DoubleLine has announced today, June 4th, that it will be opening its Floating Rate Fund to investment by the public on July 1st. The announcement was made during a webinar hosted by Jeffrey Gundlach titled “What in the World is Going On?”. Learn Bonds last week spoke with Bonnie Baha and Robert Cohen, the portfolio managers of the DoubleLine Floating Rate Fund (DBFRX, DLFRX) , for an exclusive interview about the fund and the asset class in which the fund invests.
Why is this announcement newsworthy?
DoubleLine is enormously successful, both in terms of the returns of its funds and the growth of its assets under management. Its flagship fund, TheDoubleLine Total Return Fund(DBLTX, DLTNX), founded in April 2010, has returned over 12% on an annualized basis, and accumulated over $40 billion in assets since inception. As a result of its success, everything DoubleLine does receives tremendous attention. DoubleLine has 7 mutual funds open to the public, of which four funds have a defined asset class focus. One fund is focused on equities. The bond funds are comprised of a low duration fund, an emerging markets fundand now a floating rate fund. DoubleLine does not offer funds in currently hot areas such as high-yield, convertible bonds, or inflation linked bonds. In other words, DoubleLine is not creating funds to take advantage of current market interest in a hot sector. Instead, DoubleLine’s offering of new funds should be viewed in the context that they believe the asset class will be important to investors and provide superior returns in the future. DoubleLine’s announcement is important because it sends a signal to investors that they should pay attention to floating rate funds.
Who are the portfolio manager’s of the DoubleLine Floating Rate Fund?
Bonnie Baha, head of the Global Developed Credits team, is closely associated with Jeffrey Gundlach having worked with him for over 20 years at TCW and DoubleLine. Additionally, she is listed with Jeffrey Gundlach as one of three managers of the $2.3 billion closed-end DoubleLine Income Solutions Fund (NYSE: DSL). Robert Cohen is a rarity at DoubleLine, as he is the only portfolio manager there that never worked at TCW. He was specifically brought to DoubleLine for his leveraged loan expertise. Most recently, he was a senior credit analyst at West Gate Horizons Advisors, a firm specializing in advising institutional investors on this asset class.
What’s the difference between floating rate, leveraged loans, and bank loans?
Each of these terms has a slightly different technical meaning. However, when talking about investing in a mutual fund or closed end fund they tend to mean the same thing. They refer to a fund which holds loans originally made by a bank to a corporate borrower, with a non-investment grade credit rating, that have a floating interest rate. Floating in this context means the loans have an interest rate which moves up and down based on a publicly available benchmark. However, there is also a fixed component to the interest paid on these loans. The fixed rate of interest on the loan is based on the creditworthiness of the borrower at the time the loan is made, while the floating component fluctuates based on market conditions.
Can floating rate bank loans be made to investment grade borrowers? Yes, banks often make loans to investment grade companies that have floating rates. However, they tend not to sell these safer loans to the market. Instead, they tend to make available the higher risk loans to the market.
The Three Fundamental Differences Between High Yield And Floating Rate Funds
High yield bond funds and floating rate funds are often compared against each other. Both type of funds hold debt of high risk borrowers and pay interest rates well above the yields on Treasury or investment grade debt. However, there are three major differences between them.
The floating rate bank loans are safer with respect to default risk than the bonds issued by the same company. In the case of bankruptcy, the holders of bank loans typically get paid before bondholders.
Bank loans are continuously callable at par. Basically, there is a well defined limit to how much a bank loan can rise in value.
Bank loans have very low duration compared to a high yield bond. While almost all bonds lose value when interest rates rise, there is very little impact on the price of bank loans.
The Debate Between High Yield & Floating Rate Funds
Both Floating Rate and High Yield Funds have historically yielded several percentage points more than treasuries and other investment grade bonds (with similar durations). There has also historically been a major difference between the yields of floating rating loans and high yield bonds. High yield bonds have had the higher yields, due to their higher risk. The exact difference in yields will vary greatly based on which set of dates and indexes one uses to compare. In an article published on the Alliance Bernstein blog which was making the case for investing in high yield bonds, the analyst calculated the historical difference as 3.7%, with floating rates yielding 5.4% and high yield at 9.1%. Historically, the yield difference was a compelling reason to invest in high yield bonds over loans. However, there is no longer a major difference in yields, less than 0.1% by some measures at the end of April 2013.
The Argument For High Yield Bonds Over Floating Rate Bank Loans
Alliance Bernstein has been one of the most vocal advocates in favor of high yield over floating rate bank loans. They have a two pronged argument the goes along the following lines:
1) The conventional wisdom is that floating rate bank loans will outperform high yield bonds during periods of rising interest rates is wrong. Rising rates are typically accompanied by improving economic conditions. While rising rates are bad for safer bonds, the are good for the most risky segment of the market because the conditions driving rates higher will lower the risk of default for these bonds. High yield bonds do well when rates rise.
