Floating Rates and Total Return

09/09/2013 10:00 am EST

Focus: FUNDS

Doug Fabian

Editor, Successful ETF Investing, ETF Trader's Edge, Weekly ETF Report, and ETFU.com

Mutual and ETF expert Doug Fabian discusses some intriguing ideas for income and growth, including floating rate securities and a favorite total return bond fund.

Steve Halpern: We're here today with mutual fund expert Doug Fabian. Doug, how are you doing?

Doug Fabian: Doing great, Steve.

Steve Halpern: You know, we should report, you mentioned that going forward, income investors will need to blend both income and growth, and in light of that philosophy, you've just combined two of your leading newsletters-Successful Investing, which was growth-oriented, and High Monthly Income, which, obviously, was an income publication.

Could you expand on the reason behind that move and describe for our listeners what they could expect from the new service going forward?

Doug Fabian: Well, I originally started the income newsletter from the request of long-term subscribers. Steve, my publication was started by my dad Dick Fabian in 1977, so we've been continuously publishing since then and we've had subscribers get older and then they wanted income from their investments.

But now I've blended the two newsletters; one, because I've gotten the request from subscribers to do so, but the real reason being, that people are living longer and I believe that they can't just go into complete income and depletion mode in their investment portfolios, but they still need some growth.

Also, I'm finding that many people have the goal of leaving some sort of legacy for their family, and that legacy will usually revolve around assets they're not going to spend in their own retirement, so they still want to have some growth on those assets.

For people who have been, or are familiar with the Fabian newsletters and what we do, they're now going to be able to get a combination of growth and income from their investments and I'm looking forward to delivering that message for them.

Steve Halpern: Thank you. You note that one way to diversify bond holdings and guard against rising interest rates is through floating rate securities. Could you explain what those are and how people would use them in their portfolio?

Doug Fabian: Certainly. You know, I was not ever that familiar with floating rate securities until about a year ago. I started researching, "What are we going to do when interest rates rise?" I found that there is another asset class. I consider this to be an alternative income play.

There are loans that are made in the marketplace, very large loans, and these loans are then securitized, meaning that they can be bought and sold depending upon the issuer and depending upon the credit worthiness and the like, so these senior loans-and they're called senior loans because of where they stand in the capital structure of a company.

These senior loans carry variable interest rates, so when interest rates rise, the interest on these loans is going to rise for whoever took the loans out.

So there are mutual funds and exchange traded funds that are invested in these senior loan securities, and they have different creditworthiness, so there are some higher yielding senior loans, there is some outstanding credit quality, so there are some investment grade senior loans.

You can purchase them in the form of a mutual fund. The Fidelity investments, for instance, have a floating rate securities fund that is of higher grade. We own this for our investment clients. And then also, Oppenheimer has a senior loan fund that they've had for over eight years and has an excellent track record.

And then there are now exchange traded funds in this floating rate or senior loan arena. The most popular of which is PowerShares Senior Loan (BKLN).

BKLN currently has a yield of 4.6% and it is not susceptible to rising interest rates, so it's a great way for somebody who still wants to have some fixed income component to their portfolio to be able to sell out of a bond fund that can be negatively impacted by high interest rates, and still receive a decent coupon from a senior loan invested security.

Steve Halpern: Now I know in your work you always focus heavily on making your readers aware of both risk and reward and something like this sounds like a great opportunity for income investors. I was wondering if you could touch on what the risks associated with this would be.

Doug Fabian: Well, the risks, and again, I always do research from that perspective. I looked back at history and found in the 2008 market crisis, if listeners will recall, part of that crisis was a credit crisis and so in a credit crisis situation, that's the most negative environment for senior loan securities.

One of the things that we watch, in terms of managing downside risk, is what is the spread between high yield and treasury bonds.

So if we receive yields, and credit spreads start to expand greatly, that would be kind of a red flag that we could be going into a period that could negatively affect senior loans.

These mutual funds, the ETFs weren't available in 2008, so I looked at the mutual funds price history, and they declined about 20% during the 2008 negative credit cycle, so there is downside risk that needs to be managed. You could put a 5% stop loss underneath a security, of course, to kind of manage that downside risk.

Sometimes I associate the stop loss with the yield that you're receiving on an annualized basis, that's how I came up with 5%, in this particular case, because I believe that you'll get a 5% income stream, so let's not risk any more than 5% principal when we're invested in these securities.

Steve Halpern: That's a fascinating approach. I also noticed the largest position in your income portfolio is a mutual fund called the DoubleLine Total Return Bond Fund (DBLTX). Could you explain a little about that?

Doug Fabian: Well, I'm a big fan of Jeff Gundlach and the DoubleLine Group. Jeff Gundlach has a very interesting history in the investment arena. He was the bond king over at TCW for over 20 years and then went out and started his own firm, I believe the year was 2009.

There was a lot of controversy about that, because he took a lot of people with him from TCW to start DoubleLine. That's when I first started getting interested in what he was doing, and what really attracted me to Jeff Gundlach was his track record during 2008.

What people might not remember is, in the 2008 credit cycle we were just talking about, many bond funds performed extremely poorly and in that year treasury bonds had one of their most spectacular years ever.

Treasury bonds were up over 30% in calendar year 2008, but investment grade bonds, certainly junk bonds, many of the total return bond funds, had a horrible year, some were down 15%, 20%.

But Jeff Gundlach's fund, that he was running over at TCW, had a flat year that year and he actually forewarned investors of the coming crisis at that time in subprime, so I've just really respected this man's work.

He has done a fantastic job of running the DoubleLine Total Return Fund and I just have a lot of faith in his market calls in an area that I'm not an expert in myself.

Even in this year, where treasuries have fallen some 15% on a year to date basis, the DoubleLine Total Return Fund is generating a yield slightly under 5%, and the total return on a year to date basis is down 1%, so he's done an excellent job of managing risk, even in this very difficult interest rate rising environment that we're in, in 2013.

Steve Halpern: Finally, listeners might recall that I interviewed another Fabian recently, your son Dave (see Diamonds in the Rough). You must be very proud of his role in this business and his success.

Doug Fabian: Absolutely, he's doing a great job. He has worked hard to get his name out there, writing a lot of articles at Seeking Alpha and other websites and he's a third generation money manager for the Fabian family.

Steve Halpern: Well, thanks for joining us today, we appreciate all your insights.

Doug Fabian: Thank you, Steve.

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