You Be the Banker

CLOSED-END FUND SURVEY
Forbes
September 7, 1998

You Be The Banker
by Mark Skousen

If credit risk bothers you less than interest rate risk, consider owning a prime rate fund.

Two rules of thumb on buying closed-end funds, elucidated elsewhere in this survey, have to do with the cost of ownership. One is that you should almost never pay a premium over net asset value to get a closed-end. The other is that you should be wary of a fund that has a higher than normal expense ratio. The story on page 230 sets out the reasoning for these rules.

I’d like to make a case for breaking both rules for a fund category that complements your bond portfolio. I’m talking about so-called prime rate funds. These are portfolios of bank loans, held by closed-end funds.

First, why diversify into this class of funds? Since 1994 bonds have been on a tear. But there’s a downside. Yields on 30-year Treasurys have slid to a measly 5.6%. That’s not bad in relation to recent inflation rates, but it’s a somewhat lopsided bet. It’s pretty unlikely that rates would move down another two points, handing you a fat capital gain, but it is quite possible that between now and 2028 rates could move back up two points, to where they were just a few years ago.

How, then, to get a decent yield without taking on long-term interest rate risk? Prime rate funds invest in variable-rate senior loans to corporations at interest rates tied to the so-called prime rate. Currently this benchmark at most banks is 8 1/2%. That is several percentage points higher than the yield on Treasurys, mortgage paper or money market instruments like certificates of deposit.

Even after charging stiff fees of 1.4% or more, funds holding these loans are yielding at least 7%. Although the net asset value of the funds is not completely unchanging, like that of money market funds, the fluctuations to date have been minuscule.

There’s a reason why you should be willing to stomach those high expense ratios: Your fund, to a degree, is acting more like a bank than a bond fund. It has to appraise borrowers’ credit quality and take a chance on an investment that is not traded every day and is not liquid. There’s a lot more work involved than there is in taking positions in five Treasury notes and sitting on them.

What happens when interest rates shoot up and bond prices fall? Conventional bond funds get hammered, but the prime rate funds, whose interest income floats up with the prime rate, have been remarkably stable. In 1994, when investors suffered terrible capital losses on longterm bonds, Pilgrim America Prime Rate Trust enjoyed a stable net asset value and delivered more than 7.5% total return for the year.

What’s the downside? For one, declining interest income if the prime rate declines. Next, credit quality. The senior loans are collateralized and go to respectable borrowers, but there are no government guarantees. Third, liquidity. Two funds trade publicly, but the rest are redeemable only quarterly.

Among the funds I like are Van Kampen Prime Rate Trust B shares, currently yielding 7%. Unlike the Pilgrim fund, it doesn’t use leverage. You buy at net asset value. The fund offers shareholders the ability to tender shares quarterly, receiving net asset value less a redemption charge starting at 3% the first year and then declining 1/2% per year. A brand-new sister fund, Van Kampen Senior Income Fund, will use leverage and deliver a slightly better yield. Senior Income trades publicly as a closed-end and is currently at a slight premium.

Pilgrim America Prime Rate Trust, the oldest of the breed (trading since 1992), sports an 8% yield, goosed up by some leverage. Caution: Pilgrim can play tough. In 1995 shareholders were dismayed by a rights issue that forced them to either add to their holdings or risk dilution. At a recent $10.16, Pilgrim goes for a slight premium. Try to get it for less than $10.

Emerging Markets Floating Rate Fund is for the brave. This one invests in floating-rate loans to governments in Latin America, eastern Europe, Asia and Africa. With emerging markets out of favor, the shares have dropped from $17.75 in June 1997 to a recent $12.88, close to net asset value. The yield is 12%, but that figure makes no allowance for loan losses–and you just might see a default on some of these loans someday.

Forbes · September 7, 1998

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