by Louis Basenese, Small Cap and Special Situations Expert
Thursday, November 19, 2009: Issue #1141

With interest rates resting at historic lows, we can all agree they will eventually rise.

And when they do, you’ll want to make sure you own something called Senior Secured Floating Rate bonds.

I know… these under-the-radar bonds aren’t headline makers. But please don’t let their relative obscurity – they’ve only been around since the early 1980s – convince you to overlook them.

Senior Secured Floating Rate bonds (SSFR) are actually ideally suited for the current environment and deserve a place in every investor’s portfolio. Here’s why…

The Problem With Most Bonds & Interest Rates

When it comes to bonds, the equation is simple: As interest rates decline, the value of bonds goes up. Unfortunately, however, the inverse is also true – as interest rates rise, the value of bonds declines.

And don’t kid yourself, here. We’re not talking about a minor decline in value. Even a subtle increase in interest rates will wreak havoc on the value of bonds.

Take U.S. Treasuries, for example. A mere 1% rise in the Fed funds rate will lead to an 8.5% decline in the value of 10-year Treasuries. And a 2% rise would cause a 17% price drop, according to Barclays Capital.

If you invest in bonds, you don’t want any part of that rout. So what’s the solution? That’s where SSFR bonds come in…

Senior Secured Floating Rate Bonds – Breaking Down the “S,” “S” and “F”

Despite an intimidating and long-winded name, Senior Secured Floating Rate bonds are quite simple:

• “Senior”: This refers to bondholders’ position in the event of liquidation. They’re the first in line to collect.
• “Secured”: This means the bond is backed by specific collateral, such as a company’s cash, accounts receivables, inventory, buildings, equipment, trademarks, or patents. This characteristic results in much higher recovery rates in the event of a bankruptcy. According to Credit Suisse, recovery rates on senior loans since 1995 average 70 cents on the dollar, compared to 43 cents for typical junk bonds.
• “Floating”: This is the most important part. “Floating” refers to the interest rate on the bonds. They simply reset or “float” every 30 to 90 days by a pre-determined amount (the spread) to reflect changes in a base interest rate, like the U.S. Federal Funds Rate or the London Interbank Offered Rate (LIBOR).

For example, if the benchmark LIBOR is 3% and the bond promises to pay 2% more than LIBOR, the interest rate will initially be set at 5%. Ninety days later, if LIBOR increases to 3.5%, then the interest on the bond will reset to 5.5%, and so on.

Meanwhile, a fixed-interest rate bond, paying 4% at the outset, will never pay more than 4%, regardless of how high (or fast) interest rates climb.

This isn’t rocket science. But this simple adjustment means SSFRs aren’t subject to significant price erosion as interest rates rise. And that’s why they exhibit a rare negative correlation with most bonds.

In short, no other type of bonds can offer the same preservation of capital and higher income. However, as with all investments, you need to make sure you execute the right strategy…

How to Invest in Senior Secured Floating Rate Bonds the Right Way

Before you buy individual Senior Secured Floating Rate bonds, it would be remiss of me to not warn you about the risks. Namely, if the company that issues an SSFR goes belly up, so could your entire investment. Although recovery rates average 70 cents on the dollar, that’s not a guarantee.

That’s why I recommend you spread your risk and go with a well-diversified, closed-end fund that invests in hundreds of Senior Secured Floating Rate bonds at once. Such an approach ensures the impact of any bankruptcy is minimal. It also provides daily liquidity.

You can easily search for available funds at www.closed-endfunds.com. Simply click on the “Advisor Search” tab in the left-hand column. Then on the next page, in the “Classifications” drop-down box, select “Loan Participation Funds.”

In the end, even the village idiot knows interest rates are headed higher. Such inevitability makes now the perfect time to position your portfolio to profit from it.

Good investing,

Louis Basenese

View original at: Investment U

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