2) There is a misconception about the safety of bank loans. Just because they are first in line to get paid doesn’t mean that you are more likely to get paid. Essentially, the holders of floating rate loans are standing in different lines than the holders of high yield bank loans. Floating rate loans are often used to finance leveraged buyouts (LBOs). The companies which use floating rate loans are often much more highly leveraged than those issuing high yield bonds.
DoubleLine Argues in Favor of Floating Rate Bank Loans
When presented with the arguments made in favor of high yield bonds, Bonnie Baha and Robert Cohen challenged the underlying premises of both arguments. Robert Cohen made a strong case that floating rate loans were much safer than high yield bonds. First, he took issue with the notion that there wasn’t a great deal of crossover between the companies which borrowed via floating rate bank loans and high yield bonds. He regularly looks at bank loans from companies which have both types of debt. However, the real proof that bank loans are safer is in the recovery rate numbers. When a bankruptcy occurs, bank loan holders recovered much more of the principal and interest owed to them than high yield holders. He referred to a recent report by S&P which shows the recovery rate on bank loans to be in the high 70% range, while the recovery rate on high yield was around 40%.
“The mathematics just don’t work (referring to the idea that high yield bonds would not be impacted by rising rates)”, Bonnie Baha of DoubleLine.
Bonnie Baha tackled the notion that high yield bonds would not be negatively impacted in a rising rate scenario. In her opinion, while in the past there may have been some validity to the idea that rising rates would be offset by the lower credit spread for high yield bonds. However, today the ratio of the risk-free rate to the credit spread is causing historical relationships “not to hold water”. While the risk-free interest rate has tremendous room to rise, particularly when the FED stops artificially keeping rates low, she believes that credit spreads have limited room to compress further. Thus, the ability of high yield bonds to absorb a potentially large rate increase is limited.
The Relative Value and Opportunity In Floating Rate Bank Loans
I asked Bonnie Baha if she thought floating rate bank loans are mispriced. She answered that floating rate bank loans were not mispriced but represented good relative value to other bond sectors when taking into account their yields, their credit risk, and their duration (interest rate risk). While she did not indicate when DoubleLine thought the FED’s easy monetary policy would end, she did liken easy monetary policy to a game a musical chairs. The longer the music continued the less investment assets would have a “safe” landing.
The Nature Of Passive ETFs and CLOs Create Opportunity
Tremendous amounts of money, tens of billions, have recently flowed from hedge funds into investment vehicles that buy bank loans, called Collateralized Loan Obligations. CLOs have restrictions in terms of what type of bank loans they can invest, such as the credit rating of the loan. Robert Cohen indicated these restrictions provide him relative value trades. For example, some bank loans don’t have as much investor interest because they fall outside the investment parameters of CLOs. He can find floating rate loans that just narrowly missed getting a higher credit rating, but have a significantly lower price as a result of many CLOs not being able to invest.
Active Management and Fees
Robert is essentially suggesting having talented portfolio managers will provide better performance than investing on a pre-set list of rules, more commonly known as passive investing. Those in favor of passive investinghave typically pointed to the high management fees charged by actively managed funds as a reason to avoid them. In the floating rate space, the fees charged by actively managed funds have been particularly egregious. Many funds have a one time front-end load fee (charges that investors must pay to invest in the fund) that can range from 1% to 5%. Once the money is invested, investors typically pay between 1% and 2% per year in expenses. This is not case with the DoubleLine Floating Rate Fund where they have made the fees very reasonable. There are no load fees and for those investing $5,000 of funds from an IRA (be sure to buy the I class shares) the annual expense is 0.76%. For non-IRA investors with less than $100,000 to put in the fund, the fees rises 0.25% to a still below average 1.01%.
Should you invest in the DoubleLine Floating Rate Fund?
DoubleLine has a fantastic track record as a bond fund manager and they make a compelling case that floating rate bank loans represent relative value compared to many corporate bonds. Their fund has relatively modest fees making them an attractive way to invest in floating rate bank loans. However, there is one negative to investing in their floating rate fund. The fund has no real track record, nor do the fund’s managers have a track record managing a floating rate mutual fund. In other words, there is very limited past PUBLIC performance on which to make a decision. While there is no public record to make a decision, DoubleLine hired a specialist in bank loans to be the fund’s co-manager. Given DoubleLine’s position in the market, they had plenty of choices on who to hire.