The Fed Helps This Solid Bond Fund

03/20/2012 10:15 am EST

Focus: INCOME

Carla Pasternak

Editor, The Income Investor

It&rsquo’s all in the margins for this closed-end bond fund, and low rates mean a big dividend for investors, writes Carla Pasternak of High-Yield Investing.

Closed-end bond fund Nuveen Floating Rate Income Fund (JFR) invests nearly 90% of its $700 million portfolio in adjustable-rate senior, secured loans to mostly private companies.

JFR holds some 220 positions. The bulk of these loans are sub-investment grade, with 31% rated BB and nearly 51% rated B, for an average credit rating of B+.

About a third of the portfolio value is leveraged to juice returns. The fund makes money by borrowing at low short-term rates and using the borrowed money to invest in higher-yielding, floating-rate loans. These loans reset every 60 to 90 days, and are pegged a couple of percentage points above a short-term benchmark.

The Fed&rsquo’s announcement in January that it was prepared to keep its short-term target interest rate at "’exceptionally"’ low levels until late 2014 would be expected to adversely affect profit margins on the fund&rsquo’s floating-rate investments.

However, the fund&rsquo’s borrowing costs for the 13 weeks ending January 31, 2012 averaged 0.06%. Meanwhile, the loan portfolio carries an average coupon rate of 4%, according to Morningstar data.

Distributions are made entirely from investment income, and not supplemented by return of capital or capital gains. The current rate equates to 82 cents annually, for a forward yield of around 7%.

Management fees, interest, and other expenses of 1.21% of the annualized net asset value take a thin slice off total returns. Distributions are taxable at your marginal income tax rate, so this fund is best held in a tax-sheltered account.

With a portfolio of sub-investment grade loans, the fund&rsquo’s returns can be volatile. In the credit crisis of 2008, when risk-averse investors lost interest in subprime corporate lenders, the portfolio value plunged. The fund lost 42.1% versus a loss of 37% for the S&’P 500.

But the rebound was sharper: the fund gained 84% in 2009, more than threefold the benchmark index&rsquo’s 26.5%. A strong rebound in the speculative debt market&mdash’as the economy has improved and default rates declined&mdash’has led to JFR&rsquo’s robust returns of better than 12% over the past three months.

Looking ahead, management is forecasting that the default rate for its loans over the next year will stay below the long-term average of 3.78%.

Currently trading at a discount of 2.1% to its net asset value, near its 52-week average discount of 2.5%, the fund is attractively priced for new money.

JFR has continued to raise its distribution, and the recovering US economy provides a favorable outlook for its speculative loan portfolio. If you can withstand the volatility, Nuveen Floating Rate Income Fund offers a nice monthly 7% yield, even if no distribution increases were to take place this year.

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