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Floating Over Volatility

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“Smooth out the volatility. Give up the full return potential for downside protection. Clients won’t experience the high-highs, but they won’t fall victim to the low-lows either, which is what they want, especially those heading for retirement.”

It’s about all we heard from the overlooked managers we interviewed coming out of the market lows of 2009. We thought we were through it; we were wrong, and volatility is back with a vengeance. In the month of August alone, the Dow Jones Industrial Average swung by at least 400 points on four consecutive days for the first time in its 115-year history, according to The Wall Street Journal. The reasons are obvious, but worth repeating: investor reaction to Europe’s debt crisis, economic woes in the United States and Standard & Poor’s downgrade of long-term U.S. government debt.

So a discussion of floating rate securities can’t come soon enough.

David Hillmeyer, lead portfolio manager of the Delaware Diversified Floating Rate Fund, notes the floating rate market is getting increased attention as investors seek protection from interest rate risk in today’s low rate environment—the lowest in half a century.

Hillmeyer points to two main reasons for the appeal of floating rate securities: minimal interest rate sensitivity because of their low duration and the fact that they earn increasing rates of income as interest rates rise. But, he cautions that investors need to more fully understand floating rate securities in order to select the appropriate floating rate fund.

 “At this stage of the game, I would argue that floating rate products are topical for a number of different reasons,” Hillmeyer says. “We are looking at the floating rate market now not only to protect against inflation, but to take advantage of the other things driving interest rate volatility, whether it be sovereign debt issues around our fiscal situation or what’s going on in Washington and Europe. We constantly ask ourselves what this means for financing costs for countries around the globe.”

He adds that if you layer in the fact that 35% of the overall global GDP comes from developing economies, investors have to consider the resulting increase in demand for commodities and, by extension, it’s effect on pricing.

“If you would have asked me five years ago about how I would approach the floating rate market, I would have told you, ‘Well, you approach it from the standpoint of being very tactical,’” he says. “When you think rates are going higher, you invest in the asset class, and when you think rates are going lower, you pull back and go into fixed rate securities. I think it’s an interesting way of looking at it from a strategic standpoint, just given all the uncertainties and the unknowns that are out there.”

Hillmeyer emphasizes that the manner and amount of floating rate securities in the overall portfolio are specific to the individual, but with the disclaimer out of the way, he says, generally, 5% to 15% is an appropriate target.

“It’s important to position that portion of the portfolio in a way that you don’t have a tremendous amount of commitment around the direction of rates, whether they go higher or lower,” he says. “Investment professionals could put pretty compelling arguments out there for both scenarios. But you allocate a percentage to your portfolio as a hedge. And you look at it in the context of what your needs are for fixed income and how much of your portfolio is, in fact, in fixed income that you need to protect. I would not switch all my holdings from fixed income into floating rate products; that’s too bullish of a call on floating rates. But I do think it plays a very important role in the allocation process.”

So what qualifies Hillmeyer as an overlooked manager, and what does he do with the Delaware Diversified Floating Rate Fund that’s better than his competitors in the floating rate space?

The easy answer is size, as the fund manages only about $350 million. From there it gets a bit more complicated.

“The primary differentiating factor between Delaware and the rest of the market is that most investors think floating rate products only involve bank loans,” he explains. “They end up investing in that single asset class, one that is below investment-grade.”

He notes the tremendous amount of money going into the bank loan asset class over the last six to nine months, which is driving up valuations to the point where managers are simply trying to stay invested and ahead of the curve.

“Since the asset class is callable at par at any time, it’s very difficult for the loans to trade above par for any meaningful period,” he says. “If they do trade above par, it’s an invitation for the issuer to come back into the marketplace and refinance on more favorable terms. And that’s exactly what we’ve been seeing. In 2010, there was roughly $155 billion of new supply that came into the market, with $145 billion worth of pre-payments.”

When it’s so easy to refinance, he says, “a corresponding squeeze can develop fairly easily as well.” Bank loan valuations are driven to the point where “all your paper gets called away and you’re essentially trading your upside by investing in the asset class at these [higher] levels.”

“Why give all the upside of good, fundamental credit picking back to the issuer by having them call away a premium loan?” he rhetorically asks. “Why not invest in an investment-grade name that you like for fundamental reasons and have that benefit accrue directly to the portfolio?”

Hillmeyer says opportunities in Latin America have recently presented themselves, as have opportunities that arise from volatility in Europe. Year-to-date performance is up about 187 basis points. However, the loan market is up about 225 basis points on the year, which, surprisingly, he’s perfectly happy with from a risk/return profile.

“Although you’re lagging the loan market, you’re generating a significant amount of that return with significantly less risk (and I’m quantifying risk by looking at the credit quality),” he says. “It’s a very different risk profile. This portfolio will lag during huge bull market rallies. It’s important for investors to think about this strategy as something to see them through the market cycle, rather than something that’s tactical. It’s an allocation that gives you a much more attractive risk/reward profile. You’re going to give up yield, but remember, it’s a total return idea. You want to protect the principle and offset loss. You’re going to give up income in order to do it, but over a market cycle we think total return strategies are a better way to approach the floating rate market.”