What To Make of Floating Rate Funds May 2014

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1 What To Make of Floating Rate Funds May 2014 David Hillmeyer of Delaware Investments explains the risks and potential rewards of floating-rate debt in the current environment The current low-rate environment is plaguing fixed-income investors as they search for yield amid the fear of rising rates. And bank-loan funds have become a huge benefactor. Net flows into the category exceeded all others in March, and over the past year more than $60 billion in new assets has poured in, according to Morningstar. While such products provide a hedge in the event of an interest-rate increase, they also carry more credit risk than many consider. Given the likelihood of market volatility, says David Hillmeyer, lead portfolio manager for Delaware Investments Diversified Floating Rate Fund, it s best to err on the side of caution. If the primary objective is to hedge against the downside of rising rates, do you want to own a portfolio composed of nearly all below-investment grade credit risk? he asks. Hillmeyer s investment strategy imposes a limit of no more than 50% below-investment grade and, as a result, currently carries an average investment-grade rating (as measured by Moody s and Standard & Poor s). Our approach provides us with the flexibility to allocate away from asset classes where the risk/reward [balance] is no longer attractive with the goal of preserving principal during periods of heightened volatility, he explains. A single-asset-class strategy, such as [investing only in] bank loan funds, doesn t have that luxury. Hillmeyer recently spoke with Tara Kalwarski of Morgan Stanley Wealth Management about challenges in the current market environment and where he s finding attractive investment opportunities. The following is an edited version of their conversation. Tara Kalwarski: Can you explain how the current positioning of Delaware s Diversified Floating Rate Fund is reflective of your broader macro views? David Hillmeyer: The natural go-to asset class in a risingrate environment for fixed-income investors has been the bank-loan market; today is no exception. Retail loan funds recently experienced 95 consecutive weeks of inflows [according to S&P s LCD News as of April 21, 2014]. It is important, however, that investors understand the risks of investing in a single-asset-class strategy such as loan funds. We attempt to address some of these risks in Delaware s Diversified Floating Rate Fund, which [employs] a diversified approach that provides an added layer of flexibility when managing a changing risk landscape. The portfolio s prospectus limits the Fund to no more than 50% below-investment grade. The fact that the Fund is bound by this quality constraint results in the inability to mirror the credit risk embedded in bank-loan funds. The average credit quality of the portfolio is firmly investment grade, with just over 30% exposure to the loan asset class. As you can see, we are at the midpoint in terms of our risk profile. In our opinion, market pricing for all assets that are down in quality doesn t reflect an attractive breakeven relative to security types such as investment-grade corporate credit, particularly when the primary objective is minimizing interest-rate volatility. The diversified nature of [our] strategy [helps to] provide us with the tools to address these changing market conditions and allows us to be selective and

