EFT - EFT: A Good 10.86%-Yielding Income Fund For Rising Rates

2023-08-07 19:08:13 ET

Summary

• The pervasive inflation in the U.S. has led to declining real wages and strained household budgets, driving people to seek extra sources of income.
• Eaton Vance Floating-Rate Income Trust is a closed-end fund that specializes in generating income through investing in floating-rate debt securities.
• The EFT fund's portfolio primarily consists of floating-rate bank loans, providing diversification and low default risk, and has outperformed the aggregate bond index over the past year.
• The fund's net investment income is sufficient to cover its distributions, which is very nice to see for the long term.
• The fund is currently trading at a discount to the intrinsic value of the shares.

There can be little doubt that one of the biggest problems facing the average American today is the pervasive inflation that has been dominating the economy. This has driven up the cost of living, which is quite obvious by looking at the consumer price index. This index claims to measure the price of a basket of goods that is regularly purchased by the average consumer. This chart shows the year-over-year change in the consumer price index during every month in the past 25 years:

As we can clearly see, the year-over-year increase in the consumer price index has been substantially above the 25-year average over nearly the entire period of time after 2020. This has led to declining real wages throughout the nation, as wage growth has not been nearly as rapid as the price increases that have been seen over the period. This has strained the budgets of many households and forced numerous people to resort to extreme measures just to be able to afford to feed, clothe, and shelter themselves. This is probably one of the reasons why the job numbers keep coming in as good as they are, as large numbers of people have resorted to second jobs or have entered the gig economy just to earn the extra money that they need to survive. The takeaway here is that people are desperate for extra sources of income.

As investors, we are certainly not immune to this. After all, we require food for sustenance and energy to heat our homes and businesses. Many of us may also want to enjoy some of the luxuries that modern life offers. All of these things cost significantly more than they did a few short years ago, so we need higher levels of income than we once did. Fortunately, we do not necessarily have to resort to extreme measures to obtain this extra income. After all, we have the ability to put our money to work for us to earn an income. One of the best ways to do this is to purchase shares of a closed-end fund aka CEF that specializes in the generation of income. These funds are unfortunately not very well followed in the financial media and many investment advisors are unfamiliar with them. This can make it difficult to obtain the information that we would really like to have in order to make an informed investment decision, which is a shame because these funds offer a number of advantages over familiar open-ended and exchange-traded funds. In particular, a closed-end fund is capable of employing certain strategies that have the effect of boosting their yields beyond that of the underlying assets or indeed pretty much anything else in the market.

In this article, we will discuss the Eaton Vance Floating-Rate Income Trust ( EFT ), which is one closed-end fund that can be used by investors that are seeking to boost their incomes. This is evident in the fact that this fund boasts a respectable 10.86% yield at the current price. As some readers may recall, I have discussed this fund before, but several months have passed since that time so a great many things have changed. This article will therefore focus specifically on those changes as well as provide an updated analysis of the fund's financial condition. Let us proceed onward and see if this fund could be a good addition to your portfolio today.

About The Fund

According to the fund's webpage , the Eaton Vance Floating-Rate Income Trust has the objective of providing its investors with a high level of current income. This is not surprising considering that the name of the fund implies that the fund primarily invests in floating-rate debt securities. CEFConnect confirms this, stating that fully 94.68% of the portfolio is invested in debt securities:

We can also see that the fund has a fairly sizable cash position, which is actually rather unusual for a closed-end fund. However, it does make some sense in this case because most closed-end funds store their cash in money market funds and money market funds are by their nature floating-rate instruments. The remainder of the fund is primarily in floating-rate debt securities, such as senior bank loans and floating-rate bonds. This fits with the description that the fund provides in the fact sheet :

Unfortunately, this description does not state specifically what kind of floating rate securities the fund may invest in. There are a few different kinds including floating-rate bonds, senior bank loans, and even floating-rate preferred stock. This fund appears to be only focusing on debt securities though, so presumably that would be floating-rate bonds and loans. This is confirmed by the fact that 88.96% of the fund's assets are currently invested in floating-rate bank loans:

These are leveraged loans, which are bank loans that are made to companies that already have a significant amount of debt. These loans are then pooled and paid out to investors. It is a way to achieve diversification, as an individual bank will not have to bear the risk if a single multi-million dollar (or larger) loan made to a highly leveraged company goes bad. For investors, there is also a diversification benefit here since multiple companies are making their loan payments into the pools that back each of these securities. It works similarly to mortgage-backed security. When you purchase a mortgage-backed security issued by Fannie Mae or Freddie Mac, you are not funding a single homeowner's mortgage, you are funding a very small slice of dozens or hundreds of mortgages. Thus, this fund almost certainly has exposure to loans made to thousands or even tens of thousands of corporate entities despite the fact that it only has 511 positions itself. This is something that will likely prove somewhat comforting to those investors that want to limit their risk of losses due to a default.

