As Rates Climb, So Will This 6.6% Yielder’s Monthly Dividends
A bond fund that actually benefits from rising interest rates?
That’s the recommendation in the October issue of Nathan Slaughter’s High-Yield Investing advisory. Here’s how Nathan explains the idea behind this unique investment:
“Banks and other financial institutions profit by borrowing money at low rates (say 1%) and then loaning it out at higher rates (maybe 5%). If you don’t like the idea of settling for what the bank gives, then invest in what it receives.
“Bank loan funds, which invest in syndicated, packaged pools of this debt, give ordinary investors a way to do just that. They provide access to an asset class that once belonged almost exclusively to hedge funds and other institutional investors.”
#-ad_banner-#Nathan’s favorite bank loan fund is ING Prime Rate Trust (NYSE: PPR). It’s one of the oldest funds in this category, and its $1.2 billion portfolio is designed to balance capital preservation with high income. Even though the fund invests in debt that is below investment grade, most borrowers are solid, well-known companies, including BJ’s Wholesale Club, Wendy’s, Goodyear Tire, Neiman Marcus, and Caesars Entertainment.
This bank loan fund benefits from rising interest rates because the interest rates on its holdings reset every 40 days, allowing the fund to charge more when rates move higher.
And right now may be an ideal time to invest in this type of fund.
As Nathan explains, “The fund’s dividends move with interest rates, so yields have generally drifted lower over the past few years. And that is reflected in PPR’s distributions.
“Investors currently receive monthly paychecks in the amount of $0.033 per share. That amount is fully supported by earned income, with no return of capital. The monthly distributions add up to just under $0.40 per year — for a yield of 6.6%.
“And that’s near the low-water mark in the interest rate cycle.”
And what will a turning tide in interest rates mean for bank loan funds such as PPR?
As noted, the coupon rates tied to these loans are, by definition, variable. So as interest rates edge higher, the income they generate will move in lockstep.
Bank loans are tied to short-term lending benchmarks, most commonly the three-month London interbank offered rate (LIBOR) plus a spread of maybe 3% to 4%. The three-month LIBOR was recently around 0.3%, meaning the loans in PPR’s portfolio will pay 3.3% to 4.3%.
Actually, they’re returning a bit more, as Nathan points out. As an enticement to attract lenders, most issuers agreed to pay a floor rate of no less than 1.0%. So regardless of how low the LIBOR sinks, investors will at least get a 1% base rate plus the spread — for a minimum yield of 4% to 5%.
That insurance policy is paying off handsomely right now.
In the initial stages of a rising rate cycle, there won’t immediately be an increase in fund distributions. An uptick from, say, 0.3% to 0.6% won’t matter, because the LIBOR floors already guarantee a base rate of no less than 1.0%.
“But once we reach that level, any further increase in interest rates will be duly passed through to investors in short order,” says Nathan. “That’s why these funds have performed as advertised and outrun traditional bonds during rising rate periods — and since inception, PPR’s returns rank in the top 1% of the category.”
Note: Investing “conservatively” is about to get risky. Nathan has predicted an “imminent” bond crash that will roil markets and catch many unsuspecting investors off-guard. And when it happens, you’ll want to own investments like PPR. To learn more about what’s coming and how to prepare, click here.