How to Protect Your Income Portfolio from Inflation

“As an investor, should you be worried about inflation? You bet. If you are retired and live on a fixed income like a pension, you will see prices rise much faster than your income increases. If you own long-term bonds, such as 30- year U.S. Treasuries, you can see their prices fall dramatically as yields rise to keep pace with inflationary expectations.

“So how can you protect yourself? You can invest in commodities such as gold, which hold intrinsic value and traditionally serve as a hedge against inflation. You can buy U.S. Treasury Inflation Protected Securities (TIPS) or closed-end funds comprised of them such as Western Asset/Claymore Inflation-Linked Securities & Income Fund (WIA). But while gold may protect you in the long term it has no yield and TIPS and their funds currently yield less than 4%. If high rates of inflation don’t emerge, you could continue to receive low returns for a while.

“One asset class is ideally suited to this environment—bank loan funds. These funds buy pieces of loans made by major banks such as JP Morgan (JPM) to large corporate borrowers. The loans are issued at floating rates, which are typically priced about 4 percentage points above a short-term benchmark such as the London Interbank Offered Rate (LIBOR). Libor is the interest rate that banks charge each other on loans, and it tends to follow the Federal Reserve’s key short-term rate. The rates on these bank loans reset every 60 to 90 days, so if rates do rise, you benefit from higher rates. But if inflation stays tame, you still capture a handsome yield and a steady monthly income stream.

“Closed-end funds that invest in these floating rate bank loans offer steady yields of around 6%. To ensure these returns even when rates are low, the funds often hold other assets such as corporate bonds, and use leverage. Normally, I am cautious about highly leveraged funds, since borrowing costs can squeeze their profits in a rising rate environment. But these funds are borrowing money at floating or short-term rates and reinvesting at floating or short-term, providing a natural hedge against rate increases. Typically, the funds invest in loans made to companies with a sub-investment credit rating of BB or below. These loans command top interest rates. True, there is some risk of default, but these loans are senior. In case of bankruptcy, the bank has first claim on the borrower’s assets, ahead of most other stakeholders of both secured and unsecured subordinated debt, as well as preferred or common shareholders.

“Also, the loans are typically secured by liquid assets such as accounts receivable or inventory, and occasionally even by real estate. Plus, the bank imposes covenants or loan provisions designed to keep the company from taking actions that would hurt its credit rating. As a result, senior bank loans have a historical recovery rate of 66%, well more than the 37% for traditional high-yield bonds, according to Moody’s. Moreover, with the economy stabilizing, default rates have dropped enormously. The U.S. speculative grade default rate was 3% in February 2011, down from a peak of 14.7% in November 2009. Moody’s predicts the rate will drop to 1.6% for 2011.

“What if inflation really is ‘transitory’ and interest rates don’t rise dramatically? Worst case, you would be paid to wait, reaping high yields of close to 6% for your patience. At best, you would receive both high yields and capital gains, as inflation expectations ramp up. With that in mind, one strategy is to gain exposure to bank loan funds while tightening is still just a gleam in the eye of some Fed presidents; then, dollar cost average into them when the tightening cycle starts.

“Are there risks to this strategy? Yes. A double-dip recession triggered, say, by oil prices rising to $150 per barrel, could lead to higher default rates and hence a decline in the price of bank loan funds. Still, this may be a risk worth taking while you can still find funds that are trading at a discount to their historical valuations.

“Meanwhile, valuations are creeping up, as investors rotate into this sector. In just the first two months of this year, bank loan funds already have attracted $10 billion, according to Morningstar. That puts them on track to far surpass the record $16 billion of inflows for all of 2010. If inflation does accelerate, and rates increase, returns on senior loan funds should become even more robust.

“Which funds look the most attractive? Of some two dozen bank loan funds, I identified a little more than half with a yield of 5.5% or better. I then screened for the quality of the distribution—eliminating funds that doled out large doses of return of capital, or showed weak earnings coverage. I also steered clear of funds trading much above their historical discount or premium to net asset value (NAV). [One of] my top two picks [is] examined below.

Eaton Vance Senior Floating Rate Fund (EFR – yield 6.10%)—This fund is managed by Eaton Vance (EV), one of the oldest fund managers in the U.S., dating back to 1924. The firm was also one of the first to invest in the senior loan fund category in 1989. EV’s Floating Rate Fund was launched in 2003. Its $800 million portfolio invests in U.S. senior secured floating rate bank loans. The fund is well-diversified, with senior loans to 360 individual borrowers across different industries. The largest weighting is in healthcare, at 12% of the assets. Loans from private satellite provider Intelsat, drugstore chain Rite Aid (RAD), and hospital operator Health Management Associates (HMA) counted among the top holdings at January 31. Nearly half the assets are just one-notch below investment- grade at ‘BB,’ giving the entire portfolio a fairly secure credit rating of ‘BB-.’ Interest rates on the loans reset on average every 47 days, and currently, the loans carry an average rate of 4.1%. To boost that yield, the fund invests about 6% of the assets in high-yield (speculative grade) corporate bonds and employs leverage on 35% of the portfolio.”

Carla Pasternak, High-Yield Investing, May 2011

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