They say that beauty is in the eye of the beholder -- and I
suppose that's just as true in the financial world as anywhere
For most, the Fed's unprecedented string of stimulative rate cuts
couldn't have been better timed. Low interest rates make it easier
for consumers to finance big ticket purchases.
That's why traders typically cheer each time the Fed Funds rate is
lowered a notch or two. In fact, unexpected cuts have triggered
triple-digit rallies in the Dow.
But if you're part of the fixed income crowd, you probably see
things a bit differently. Lower rates mean lower yields on your
investments. Money markets and savings accounts pay next to
nothing. A 3-month Treasury will get you a negligible 0.01%. At
that rate, a $10,000 3-month Treasury will generate a grand total
of $1 in interest.
Another option is moving farther out on the yield curve. According
to Bankrate, 5-year CDs offer 2.85% and 20-year AAA corporate bonds
pay up to 5.22%.
But I'd avoid both right now. Because when interest rates start
climbing, you'll be locked in and unable to move your money --
unless you don't mind paying early withdrawal penalties or selling
your bond for much less than you paid for it.
But what if you could get payouts above 4% without having to tie up
your cash through 2029, or even the next three months?
I'm not going to spend too much time today trying to convince you
that interest rates are headed higher.
The Fed Funds rate has been slashed to near zero, so there's really
only one direction rates can go -- and that's up.
We're only here now because the Fed had to dispense an emergency
dose of monetary drugs to keep the U.S. economy from flat-lining.
But the patient has begun to recuperate, and sooner or later the
Fed will have no choice but to stop the medicine.
Keep in mind, we have a long way to go just for interest rates to
return to normal -- let alone elevated levels needed to choke off
inflation. So once the rate tightening cycle begins, don't expect
to see just one or two quarter-point hikes. The last time rates
sunk to 1.00% in 2004, they were ratcheted upward 17 times during
the next two years -- to a peak of 5.25% in 2007.
This doesn't paint a pretty picture for bonds, which move inversely
to interest rates. But there is one unique class of securities
built for this exact environment -- floating rate loans.
Floating rate funds go by many names: Prime rate, senior loan or
sometimes bank loan participation. Whatever you choose to call
them, these funds all contain pieces of syndicated loans that large
JP Morgan Chase (
issue to corporate borrowers.
As you know, banks profit by offering depositors low rates, then
loaning that money out at much higher rates and pocketing the
spread. With these funds, investors like you and me have a rare
opportunity to invest alongside the bank. This was once the
exclusive domain of large institutions -- retail investors weren't
access until 1989.
The loans come with a number of perks. These funds offer compelling
spreads over other types of bonds since underlying rates are tied
to benchmarks such as the Prime Rate or the London Interbank
Offered Rate (
). Default rates are quite rare, historically averaging less than
2%. In the event of liquidation, these loans carry the highest
claim on assets, followed by subordinated debt, preferred stock and
then common stock. So even when there's trouble, investors
typically recoup $0.80 on the dollar -- double what junk bond
holders may get.
While that assurance is nice, it's not what makes these funds so
attractive in today's market. The real selling point is that
interest rates tied to these loans are variable, not fixed.
Floating rate bank loans ratchet higher to adjust to rising
interest rates -- yields typically reset every 30-60 days.
Funds that hold these loans aren't just immune to rate hikes, they
actually benefit from them. Each time the Fed tightens the screws,
your dividends get a little bit fatter.
Back in 1994, when short-term rates were lifted six times, the
average bond fund fell -3.3%, while floating rate funds posted a
gain of +6.1%. The same thing happened again in 1999.
I think we'll see a more extreme version of this scenario play out
during the next two years.
All the signs are lining up in favor of floating rate funds in
2010. Aside from the prospect of rising yields, keep in mind that
these loans (like any debt) are affected by credit quality.
Improved balance sheets and rebounding cash flow could lead to a
series of upgrades in the year ahead.
The ETF Authority
P.S. After evaluating all the contenders, I've found one fund in
particular that has the most to offer investors right now: Nuveen
Senior Income (
). For my complete analysis -- and to see how you can profit from
this unique investment vehicle, visit this link.
Disclosure: Nathan Slaughter does not own shares of any security
mentioned in this article.
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