Opportunities in Floating Rates
DWS Floating Rate Plus Fund
US > >
May 07, 2010
52 Week HL
21.67 - $16.37
Jul 01, 2008
Q: Would you give an overview of the fund?
A : The DWS Floating Rate Plus Fund primarily invests in senior secured loans or other floating rate debt instruments.
Generally speaking, these loans are debt instruments which are both senior in a firm’s capital structure, secured by company assets and offer a floating or variable rate of interest. These instruments peg their coupon or interest rate payable to a market-driven rate such as the London Interbank Offered Rate (LIBOR). Hence, each time the benchmark rate fluctuates, the coupon rate is adjusted accordingly.
The primary advantage of these loans is that they are less sensitive to interest rate moves than other types of fixed rate debt investments. This advantage is anchored in the inherent structure of floating rate loans. In the case of fixed rate bonds, when interest rates change the price of the bond adjusts up or down to account for new bonds being issued at either a higher or lower interest rate. However, given that floating rate loans interest payments adjust to market interest rates on a regular basis they do not lose the value of the principle because of the interest rate movements.
Given the fund invests largely in these floating rate instruments it is better designed to mitigate risk arising from interest rate fluctuations.
Q: What is a floating rate instrument?
A : Floating rate instruments are loans that pay a variable interest rate. Floating rate instruments are designed to curb interest rate risk that is generally prevalent in the corporate bond markets. In a floating rate instrument, the coupon rate is not fixed; rather it is tied to a market-driven interest rate like the London Interbank Offered Rate (LIBOR). Investors then receive addition income or spread over that market rate to account for additional risk being taken on. So, every time LIBOR fluctuates, the interest rate on the loan is adjusted accordingly, either up or down. That is why the coupon rate is referred to as ‘floating rate.’
Q: What exactly distinguishes loans from bonds?
A : First of all, loans tend to be senior in the capital structure and secured by the company’s assets giving them additional protection relative to bond in a company’s capital structure. Second, bank loans traditionally are offered on a floating rate basis and not a fixed rate basis, eliminating interest rate risk.
Q: What are syndicated loans and what is the size of that market?
A : In a syndicated loan, a group of lenders, called a syndicate, work together to provide funds for a single borrower. The loan is generally arranged by a large commercial or investment bank which facilitates the transaction. The borrower could be a corporation, a large project, or a government. The loan may involve a fixed loan amount, a credit line, or a combination of the two.
The size of the market is between $500 billion and $700 billion. Generally speaking, it is two-thirds the size of the U.S. high yield bond market.
Q: Is it true that all floating rate bonds are below investment grade?
A : The answer to that question would be both yes and no. The traded market for loans tends to be below investment grade. There are some funded term loans that are investment grade but those tend more to trade between banks and not so much between institutional investors. Generally, the syndicated or the bank loan market is the below investment grade market.
Q: What is the investment philosophy behind the fund?
A : Our primary objective is to provide clients with an attractive level current income together with capital appreciation while at the same time trying to avoid the potential pitfalls that are associated with significant credit risk. In other words, we are also trying to protect investors from unexpected downside.
Q: How do you transform this philosophy into an investment strategy?
A : We seek provide clients with a high current income and attractive total returns over time. In order to achieve this, the fund normally invests at least 80% of total assets in senior secured loans of corporate issuers.
Q: What is your research process in terms of security selection?
A : We have a team of seventeen research analysts whose job is to look at individual issuers in the market and do fundamental credit research. Our main aim is to understand the stability of operating cash flow of issuers in the market. The focus is not on how much money they are generating but how stable is their earnings base.
Most of these companies are below investment grade and have financial leverage on them, so they are subject to unexpected shocks and have limited capacity to react to those shocks. We need to understand the stability and repeatability of its operating cash flow. We do that by looking at their historical results, understanding the context of the market in which they operate, knowing the management teams and what the investor’s ultimate goals for the company are.
We also do financial modeling in order to identify the potential risks for that company. Additionally, since most of our loans are secured by the company’s assets, we do assessments about the value of that collateral to assess how much money we would get back in terms of a default.
