Fidelity’s active floating rate loan fund

Managing risk as rates rise

Floating rate loan funds are a relatively new and as yet unheralded concept in retail investing, with only a couple of the 15 funds in the category having a 10-year history. But with interest rates now on an upward trajectory (and equity markets seemingly in retreat), they’ve begun to attract considerably more attention. In fact, the category’s performance in recent months has been near or at the top the fund listings.

So what exactly are floating rate loan funds? According to the Canadian Investment Funds Standards Committee (CIFSC), funds in this category must commit to investing at least 25% of their portfolio in non-investment grade (lower than BBB or equivalent) floating rate loans.

“These loans are not registered securities, they are syndicated bank loans,” says Kevin Nielsen, a portfolio manager in the high-income division at Fidelity Investments in Boston, MA, and co-manager (with Eric Mollenhauer) of the FundGrade A+® Award winner (2016) Fidelity Floating Rate High Income Fund. “You can’t just go out and buy them on your own. “It’s a very different asset class, one that has grown pretty quickly in the past few years.”

Neilsen explains that usually lenders (in this case commercial banks) would tap other banks to syndicate the risk on large loans, but in recent years that net has been cast further and further afield. “If the bank extended a $100 million loan to a widget company, for example, they would go to other banks to spread the risk. But then gradually they started going to institutional investors, and now they’re in mutual funds.

“The structure of these loans is similar to other fixed-income investments such as bonds,” says Nielsen, “but the unique part is the floating rate on the coupon. It’s not fixed, but rather is indexed to LIBOR” (the London Interbank Offered Rate, a benchmark representing the average interest rate at which banks lend funds to one another, and calculated daily from estimates submitted by leading global banks).

So, for example, at press time LIBOR was 270 basis points, or 2.7%, according to Nielsen, and the spread was 330 basis points (3.3%), so the average yield would have been 6%. “The spreads do move, though. For example, during the financial crisis the spread went to 5%. When the markets are doing better, the spread gets smaller.

“Obviously, the issue of supply and demand can also drive prices and impact returns, but the coupon helps to offset some of the price volatility,” Nielsen adds. “And the floating rate takes away some of the interest rate risk when rates are rising. This feature has put us in the spotlight as investors start looking for protection.”

In terms of actual holdings, the CIFSC mandates a minimum BBB rating, but Nielsen says their fund’s holdings average around B or BB. “The high single Bs are most interesting, because they are the most difficult to rate accurately,” he adds. “People misunderstand them, but if you do your homework you can beat the competition by picking up companies that are rated worse than they should be and avoiding companies that are overrated.

“Of course, if you get it wrong, then you can go to zero,” Nielsen adds. “But if you can avoid companies that get into trouble, that’s 80% of the battle. “It’s the ones that get into trouble that can damage your returns.”

And how much can you expect by way of returns? The Fidelity Floating Rate High Income Fund boasts a 5-year average annual compounded rate of return of 7.5% to Oct. 31, 2018 (the floating rate category average was 5.5%), and 4.8% for the most recent 12 months (3.1% category average). Those aren’t bad numbers, considering the alternatives. “It’s been a good asset class for the past few years, with low volatility even compared to investment-grade markets,” says Nielsen.

Olev Edur is an experienced financial and business journalist and a frequent contributor to the Fund Library.

Notes and Disclaimers

© 2018 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without written permission is prohibited.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.