3 Questions: Federated Floating Rate Strategic Income Fund

01-27-2017

“3 Questions” delves into investment approaches used by Federated Investors strategists. This installment features Portfolio Manager Steven Wagner.

Q: Can you explain the Federated Floating Rate Strategic Income strategy? At its core, the strategy offers fixed-income investors who are concerned about rising inflation, rising interest rates and longer-term credit risks a singular opportunity to play both offense and defense. From the offensive side, because it invests in floating-rate securities whose coupon payments increase or decrease with changes in short-term market rates, the fund has the potential to generate more income during periods of rising rates, as is the case now. The 1-year London interbank offered rate (Libor), for example, has nearly doubled over the past 52 weeks to above 1%. We believe the bias on rates will continue to be higher, driven by a strengthening economy, more inflation and a Federal Reserve early in a tightening cycle.

On the defensive side, relatively short duration and frequent rate resets protect against interest-rate risk, providing some defense against the potential negative price impact of rising rates. In addition, portfolio diversification and disciplined sector allocation management can help to mitigate the negative impact during pockets of downside volatility in the leveraged-finance credit markets. The fund primarily invests in short-term securities across three non-correlated floating-rate asset classes—U.S. non-investment-grade (primarily floating-rate bank loans); international fixed income (trade-finance loans that facilitate the production and shipment of goods across borders); and U.S. investment grade (primarily adjustable-rate mortgages and corporate debt).

Portfolio managers are given the flexibility to seek what they believe to be the optimal mix among the three asset classes, with the ability to concentrate up to 75% of holdings in any of the floating-rate sectors. These decisions are based on relative valuations among the asset classes, and on economic and market conditions. The goal is to generate attractive risk-adjusted returns relative to the Morningstar pure bank-loan category over a full market cycle.

Q: How has the strategy performed in the current environment of rising rates and stronger growth? Relative to its pure bank-loan peers in the Morningstar category, this multi-sector fund has provided competitive risk-adjusted returns in this current rising-rate cycle, along with comparatively lower volatility as measured by the fund's standard deviation and downside capture ratios—key measures of volatility and performance in down markets (the lower the number, the better)—relative to the Credit Suisse Leveraged Loan Index. This reflects the historical benefits of a blended strategy that also includes trade finance and high-quality non-bank loans in the asset mix.

Q: What is the outlook and positioning for the strategy over the next 3 to 6 months? We believe, as mentioned above, that we are in upward rate cycle, accompanied by improving GDP, rising business and consumer confidence, a more pro-business Washington, solid corporate credit fundamentals and a healthy macro environment for well-capitalized U.S. banks. As such, we are overweight in the credit portions of our portfolio. While the difference between 3-year bank loan yields and 3-month Libor—the so-called 3-year discount margin, which acts as proxy for yield spreads on floating-rate loans—has tightened below its historical median, we believe bank-loan market valuation is reasonable in the context of healthy credit fundamentals and a favorable macro outlook. This creates potential benefits in two ways: attractive current yield stream at present spread levels and possible income appreciation if and when rates rise.

Thank you, Steven