2 opportunistic in our approach. High-grade credit makes up the majority of the portfolio with just over 50% of it in fixed or floating investment-grade corporate bonds. We utilize interest-rate swaps as a risk-management tool to hedge the interest-rate risk associated with fixed-rate bonds. This allows us to provide additional diversification and maintain a duration of approximately a quarter of a year, with the goal of limiting price volatility due to changing rates. The exposure to bank loans and high-grade corporate credit is close to 90% of the total portfolio. Additionally, the portfolio has exposure to a few select asset classes that are more opportunistic in nature, including municipal bonds, convertibles and AAA-rated asset-backed floating-rate securities. The liquidity that higher-quality assets generally provide allows flexibility to manage the risk during periods of heightened volatility. Kalwarski: How has the ratio between those different types of securities varied in different economic climates? Hillmeyer: This particular strategy was founded in the first quarter of 2010, and although it hasn't been through a significant economic slowdown, it has been managed through periods of heightened volatility. Examples include the European crisis and the downgrade of sovereign U.S. [debt securities]. During these periods it wasn t uncommon to see our loan allocation [go] lower by 10% and [for us to mount] a concerted effort to reduce risk further by shortening maturities in the more liquid sectors such as investment-grade corporates. We also moved the portfolio to a more defensive [positioning] by increasing the holdings of asset-backed securities. Absent pockets of volatility, there haven t been major catalysts that required us to make significant adjustments to the holding. Relatively stable fundamentals and easy monetary policies were supportive of credit. Kalwarski: What indicators might compel you to reposition the portfolio? Hillmeyer: We have to continue to be very cognizant of the Federal Reserve s monetary policy and the market s response to a changing liquidity environment as the central bank adjusts policies to address the growth trajectory of the economy. How the market reacts to these changes is one of the most important questions investors will face in 2014, because the ripple effects of the Fed s actions will likely be pronounced. We observed during the late spring and early summer of 2013 how monetary policy s tentacles are far reaching, as bond yields in emerging markets spiked meaningfully higher while currencies [of these economies] came under selling pressure. This created a situation where the central banks of these countries had to make difficult decisions, such as the need to raise rates in order to defend their currencies when growth was already slowing. The significant injection of liquidity into the system by the Federal Reserve left emerging markets in a very difficult predicament. During this period, certain markets experienced significant capital inflows that are now at risk of being pulled as the Fed slowed the pace of purchases of securities. Kalwarski: You mentioned some strategies that you employ to mitigate risk or dampen volatility. Can you describe these in more detail? Hillmeyer: At times, we will use derivatives to hedge credit risk. It is important to note, however, that we can't use leverage in our strategy. But derivatives are a material part of our risk-management. For instance, in 2011 when markets were under selling pressure, we utilized hedges in an attempt to mitigate some of the price volatility in the portfolio. Interest-rate swaps represent the largest use of derivatives in the strategy by [helping to] provide us with the flexibility to purchase fixed-rate bonds for diversification purposes and total-return opportunities. If we want to have the versatility to move out of bank loans which are naturally floating-rate instruments and into an asset class that's higher in credit quality, like the investment-grade market, problems would exist if [we] were to just try to source floating-rate product in the investment-grade corporate market. For instance, the majority of the Barclays U.S. Floating Rate Index is composed of financials. We do not want to swap credit risk in the loan market only to take on specific sectorconcentration risks. Therefore, being able to use interest-rate swaps and buy fixed-rate bonds allows us to [potentially] take advantage of the entire fixed-income market. Kalwarski: What are you are seeing in the bank-loan market today? Hillmeyer: A lot of people have talked about the risk associated with so much money coming into the loan market. It has driven the bank-loan market to prices that are at or near par. This creates a dilemma for portfolio managers that are limited by their prospectuses to purchasing primarily bank loans because it can be challenging to source enough product, not to mention at levels that represent value. 2

