In pursuit of “high yield candy”: Floating Rate Income Funds and mutual fund disclosure in Canada…

Floating rate income funds are not automatic high yielding replacements for a portfolio’s low yielding core bond or cash holding and have a myriad of risks that may impact a portfolio’s ability to meet an investor’s income and or capital needs over the duration of their lifetimes, especially during risk events.

Yet, these investments are apparently “sold” with next to no disclosure over the risks, or the complete nature, of the investments and no apparent guidance over allocation and risk management imperatives. Too much emphasis is placed on a couple of simple and easy reasons for buying them – yield and reduced interest rate risk.

In my last post I introduced the complexity of Floating Rate Income funds – ETFs and Mutual funds that invest in securitised secured bank lending – and in this post I address the issue of disclosure (with respect to that complexity) in the minimum transaction standard Canadian retail financial services market place.

Reading Vanguard’s A primer on floating-rate bond funds makes it clear that floating rate securities are complex beasts:

  • Their credit risks are high because they invest predominantly in sub investment grade leveraged loans and default rates mirror those of speculative grade debt.  To understand the risks of sub investment grade credit you would need to understand cumulative default rates for different rating bands as well as the risks that adverse market and economic conditions can have on the risk of default.   Seniority and hence recovery needs to be assessed in the wider context.   With the increasing use of covenant lite terms in leveraged loans there are also increasing risks to recovery.
  • Floating rate returns move inversely to the direction of credit spreads and credit spreads are at historically low levels.  Traditionally cash and bonds are allocated to provide income and capital certainty during risk events that impact higher risk assets: leveraged loans are more likely to be impacted during these events eviscerating the portfolio allocation rationale of lower risk assets.
  • They are vulnerable to “liquidity shocks in unfavourable loan markets”: this is a much more complex risk than many might perceive.  Demand for FR investments over the last few years has grown considerably, as has issuance.   A readjustment in demand flows and/or a change in the interest rate and economic environment could have a significant impact.  Again, liquidity is a key decision in cash and bond allocation, part of which is meant to defray higher risk asset characteristics of other assets during risk events.  I am also concerned about increasing Collateralised Loan Obligation demand for leveraged loans especially if the market becomes dependent on CLO demand for refinancing.
  • Additionally doubts over inflation hedging, diversification benefits (note the exceptions discussed in the Vanguard Primer) and costs of active management add further layers of complexity to the retail investment decision.  Diversification benefits in particular may be fictional where you are swapping traditional higher grade fixed for sub investment grade credit spread sensitive assets.

Yet, when we look at mutual fund risk disclosure in the Canadian retail space, what do we find?  The following is the risk disclosure taken from one Fund Fact document for a Floating Rate Income Fund

HOW RISKY IS IT? The value of the Fund can go down as well as up. You could lose money. One way to gauge risk is to look at how much a fund’s returns change over time. This is called “volatility”. In general, funds with higher volatility will have returns that change more over time. They typically have a greater chance of losing money and may
have a greater chance of higher returns. Funds with lower volatility tend to have returns that change less over time. They typically have lower returns and may have a lower chance of losing money.

The Vanguard report does not discuss volatility per se, even though price consequence is implied, but many of the fundamental risks impacting the asset: credit risks, liquidity risks, active management risks and other timing risks of this investment asset class.  Emphasis in mutual fund marketing communication is placed on the higher yield and the reduced exposure to interest rate risk, which is an incredibly narrow fixation on the positives.  Yes, if economic conditions improve and profitability amongst sub investment grade improve likewise, then rising interest rates should see a rise in yield and stable default risks, but risk is not about upside deviation alone and neither is portfolio management.  Moreover, a low to medium volatility measure masks the impact of significant volatility characteristics during risk events, characteristics which have been muted in a demand hungry low yield environment.

Additionally Fund Facts also give a rather bland and wide pigeon hole (suitability spectrum) with respect to who the investment is suitable for.

WHO IS THIS FUND FOR?
The Fund is suitable for investors who: Are looking for an income-producing investment that is linked to changes in interest rates

Prefer a low to medium level of investment risk
Are investing for the medium-to-long term – 3 to 5 years

This completely ignores the switch of asset characteristics if we are moving from low yield cash and bonds to higher yield, higher credit and liquidity risk assets, let alone the impact on overall portfolio exposure to areas of higher credit risk.   This touches on one of my pet hates re transaction based service processes: every transaction will impact the structure of the portfolio and no transaction can be assessed effectively without first assessing its overall impact on the whole.  Yet here we are with sales processes and marketing messages calling for abandonment of disciplined process in pursuit of “yield candy”.  Adding floating rate assets to a portfolio may require readjusting portfolio structure to accommodate a weaker liquidity and a higher credit risk profile.