This diversification is also a very nice thing due to the fact that leveraged loans are made to entities that already have a considerable amount of debt. As such, they are much more likely to encounter financial distress in the event of an economic downturn or other event that adversely impacts their cash flows. We can see this in the credit ratings of the securities that comprise the portfolio:

An investment-grade security is anything rated BBB or higher. As we can clearly see, that describes only 2.14% of the investments in the portfolio. It is highly unlikely that any of the unrated securities would have investment-grade ratings if they were rated since any company with a strong enough balance sheet to receive such a rating will almost certainly opt to have its securities rated in order to save money on interest payments. Thus, it appears that nearly all of the portfolio's assets are invested in junk-rated debt.

That is something that could prove to be concerning for risk-averse investors. After all, we have all heard horror stories about the high default risk of junk bonds. However, we can quickly see that 83.14% of the fund's portfolio is invested in securities that carry either a BB or a B rating. These are the two highest possible ratings for junk debt and according to the official bond rating scale , are only awarded to companies that have sufficient financial strength to handle all of their current debt even through a short-term economic shock. While the issuers of these securities are still not quite investment-grade, the actual risk of default is thus quite low. When we combine this with the high level of diversification that was already discussed and the fact that the fund has 511 separate positions right now, we can conclude that any actual principal losses due to default will not be noticed in the aggregate. We should not need to worry about the safety of the fund's holdings, at least as far as default risk is concerned.

The big risk with bonds is not default. That is easy to diversify away if there are enough holdings in the portfolio, and this fund certainly qualifies as having enough to accomplish this. The big risk relates to interest rates, and the fact that bond prices move inversely to them. In other words, when interest rates rise, bond prices decline. We saw this during 2022. As everyone reading this is no doubt well aware, the Federal Reserve has been aggressively raising the federal funds rate in order to combat the incredibly high inflation that has been wreaking havoc in the United States. As we can see here, the effective federal funds rate went from 0.08% in January 2022 to 5.12% today:

This is one of the most rapid increases in interest rates ever, and rates are currently at the highest levels that have been seen in the United States since 2007. This caused a great deal of devastation in the bond market, as the iShares Core U.S. Aggregate Bond ETF ( AGG ) had a -13.06% total return over the course of the year. The Eaton Vance Floating-Rate Income Trust did much better than this, though. The fund had a total return of -5.88% during the year:

It can be expected that this fund beat the aggregate bond index. This is because of the inherent protection against interest rates that the securities in this portfolio provide. The reason why bond prices decline with interest rates is that newly-issued bonds will have a coupon yield that correlates to the market interest rate at the time of issuance. This does not change over the life of the bond. As such, a bond issued today will have a coupon rate that is much higher than a bond that was issued at the start of 2022. As such, it makes no sense for anyone to purchase an existing bond when they could buy an otherwise identical one that has a much higher rate. The price of the existing bond thus needs to decline until it delivers a yield-to-maturity that is comparable to an otherwise identical brand-new bond.

However, the securities owned by this fund are different because they are floating-rate securities. This means that the coupon rate actually goes up when interest rates rise, so an existing security should always deliver a competitive yield to a brand-new security. As such, they should be able to hold their value much better in a rising rate environment. This is certainly the case, as the iShares Floating Rate Bond ETF ( FLOT ) delivered a 1.23% total return in 2022 and a 5.26% total return over the past twelve months. These figures both beat the aggregate bond index by quite a lot. The Eaton Vance Floating-Rate Income Trust compares favorably to this index fund, though. As already mentioned, the fund's portfolio delivered a -5.88% total return in 2022 but it also delivered an 11.85% total return over the trailing twelve-month period.

That is a pretty substantial outperformance, which speaks well to the quality of the fund's management. While past performance is no guarantee of future results, this strong twelve-month performance relative to the index is a very encouraging sign.

Leverage

In the introduction to this article, I stated that closed-end funds such as the Eaton Vance Floating-Rate Income Trust have the ability to employ certain strategies that have the effect of boosting their yields beyond that of any of the underlying assets. One of these strategies is the use of leverage. In short, the fund borrows money and then uses that borrowed money to purchase floating-rate debt securities. As long as the purchased assets have a higher yield than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, so this will be the case. Unfortunately, this strategy is not as effective at boosting yields today as it once was. This is because the difference between the yield of the purchased securities and the interest rate of the borrowed money is a lot less than it was back when interest rates were at 0%.

