Income Trust for Rising Rates
04/30/2004 12:00 am EST
"There are growing signs that the Fed may have to move sooner than expected to raise rates," cautions Gordon Pape, editor of The Income Investor. For his top pick of the month, he recommends an income trust, which will benefit from a rising rate environment.
"The Consumer Price Index for March showed that inflation jumped 0.5% during the month and is now rising at an annualized rate of 5.1%. The trailing 12-month rate is still only 1.7%, but the spike since the start of the year must be causing some worried frowns among the Fed governors. An upward turn in interest rates generally has a negative effect on several types of securities. These include REITS, long-term bonds, and bank and utility stocks. If you are holding any of these in your portfolio, keep a close eye on them and consider taking profits where appropriate. Meanwhile, our top income buy for the month is Van Kampen Senior Income Trust (VVR NYSE).
"What it does: Van Kampen Investments is a Chicago-based money management company with about $100 billion in assets. This trust invests in a portfolio of senior collateralized loans to corporations with low credit ratings (or in some cases with no credit rating at all), usually with maturities of less than five years. The portfolio is broadly diversified (about 300 positions at any given time) so that default risk is minimized.
"Why we like it: There are very few income securities that offer protection against a rise in interest rates, which appears likely to happen in the US this year. This is one of the exceptions. Most of the loans held in the fund are variable or floating rate. This means that if US interest rates rise, the yields on the loans held by the fund will follow suit. The fund provides steady cash flow in the form of distributions which are currently being paid at the rate of about $0.40 a year for a cash-on-cash yield of 4.5% based on the market price. Payments are made monthly.
"Who it's for: This selection is for aggressive income investors. The fund is coming off a hugely successful year with a total return of almost 36% in 2003 (market price), due to the surge in the market value of corporate notes. That was probably a once-in-a-lifetime event and is unlikely to be repeated. However, there is still some capital gains potential here to go along with the decent cash flow. This higher risk security is suitable for investors who are looking for US dollar income, protection against rising interest rates, and modest capital gains potential.
"Summing up: The fund has what might be called reverse interest rate sensitivity. It actually lost money in its 2001 and 2002 fiscal years (ending July 31), when US interest rates were on the decline. However, it appears very unlikely that US rates will move down from this point. There is also default risk, arising from the nature of the portfolio. We recommend buying VVT now."