As soon as the core credit analysis is done, the analyst then discusses their findings with the portfolio manager to put that in the context of relative value. It is essentially a bottom-up security selection process with a top-down overlay on it.
Q: Would you elaborate on your research process with some examples?
A : Again, the primary theme of our analysis is to examine stability of operating cash flow. There are some industries that we find it easier for companies to operate in with leverage than other industries. A good example is the cable television industry, which has very stable cash flow. In addition, we found that revenues of cable television operators are also very stable over time. Moreover, once cable companies’ systems are constructed there is normalized capital expenditures with predictable earnings. Hence, we felt those are good companies to own in a leveraged format.
On the other side of the equation, companies like airlines are very difficult to own because there is severe price competition in that market and the size of the market shifts with economic activity. They are exposed to commodity prices and it's very difficult for individual airlines to have pricing power. Thus, it's much more difficult to own leveraged credit in the airline industry.
Q: What is your sell discipline?
A : When we enter a position, we would generally put a price bracket around it - an upside target and a downside price review level for that position if we hit the upside. But those are not hard triggers. In other words, if we hit the loss or profit review level, we don't necessarily sell it. But it's a discipline to allow us to ensure that we review the position in light of the current price and market conditions at the time to make sure we stay on top of it.
Q: What is the maturity timeframe of the floating rate notes?
A : The timeframe of the floating rate notes tends to be six to eight years of stated maturity. But one thing that's different about this market from the bond market is that loans tend to be callable at the borrower's option at anytime. So if credit spreads are coming in, we tend to get loans refinanced and the issuer will refinance that loan to lower spread.
Over time, the average actual outstanding time of a corporate leveraged loan tends to be about three years, even though the stated maturity is six to eight years.
Q: Could you illustrate with an example where you find opportunities for capital appreciation?
A : The credit crisis that we had in 2008 into 2009 had a substantial impact on the loan market. That the loan market was particularly hard hit from a market value standpoint was evident in the performance of loans 2008. Supply and demand imbalances drove this negative performance as entities such as hedge funds and others, which had funded loan purchases with short-term financing or margin financing, were forced to sell as broker-dealers ran out of capital and pulled back financing to those entities. In turn, the market value of loan funds fell dramatically 2008 as forced selling overtook fundamentals. However, as the market found its new balance with forced selling abating and demand once again picking up the loan market improved dramatically in 2009 with our fund having over a 45% total return last year. That’s dramatic capital appreciation.
The recent surge in market gains is not representative returns in the asset class but more are the result of a market in disequilibrium so this is not the kind of asset class that should give rise to 45% annual total returns. It is more a result of the global liquidity drying up in 2008. This is a very unusual circumstance where we had the opportunity for significant capital gain.
Q: What is your portfolio construction and how do you diversify?
A : The portfolio consists of over 150 names whose market cap is $300 million. Typically, an average hold position might be 1% of the fund and we have several that are between 1% and 2%. The highest level exposure for any given industry would be 15%.
As the portfolio consists of below-investment-grade securities the idea is that we lose a lot more by owning a bad loan than we gain when owning a good loan. To this end, we do very intensive credit work to make sure we like what we own and then we diversify the portfolio to protect ourselves from the risk that we are not able to analyze.
The turnover in the portfolio is in the mid-50 percent range. The relevant benchmark index for the fund is the S&P/LSTA U.S. Leveraged Loan 100 Index.
We attempt to avoid fraud risks, change in legislation, or dramatic change in market conditions through portfolio diversification. We do take reasonable and modest overweights to reflect our fundamental view but we do not expose the portfolio to significant risk of unexpected consequences.
Q: What are the sources of risk and how do you contain them?
A : For us, the biggest risks are default risks. We manage those risks by a combination of detailed industry specific issuer credit analysis combined with analysis of collateral value and diversification. There are other risks that prove hard to analyze, such as the risk of corporate frauds or wholesale changes in markets due to regulation.
However, credit risk is the most important risk to a fund like this, so we pay a lot of attention to that as part of our research process. Still, the advantage of a fund like this is that it does not have duration or interest rate risk because all the loans that we invest in have floating rate coupons.