The use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that a fund does not employ too much leverage since this would expose us to an excessive amount of risk. I generally do not like to see a fund's leverage exceed a third as a percentage of its assets for this reason. Unfortunately, this fund slightly exceeds that level as its levered assets currently comprise 34.09% of its total portfolio. This is probably okay because the fund's leverage is only slightly above that one-third level and its assets are relatively non-volatile. After all, floating-rate securities should hold their value better than either stocks or traditional bonds in any interest-rate environment. Thus, the fund's balance between risk and reward appears to be acceptable but we do want to ensure that it does not take on much more in the way of leverage.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the Eaton Vance Floating-Rate Income Trust is to provide its shareholders with a high level of current income. In order to achieve this objective, the fund invests in floating-rate securities that deliver the bulk of their investment returns in the form of direct payments to the investors. The fund then applies a layer of leverage to boost the effective yield of the portfolio. Finally, it pays out all of its investment profits to the shareholders. As such, we can probably assume that this fund would have a remarkably high distribution yield.

That is certainly the case, as it currently pays a monthly distribution of $0.11 per share ($1.32 per share annually), which works out to a 10.86% yield at the current price. The fund's distribution has varied considerably over the years:

It is not surprising to see such considerable variation in the fund's distribution over time. After all, this is a fund that generates the majority of its income by holding securities that make variable payments based on the prevailing interest rates in the economy. As such, the fund would have to vary its distribution over time to keep its distributions in line with the money coming in. The fund has increased its distribution three times in the past year for this reason, as rising rates have caused the securities in the portfolio to pay more money to the fund. Unfortunately, the fact that the fund's distribution does vary so much somewhat reduces its appeal to those investors that are seeking a consistent and secure source of income to use to pay their bills and cover their expenses.

As is always the case though, we want to be sure that the fund can actually afford the distributions that it pays out. After all, a distribution cut will reduce our incomes and almost certainly cause the share price to decline.

Fortunately, we do have a very recent document that we can consult for this purpose. The fund's most recent financial report corresponds to the full-year period that ended on May 31, 2023. As such, it will give us a pretty good idea of how well the fund managed to capitalize on the general market strength that dominated the first half of the year. It should also give us some insight into how well the fund can cover its recent distribution increases. Finally, it is a newer report than we had available to us the last time that we discussed this fund, so it will also give us a simple update on the fund's finances.

During the full-year period, the Eaton Vance Floating-Rate Income Trust received $1,072,827 in dividends along with $48,224,702 in interest from the assets in its portfolio. This gives the fund a total investment income of $49,297,529 for the period. It paid its expenses out of this amount, which left it with $33,572,147 available for shareholders. That was actually more than enough to cover the $30,661,298 that the fund paid out in distributions. Thus, it appears that all this fund is really doing is simply paying out its net investment income to the shareholders. This is sustainable over the long term, however, it does mean that any event that causes the fund's income to decline will also represent a distribution cut. A fall in interest rates could have that result, although it seems unlikely that the Federal Reserve will be cutting rates in the near future. That belief has support in the fact that headline inflation will likely come in fairly high going forward due to rising crude oil prices.

Valuation

It is always critical that we do not overpay for any assets in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. In the case of a closed-end fund like the Eaton Vance Floating-Rate Income Trust, the usual way to value it is by looking at the fund's net asset value. The net asset value of a fund is the total current market value of all of the fund's assets minus any outstanding debt. It is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can obtain them at a cost that is less than the net asset value. This is because such a scenario implies that we are purchasing the fund's assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of August 4, 2023 (the most recent date for which data is available as of the time of writing), the Eaton Vance Floating-Rate Income Trust had a net asset value of $13.16 per share but the shares only trade for $12.14 each.

This gives the fund's shares a 7.75% discount to the net asset value at the current price. This is not quite as good as the 8.67% discount that the shares have had on average over the past month, but it is not an especially unattractive discount. The current price appears like a reasonable level to purchase the fund's shares, but it might be possible to get an even better price if you are willing to wait for a bit.

Conclusion

In conclusion, floating-rate bonds can be a good way to protect yourself against the losses that accompany traditional bonds during rising rate periods while still generating a high level of income. The Eaton Vance Floating-Rate Income Trust invests in a portfolio of these bonds and it appears to do a reasonably good job of it. This can be seen in the portfolio's overall diversification and the fact that it managed to beat the floating-rate securities index over the past twelve months. The fund boasts a very attractive 10.86% yield, but all it is doing is paying out net investment income, which is sustainable over the long term. The fund trades at an attractive valuation that is less than the fund's intrinsic value, which adds to its appeal. Overall, there could be some reasons to consider Eaton Vance Floating-Rate Income Trust today, especially if you expect interest rates to rise further.

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