Here is another excerpt from another marketing communication:

    • The Fund can help to diversify the fixed-income portion of your portfolio.
    • The Fund can help to safeguard capital by reducing interest rate risk.
    • The Fund can provide a competitive monthly income stream linked to interest rate changes.

And another

Why invest in this fund

Protects fixed income holdings because unlike fixed rate bonds,
floating rate loans are not negatively affected by rising interest rates.

Helps diversify and lower risk in your portfolio

Floating rate income funds are not automatic high yielding replacements for a portfolio’s low yielding core bond or cash holding and have a myriad of risks that may impact a portfolio’s ability to meet an investor’s income and or capital needs over the duration of their lifetimes, especially during risk events.     

Yet, these investments are sold with next to no disclosure over the risks or the nature of the investments and apparently no guidance over allocation and risk management.  Too much emphasis is placed on a couple of simple and easy reasons buying them – yield and reduced interest rate risk.  So just what is happening at the retail level? Who knows!

While floating rate investments may have a place in a well structured portfolio it requires a certain level of expertise to be able to understand these investments and then to allocate and manage them.   That they can be sold by inexperienced product sellers who are not responsible for providing a well structured process for managing and monitoring risk and for modelling and valuing risk and return is, of course, worrying.  But what concerns me most is the unbalanced promotion of the benefits of these investments by many professionals who should be charged with higher levels of responsibility and accountability for transparent and full disclosure of risks.  Two notable exceptions to this are Dan Hallet of Highview Financial and Tom Bradley of Steadyhand.

In a low yield environment, these investments, given the lax regulation of risk communication, could well be easy shoe ins for aggressive sales practises with little or no comeback to those who have recommended them.   But regulators seem content to allow incredibly poor disclosure of risk and uneven and misleading communication of benefits. 

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The Ontario Securities Commission does have an Investment Funds Product Advisory Committee and one wonders what discussion they have had with respect to Floating Rate Income Funds. 

I also note that the OSC has asked fixed income fund managers to pay more attention to the risks of floating rate notes, a concern that does not seem to have found its way to the retail market space:

March 2014 Investment Funds Practitioner: Issues And Tips

Fixed income funds

Issue: The OSC has undertaken a review of the risk management processes used by portfolio managers of fixed income funds. The OSC noted that portfolio managers have engaged in shortening fixed income portfolio durations and investing in floating rate instruments.

Tip: The OSC encourages portfolio managers of fixed income funds to assess the impact of various factors including interest rate spikes, widening spreads and elongated periods of higher volatility in the fixed income markets, by conducting scenario analysis testing for those factors.

Tip: The OSC encourages managers to stress test and assess the sources of the fund’s liquidity during normal periods as well as high redemption periods and lengthened periods of reduced liquidity.

Tip: The OSC encourages funds to continue providing robust disclosure in the MRFP regarding risks that have arisen due to recent events as well as the potential impact of recent actions by central governments regarding fixed income portfolios. The OSC also encourages funds to consider increasing the frequency of monitoring their risk ratings given the elevated volatility in the current fixed income markets.

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Further reading:

THE RISE OF THE LEVERAGED LOAN Feb 2014

Spotlight on fixed income (Howard Atkinson’s blog)

Rate rise fears stoke EU floating rate bond revival (FT)

Leveraged Finance Strategy Weekly (Credit Suisse)

Leveraged Loan Asset Class Grows To Record Size In August (Forbes)

Leveraged Loan Bubble? In Yield vs. Risk Analysis, Loans Sit Between Boom and Bust (Forbes)

What To Make of Floating Rate Funds (Morgan Stanley)

Floating Rate Senior Loans: Why Is It Time For A Strategic Asset Allocation?

A Guide to Investing in Floating-rate Securities (Wells Fargo)

Markets Are Restacking the Building Blocks of a Financial Crisis (New York Times)

2012 Annual Global Corporate Default Study And Rating Transitions (Standard & Poors)

A Guide To The U.S. Loan Market (Standard & Poors)

Bank Of England Eyes Covenant-Lite Leveraged Loans, High Yield Bonds As Potential Asset Bubbles

Exclusive: U.S. banking regulator, fearing loan bubble, warns funds

European regulators warn as risky loans rise above bubble peak (FT)

The Return of the Leveraged Loan Market

The Search For Yield (LSTA) under publications

MACKENZIE FLOATING RATE INCOME FUND – light on the risks…

AGF Floating Rate Income Fund – mentions IR, credit, liquidity risk, exchange rate risk, but only talks about IR and fails to explain credit and liquidity risks.

Fidelity Floating Rate High Income Fund

Investing in floating rate notes? Here’s what the industry isn’t telling you (Globe & Mail)

Leveraged Finance News

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