PHD - Invesco Senior Income Trust: When Interest Rates Fall Time To Bail

2024-01-19 14:30:25 ET

Summary

• The Federal Reserve raised interest rates in an attempt to combat rising inflation from 2021-2023.
• Uncertainty remains about the market's response to the next rate decision in March.
• The article reviews the performance and prospects of the Invesco Senior Income Trust floating rate closed-end fund in the current inflationary and interest rate environment.

With rapidly rising inflation from 2021-2023, the Federal Reserve decided to raise interest rates in their attempt to combat inflation. For the six years from 2018 through the end of 2023, interest rates remained low until inflation started soaring in 2021 before peaking in mid-2022. Meanwhile, interest rates were forced to rise dramatically beginning in the summer of 2022 in an effort by the Federal Reserve to bring inflation back down to the target rate of around 2%.

Everyone probably knows the story by now, but what we do not know is what will happen next! As of the end of December, it appeared that the Fed was winning the inflation fight, but then lo and behold, the trend changed again. The ongoing high costs of food, shelter, and energy caused the inflation rate to tick back up again, even if only slightly.

Now, Fed forecasters and economists are not so sure if the market will respond positively or negatively to the next rate decision in March. Some Fed officials still believe that rates will be cut this year, but perhaps not as early as March.

"With economic activity and labor markets in good shape and inflation coming down gradually to 2%, I see no reason to move as quickly or cut as rapidly as in the past," Waller said in a speech at the Brookings Institution in Washington.

Cleveland Fed President Loretta Mester told Bloomberg TV in an interview that March is probably too early for a rate cut and that the CPI report shows the central bank still needs to bring inflation down further.

Richmond Fed President Tom Barkin said he is still looking for conviction that inflation is on track to reach the Fed's 2% goal, while Chicago Fed President Austan Goolsbee said he also needs to see more data before cuts can begin.

If rates do stay higher for longer, how will that impact closed-end funds, or CEFs, that hold senior secured floating rate loans and high-yield corporate bonds? Last year, several of those CEFs performed extremely well due to rising rates, and I discussed some of them in an article that I wrote back in September. In that article, I wrote:

The types of CEFs that I am referring to include those that invest in floating rate securities such as senior secured loans and corporate bonds. One reason to invest in CEFs that hold floating rate senior loans is because those loans sit at the top of a company's capital structure. In the event of a default, senior loans are paid off first before any corporate bonds or equity positions. Loans also have less credit risk and no duration risk because the loan coupons adjust with short-term rates.

In fact, there are several of those floating rate senior loan CEFs that have recently increased the monthly dividend payouts that they offer, and in some cases have raised the distribution multiple times over the past year. In this article, I am going to briefly review five of them for your consideration.

The 5 floating rate CEFs (floaters) that I reviewed in that article included:

1. Apollo Senior Floating Rate Fund ( AFT )
2. BlackRock Floating Rate Income Trust Fund ( BGT )
3. Nuveen Floating Rate Income Fund ( JFR )
4. Pioneer Floating Rate Fund, Inc. ( PHD )
5. Invesco Senior Income Trust ( VVR ).

Since that article was published (9/25/23) and through last Friday (1/12/24), all of them have shown a positive total return of from 2.5% to 6.5%, with VVR delivering the highest total return in that time.

In this article, I wanted to delve a bit deeper into Invesco Senior Income Trust to try to determine whether the fund can continue its outperformance in 2024 given the uncertain inflationary and interest rate environment that we find ourselves in.

While VVR performed well in 2023 with rising rates, will it continue to outperform once rates start falling? My gut tells me no, but I wanted to dig deeper into the fund holdings and strategy to determine whether VVR is a Buy, Hold, or Sell now in January. Back in September, I rated VVR a Buy, and then they raised the distribution again in October and the share price shot higher, closing the discount. The fund had been trading near the 1-year average discount of about -5-6%, but shortly after the October distribution increase it closed the discount to trade near par.

Then in late October the price dropped again along with the broader market, again widening the discount back to around -6% and has since closed the discount once more to trade near par again. Now in mid-January, the discount is starting to widen again as the market price has dropped over the past few weeks. I have seen this price action previously, and it appears to be due to an assumption that interest rates will be falling this year, although that assumption is being challenged again after the latest unemployment report, which showed ongoing strength in the labor market.

Level Distributions

As I have discussed regarding other high-yield CEFs in my recent articles discussing several CEFs that have raised distributions in 2024 and several that have reduced them, VVR pays investors a level monthly distribution that is paid based on the fund's managed distribution policy. The January distribution of $.0430 was last raised in October, as explained in the press release announcing this month's payout.

