AFT CEF: Fight Inflation With This Floating Rate Fund

Thesis

Apollo Senior Floating Rate Fund (AFT) is a closed-end management investment company. The fund’s investment objective is current income and preservation of capital by investing primarily in senior, secured loans made to companies whose debt is rated below investment grade and investments with similar economic characteristics. Under normal market conditions, the fund invests at least 80% of its managed assets in floating rate senior loans and investments with similar economic characteristics. AFT has enviable trailing total returns, with the 5- and 10-year total return performance standing at 7% and 7.3% respectively. The fund had its maximum historic drawdown during the Covid crisis when it lost -23.49% (measured on a monthly basis), and it exposes a 10.23 standard deviation. The fund is well diversified from both an industry and top issuer concentration perspective and runs a single-B credit risk profile. AFT is a good leveraged loan fund that employs a standard high leverage for a low volatility asset class to extract yield. Its performance speaks to the managers’ ability to pick good credits. The fund nonetheless is currently overpriced, trading at a premium to NAV. AFT has historically traded at a discount to NAV of 5-7% and has only recently moved to a premium, driving a high z-stat. We fundamentally like the fund and its performance but we believe the timing is very poor. We rate it a Hold for current investors and would revisit the vehicle to allocate new money only when the market price would start trading below NAV again.

Libor vs. SOFR

One less known aspect for retail investors in respect to leveraged loans is the transition away from Libor and into SOFR. Libor (London Interbank Offer Rate) is a rate that was tainted by manipulation and fixing that came to light post the great financial crisis of 2008-2009. The regulators set about to create more transparent floating rates, hence the genesis of SOFR (Secured Overnight Financing Rate). The leveraged loan market has been extremely slow in terms of transitioning from Libor into SOFR and the reason for that is a lack of term structure for SOFR. The main differences between the two rates are as follows:

One very important aspect to keep in mind as an investor into the leveraged loan market is that SOFR is usually lower than Libor, because it is a secured rate. Below you will find a graph from Reuters outlining the difference between the 2 rates during 2019:

Source: Reuters

For an investor into the leveraged loan market SOFR means a lower rate paid to you, hence a lower yield. While LIBOR was scheduled to be discontinued for new loans starting in 2022, bank regulators made an exception for those under contract last year.

Holdings

None of the top-10 holdings exceeds 4% of the fund, with the majority of the larger names around a 2% fund concentration:

The fund is also well diversified from an industry perspective, with a maximum 15% concentration:

The fund holds senior secured loans which are credits that have a first priority in the capital structure of a company, hence a good portfolio diversification provides for a solid credit risk performance even if the weighted average portfolio rating is fairly low at a single-B level:

Interest Rate Risk

The fund is generally on the low duration side given its collateral which is composed of floating rate loans, but nonetheless has fixed rate collateral as well:

The overall portfolio duration sits at 4.33 years, which is driven by the fixed rate assets and high coupon floating rate loans. While representing a good inflation hedge due to the floating rate nature of the underlying index (Libor and SOFR), the fund does have interest rate risk, and a very sudden and aggressive Fed can have negative portfolio performance implications.

Performance

On a 5-year lookback period the fund has a robust performance outside of the Covid induced sell-off:

The fund had a mixed performance during the past Fed tightening cycle, with AFT losing value first in 2013 when the Fed taper was announced, and then again in 2015 when the Fed actually raised rates correlated with a wider market sell-off driven by a dive in oil prices:

The fund lost a modest amount of money during the Fed tightening cycle with 2014 and 2015 exhibiting low negative total returns:

AFT also has a propensity to have above average number of months with negative total returns, which represents a negative for a retail investor:

Premium / Discount to NAV

The fund has historically traded at a discount to NAV:

During most of the past decade we have seen this fund trade at a discount to NAV, which has averaged -7%. In the above table the green color indicates periods of time when the fund has traded at a discount, with the blue portions representing the premium to NAV. We can see that the past Fed tightening cycle that occurred from 2013-2015 (the initial steps that is – the tapering and the first rate increase) saw a move from a low discount to NAV to a higher one.

Conclusion

AFT has exhibited a strong historical performance, although it has traded water for long periods of time in the past when looking at total return metrics. A highly leveraged loan fund AFT has low volatility metrics in a normalized credit environment but is running a higher than usual duration profile for a floating rate class fund. We fundamentally like the fund and its performance but we believe the timing is very poor. We rate it a Hold for current investors and would revisit the vehicle to allocate new money only when the market price would start trading below NAV again.