

For the fixed income side, annualized yields are also decent.

Blackstone's GSO Senior Floating Rate Term Fund weighs in at 6.6%, followed by the Apollo Senior Floating Rate Fund Inc. (6.5%), and the Nuveen Senior Income Fund (5.8%.) Invesco has five closed-end funds specializing in senior loans, with yields ranging from 3.9% to 4.1%, according to Roseen's survey.

"On the closed-end side we get another benefit in that they trade at a discount," says Thomson Reuters Lipper's Roseen. "If I can buy something at 95 cents on the dollar and I can get yield, that is a benefit."

While the businesses making the big interest payments that power the profits of these closed-end funds may have greater credit challenges, that doesn't necessarily mean they are dogs, either.

It could be a case of a business in an industry that is out of favor, Roseen notes. Examples of companies with senior loans range from burger chains and airlines to a major computer company and well-known cosmetics firm. Tech start-ups and energy firms have also had to turn to senior loans to get the financing they need.

Still, there are also risks to investing in closed-end funds that specialized in senior loans.

For one, an economic downturn could hit these funds hard, with hard times meaning companies may have problems making payments on high-interest loans.

Closed-end funds that specialized in senior loans experiencing a rough ride in 2008/2009.

"Since they are loser credit-quality companies, if the economy starts going down or is not growing as robustly as it had been, these are the companies that are going to get hurt," says Ken Nuttall, director of financial planning BlackDiamond Wealth Management in New York.

If interest rates rise faster and higher than expected, that could also undermine the ability of some of these companies to pay.

"You are taking on more risk -- these are not investment grade and if they are not junk, they are just outside of investment grade," Roseen says.

And while banks will be first in line to get paid if some of these senior loans go south, how much they end up retrieving will hinge on the quality of the collateral pledged.

If that collateral is real estate, as it is in so many cases, the ability for the bank to get its money back will depend on the marketability of that real estate, potentially at a time when real estate prices may also be taking a hit.

Nuttall notes that bank loans can take 20 days to settle.

It's also important for investors to look closely at the closed-end fund's portfolio of loans. You'll want to see a diversity both of credit risk and companies and sectors as well, he says.

"If you have a fund that is all in one particular industry, that could be a red flag," Nuttall notes.

You also need to take into account not just the higher gains you can get from closed end senior loan funds, but the extra risks that make it possible, says Stephen Vogel, an advisor with Corvus Capital Management in Nashville.

In particular, closed-end fund managers can borrow and use leverage to boost results, something their open-end counterparts can't do.

However, in some cases, the distribution to investors may be just a percentage point higher for the closed-end fund than it is for an open-end fund that is also focused on senior loans, according to Vogel.

The investor must then make a judgement as whether the additional percentage point is worth the risk, for debt and leverage can accelerate a decline the same way it can fuel a gain.

"Starting with senior loan CEFs, there are definitely benefits to investing in senior loans when interest rates rise," Vogel notes in an email. "However, the extra benefits coming from a closed-end fund structure versus an open-ended mutual fund structure can be limited when investing in this space."

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