3 This asset class is generally callable at any time. So if a loan manager buys a loan at a premium, that manager could essentially have this investment get called away at any time. Furthermore, if this loan was purchased at a premium, the investor would realize a loss on principal. We remain comfortable with the fundamentals, but the absolute level of pricing in the loan market isn't as attractive as it was the past year due to this call feature. Given this dynamic, we would rather look for opportunities that would include moving up in quality and identifying investment choices that won t experience the same limited total-return opportunity due to structure. For example, the risk/reward profile may be [made] more attractive by investing in a 10-year, fixed-rate, investment-grade corporate bond that our research team has identified as an improving credit story. In the event our credit call is correct and the risk premium of the investment compresses, the potential benefit accrues directly to the shareholders rather than back to the issuer when the security is called. Remember, a significant majority of the investment-grade corporate market isn t callable. This is in stark contrast to what we observe in the loan market. Kalwarski: What is the most challenging aspect about the current environment? Hillmeyer: People who are invested in fixed income are concerned about rising rates. When I ask them, "Why do you want to own a floating-rate product and in particular a bankloan fund? Nine times out of 10, they'll tell me it's because they're worried about rising rates, not because they are concerned about rates and believe there is value in the loan market. Generally two primary risks of a bond portfolio are credit risk and interest-rate risk. Buying a loan portfolio addresses the interest-rate risk, but it doesn't address the credit risk. That's another conversation that investors need to have. The reason it is so important is because there is very little yield coming from fixed income. Risk premiums would not have to change by much before many asset classes would experience negative price returns. Kalwarski: How might the market respond to increased defaults? Hillmeyer: In the past, when you start to see defaults increase as liquidity and access to capital markets become impaired, recovery values decrease too. Historically, recovery values are [among] the important things that differentiated the loan market from the high-yield market. The loan market is a secured market, while the high-yield market in most instances is unsecured. As a result, recovery values in the high-yield market are typically [lower] than those experienced on first-lien loans. The change in the size of the loan market over the past 10 years, combined with a higher degree of daily valued assets, may result in a change in the volatility experienced by the asset class as investors exit the loan market. Delaware s diversified approach to managing interest-rate risk will provide multiple sources of potential liquidity away from the loan market. Additionally, the limit of no more than 50% [allocation] to below-investment-grade assets should help temper portfolio volatility during an increase in defaults. Kalwarski: How and where does a diversified loan product fit into a broadly diversified fixed-income bucket? Hillmeyer: It's very dependent upon the individual. [I believe] the best way to think about floating-rate funds now in a fixed- income portfolio is as a tool to reduce price volatility due to rising rates in an investment environment where low absolute rates [help] provide an interesting entry point. When you evaluate yields on fixed-income assets today, a significant portion of the yield is the result of credit risk, not rates. Whether investors choose bank loans or a diversified strategy like ours, it s an opportunity to add an interest-rate hedge to their fixed-income portfolios. Kalwarski: What is your interest-rate outlook? Hillmeyer: At this stage, it continues to be our belief that a 3%-to-3.5% 10-year Treasury rate is enough to provide somewhat of an anchor on growth. With that said, however, a rebound in growth during the second quarter could easily make investors question if the Federal Reserve is behind the curve as it pertains to its interest-rate policies. If this occurs, we should anticipate more interest-rate volatility. This would most likely lead to a continuation of the bear flattener that has been observed over the course of the past several months. Kalwarski: What concerns are you hearing from investors? Hillmeyer: [In] just about every conversation that I have, there is real concern about rising rates. Right now it appears as though the economy is continuing to point toward growth, [and that] would lead to higher rates. However, as a risk manager, [I think] it is important to evaluate the contrarian view that we actually won t see the rate increase that is widely expected. Although this isn t our base-case assumption, it is a possibility that should not be ignored. 3

4 Furthermore, the position surveys we observe indicate that investors are very short the rates market, which could make it more difficult to exit the current trading range. Another concern being raised by investors pertains to the need for income. Income is incredibly important, particularly when interest rates are near historic lows. One source of income that investors have pursued is investing in the loan market. It is important to ensure that people understand that most of the bank loans in the market now carry a Libor floor, which averages approximately 0.85%. What this means is that Libor must move to a level above the stated floor on the loan before the coupon will begin to reset higher and the investor actually realizes additional income. I find that many investors don t understand this fully and instead believe the coupon stream coming off their investments will reset immediately. This just isn t the case. Kalwarski: Looking at the past 12 months, do you recall anything that surprised you? Hillmeyer: Quite frankly, I underestimated the influence of all the liquidity that has been created the past several years on valuations. It appears that market participants used this as the foundation of their investment thesis. It was my expectation that negative consequences would cause a correction that has yet to materialize. However, this experiment of quantitative easing has further to run, and markets could be still be surprised by just how choppy the landing could be. *Unless otherwise noted, the source for all information is Delaware Investments as of April

5 Investors should carefully consider the investment objectives and risks as well as charges and expenses of a mutual fund before investing. To obtain a prospectus, contact your Financial Advisor or visit the fund company s website. The prospectus contains this and other information about the mutual fund. Read the prospectus carefully before investing. Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. 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