The Board of Trustees (the "Board") of Invesco Senior Income Trust (the "Fund") approved an increase in the monthly distribution amount payable to common shareholders pursuant to the Fund's Managed Distribution Plan (the "Plan"). Effective October 1, 2023, the Fund will pay its monthly dividend to common shareholders at a stated fixed monthly distribution amount of $0.0430 per share, an increase from a stated fixed monthly distribution amount of $0.0390 per share.

This statement from the press release also helps to explain the reasoning behind the managed distribution policy:

The Plans are intended to provide shareholders with a consistent, but not guaranteed, periodic cash payment from each Fund, regardless of when or whether income is earned, or capital gains are realized. The Plans may have the effect of narrowing the discount between each Fund's market price and the net asset value ("NAV") of each Fund's common shares, but there is no assurance that the Plans will be effective in this regard.

As it turns out, that increase in October was the second increase in 2023 following a raise in February when the fund went from $0.0320 to $0.0390 per share monthly.

Now trading at a market price of about $4.06 per share (as of 1/8/24 market close), the current annual yield works out to about 12.8% per year. The VVR fund does offer a discounted DRIP (dividend reinvestment plan) that allows shareholders to buy shares at below market price when the fund trades at a premium to NAV. The details of the DRIP are explicitly stated in the fund's semi-annual report .

Shareholders who participate in the Plan may be able to buy shares at below-market prices when the Trust is trading at a premium to its net asset value ((NAV)). In addition, transaction costs are low because when new shares are issued by the Trust, there is no brokerage fee, and when shares are bought in blocks on the open market, the per share fee is shared among all participants.

Portfolio Composition

The VVR fund holds roughly 550 individual securities as of 12/31/23 and is valued at about $728 million in terms of total assets. The majority of fund holdings include variable rate senior loans. The fund employs leverage of about 33% as of 1/17/24 (according to CEFConnect, which may not be a reliable source but has the most current data that I could find). The average maturity of the loans is around 4 years.

Some of the top holdings are with respected and familiar names including airlines, retailers, and other reputable businesses as shown in CEFConnect.

However, overall credit quality is lower than I would like to see in a fund that holds senior loans, with the vast majority of those loans rated below investment grade (BB or lower).

While defaults have remained at historic low levels, the trend is expected to show an increase in defaults heading into 2024, at least according to a recent forecast from Fitch Ratings.

Fitch Ratings is forecasting corporate high yield and leveraged loan default rates to rise in 2024 from 2023 levels before declining in 2025. We expect 2024 default rates of 3.5%-4.0% for leveraged loans, and 5.0%-5.5% for HY, up from 2023 default forecasts of 3.0%-3.5%, and 2025 default rates to range from 2.0%-3.0% across both markets. On an issuer count basis, we forecast 3.5%-4.0% for leveraged loans and 4.5%-5.0% for HY in 2024.

Default or credit risk is another risk to consider in addition to interest rate risk if you are thinking of starting a position in VVR. In fact, that risk is specifically called out in the fund's semi-annual report:

The Trust may invest all or substantially all of its assets in senior secured floating rate loans and senior secured debt securities that are determined to be rated below investment grade. These securities are generally considered to have speculative characteristics and are subject to greater risk of loss of principal and interest than higher rated securities. The value of lower quality debt securities and floating rate loans can be more volatile due to increased sensitivity to adverse issuer, political, regulatory, market or economic developments.

Summary and Conclusion

While VVR performed well in 2023 and offers income investors a level distribution that is paid on a monthly basis and offers a yield exceeding 12% annually at the current rate, I would rate Invesco Senior Income Trust a Hold at this time due to both interest rate risk and credit risk, with the potential for rising defaults due to a slowing economy in 2024. With a relatively short duration of fund holdings, many loans will be maturing and needing to be refinanced at potentially lower interest rates if the Fed does decide to reduce interest rates later this year, which will likely lead to a drop in net investment income.

While the fund currently trades near par (close to NAV) there is not much room for downside protection if the market goes through a correction, and we are already starting to see some reversion to a wider, or more typical discount over the past few weeks. For investors that already have a position in VVR, I would not suggest selling unless the Fed does announce a reduction in interest rates, and then I would be looking to sell before the price drops because I expect that it will happen quickly when the time comes.

Until then, I would suggest closely monitoring the fund for any signs of a reduction in the monthly distribution, such as a substantial increase in ROC in the fund's monthly distributions. There has been a slight increase in ROC over the past few months, but not enough yet that I would become concerned about it.

My expectation is that interest rates will probably remain elevated for longer than most people currently expect, so investors interested in the monthly income from VVR should be able to continue to hold for a few more months, but again, that could change quickly based on what the Fed decides to do in March at the next FOMC meeting.

Thanks for reading and good luck whatever you decide.

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