The last time we had this Fed setup, these safe 6%+ paying bonds jumped 20% in the year ahead!
The setup? The likelihood that short-term interest rates (as set by the Federal Reserve) will go nowhere over the next 12 months. To see this we&a;rsquo;ll turn to the Fed funds futures, which are contracts that reflect real money being bet on the Fed&a;rsquo;s upcoming action (or lack thereof). Collectively they comprise the smartest crystal ball available this side of Jay Powell.
Right now, the smart money is giving &a;ldquo;no hike&a;rdquo; a 75% probability between now and January 2020. And when we add in the bets on a rate cut or two, we&a;rsquo;re looking at a 92% chance that rates will either be unchanged or lower this time next year!
This is bullish for &a;ndash; you&a;rsquo;ll never guess &a;ndash; &l;i&g;floating rate bond funds&l;/i&g;.
We have a historical parallel we can draw on. In the summer of 2006, then-Fed chair Alan Greenspan capped off three years of rate hikes. &l;i&g;Contrarian Income Report&l;/i&g; favorite &l;b&g;BlackRock Floating Rate Income Strategies Fund &l;/b&g;continued to rally until the following summer, even though rates were going nowhere.
The Fed rate remained unchanged while the 10-year Treasury rate traded in a range (between 4.4% and 5.3%). Interest rates were flat, yet floating rate fund FRA gained 20% in 12 months. Who would have predicted that!
This big year was nothing new for FRA, either. Over the past 10 years, the fund has delivered impressive 11.8% annual returns on its net asset value (NAV), or the value of the bonds in its portfolio.
And which bonds does it own specifically? Corporate bonds, which are issued by firms to fund future growth.
FRA&a;rsquo;s &a;ldquo;secret&a;rdquo; is that it buys bonds that are just below the &a;ldquo;investment grade&a;rdquo; demarcation. Blackrock&a;rsquo;s managers David Delbos, Mitchell Garfin and Josh Tarnow know that it doesn&a;rsquo;t matter what a rating agency says. What matters more is the actual health of the business issuing the bonds, its cash flow, and its ability to service the debt.
There&a;rsquo;s an absence of big buyers in these underappreciated debt pools. Many pension funds aren&a;rsquo;t allowed to buy bonds that don&a;rsquo;t have the investment grade stamp, regardless of any deeper analysis. As a result, the Blackrock team is able to find value in the Bs, and 94% of the fund&a;rsquo;s portfolio in BBB, BB, or B rated debt.
So what&a;rsquo;s &l;i&g;our&l;/i&g; secret as income investors? We want to select excellent funds like FRA and buy and hold them when they trade at discounts to the value of the bargain bonds they hold.
FRA, after all, is a closed-end fund (CEF). And we can be smart about our CEF purchases and buy them:
&l;/p&g;&l;ol&g;&l;li&g;For 6% yields or higher,&l;/li&g;
&l;li&g;And at discounts so that you can snare some price upside to boot!&l;/li&g;
&l;/ol&g;
Here&a;rsquo;s why: CEFs (unlike their ETF and mutual fund cousins) have fixed pools of shares. Meanwhile, their prices trade up and down like stocks - which means these funds can sometimes trade at a discount to the value of their underlying assets! You can literally &l;i&g;buy a dollar for less&l;/i&g;.
As I write, FRA pays 6.2% today yet is priced at a 13% discount to its NAV (net asset value). Shares trade for just 87 cents on the dollar, the cheapest they&a;rsquo;ve been in 10 years!
Disclosure: none
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