FCT - FCT: Low Leverage Floating Rate Loan Fund 11% Yield (Rating Upgrade)

2023-10-10 05:23:53 ET

Summary

• First Trust Senior Floating Rate Income Fund II is a fixed-income closed-end fund that focuses on leveraged loans, offering a high dividend yield.
• FCT has outperformed other fixed-income offerings this year, thanks to its floating rate collateral and the current market conditions.
• The fund has a low leverage ratio of 18% for its asset class and an 11.7% dividend yield.
• The fund will continue to outperform the fixed-income market as long as rates stay elevated.

Thesis

First Trust Senior Floating Rate Income Fund II (FCT) is a fixed-income closed-end fund. The CEF has income as its primary objective and leverages up a portfolio of senior floating-rate loans to attain a high dividend yield. The fund is mostly made up of loans, with a very small sleeve for bonds, which make up 8% of the collateral pool.

The CEF has done extremely well this year, being up over 13%, when other fixed-income offerings have negative year-to-date total returns. The reason for the fund's outperformance is constituted by its floating rate collateral which has managed to successfully pass to investors higher rates. Floating rate funds, in any asset class, have done well this year.

We have covered this name before here , where we assigned it a hold rating due to the forward curve. As a reminder, at the beginning of the year, the Fed Funds forward curve was pricing Fed cuts as early as September 2023! Floating-rate loan funds will start lagging once the Fed starts cutting. But with ' higher for longer ' firmly entrenched in the market, and a forward curve that does not see any cuts until mid to late 2024, it is worth re-visiting the name.

The CEF has a low leverage ratio of 18% for the asset class, while most of its floating-rate loan CEF peers have ratios well above 30%. The fund has an 11.7% dividend yield, but it is only 80% supported. A retail investor is actually getting 10% in true dividend yield here. Expect this figure to persist until we see Fed Funds cut lower.

We find the leveraged loan asset class to be extremely attractive at the moment. Even if the Fed raises rates one more time on the back of inflationary pressures stemming from higher oil prices, leveraged loans will perform. FCT has a low standard deviation of 6%, and its price has been fairly constant in the past 12 months, with all dividend yields passed to investors.

The main risk factor here is represented by credit spreads. While the CEF's low duration allows it to outperform in a rising rates environment, a serious market downturn where credit spreads spike will put pressure on the fund. As a mitigant to a downturn we have the seniority of leveraged loans in the capital structure. Leveraged loans usually have a first lien on the assets of the underlying company, and they exhibit high recovery rates, which put a down barrier on their market prices.

Analytics

AUM: $0.26 billion.

Sharpe Ratio: 0.47 (3Y).

Std. Deviation: 5.94 (3Y).

Yield: 11.7%.

Premium/Discount to NAV: -10%.

Z-Stat: 0.82.

Leverage Ratio: 18%

Composition: Leveraged Loans

Performance

The CEF has outperformed so far in 2023:

We are comparing the fund with the leveraged Nuveen Floating Rate Income Fund (JFR) and with the unleveraged ETF Invesco Senior Loan ETF (BKLN). From a total return perspective, FCT outshines both its peers, with a 13.5% total return so far this year, versus only 8.6% for BKLN. The fund has been a great way to express a view on higher rates while taking advantage of the leverage loan asset class.

On a 3-year look-back, the fund has done well:

FCT has underperformed JFR due to the low leverage of the fund sports in comparison with the Nuveen name but has consistently delivered better results than BKLN.

Holdings

The fund has an average build, without any large 'CCC' concentration:

Many funds tend to make up for a lack of leverage via credit risk. Not here. We can see the 'CCC' bucket being fairly small at under 4%, although the fund does focus on 'B' rated names, which make up over 65% of the portfolio.

The fund takes a bit of concentration risk via its holdings:

We usually like to see the top names in a leveraged loan fund account for under 1.5% of the collateral, but this is not the case here. All of the top 10 names represent more than 2% of the fund, meaning that the collateral manager's credit acumen matters for this fund.

The positive performance recorded thus far by the fund comes down to its low duration profile and floating rate collateral:

The weighted average yield to worst for the portfolio is 10.2% at the current SOFR levels, and over 44% of the collateral pool contains interest rate floors.

Distributions

The fund sports an 11.7% dividend yield, but it is not fully covered:

As of the September 2023 payment date, as per the CEF's Section 19a, the vehicle is using 20% ROC to cover that distribution. That translates into an actual CEF cash flow yield of a little bit under 10%.

We are not big fans of ROC utilization, but we understand why fund managers do it. As long as ROC does not exceed 30% of distributions (in the fixed income space) we are fine with it if risk factors are favorable otherwise.

Conclusion

FCT is a fixed-income closed-end fund. The vehicle focuses on leveraged loans, a floating-rate asset class. This feature has helped FCT outperform, the fund being up 13% year to date, versus negative performances in other fixed-income sectors. When rates move higher, floating rate loans are one of the few pockets of the fixed income market where an investor can successfully 'hide'.

The CEF has a lower-than-normal 18% leverage ratio, a feature that makes it attractive when thinking about a conservative investment. Leverage magnifies returns, but also introduces volatility. The fund's 11.7% yield is not fully supported, with our rough estimate of a 10% true yield. Expect this figure to stay the same until the Fed starts cutting rates.

While duration is not an issue for FCT, credit spread widening does represent a risk factor. Given the seniority in the capital structure and high recovery, we are less concerned about credit spread risk here when compared to bonds.

With the market fully onboard with a higher-for-longer doctrine, leveraged loans look attractive until the Fed starts cutting rates. We are therefore upgrading the fund to Buy, with a 12-month investment horizon.

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