VVR: Higher Interest Rates, Higher Income (NYSE: VVR)

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Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on August 17, 2022.

Invesco Senior Income Trust (NYSE: VVR) is a closed-end fund focused on investing in Senior Loans. These old people the loans are mostly floating rate in their structure. This means with higher interest rates; the fund should be able to generate higher income from its underlying portfolio.

Since we last reviewed this fund, they have released a new annual report showing that their net investment income has increased significantly. However, the report reflected the end of the fiscal year, which comes at the end of February. That was even before the Fed raised its target rates.

Effective federal funds rate

Y-Charts

This suggests that from the positioning of the portfolio alone, they were able to derive higher income from the portfolio. They last reported an 86% turnover rate. Over the past five years, they’ve had an average turnover rate of 65%, which means they’re generally quite active. Although this is the first year to see a substantial increase in the NII figure compared to the last five years.

With higher rates now, we should see additional bumps in the income the portfolio can generate. The fund benefits from an attractive discount, which makes it a potentially attractive candidate in this environment. However, widening discount and credit risks play a role in the portfolio. This should be considered before investing in a leveraged senior loan fund such as VVR.

The basics

  • Z-score over 1 year: -0.75
  • Discount: -8.37%
  • Distribution yield: 7.92%
  • Expense ratio: 1.53%
  • Leverage: 32%
  • Assets under management: $963.8 million
  • Structure: Perpetual

VVR’s investment objective is “to provide a high level of current income consistent with the preservation of capital”.

To achieve this, the fund “will invest primarily opportunistically in senior floating or variable loans from issuers that operate in a variety of industries and geographic regions.”

The fund is quite large in size compared to other closed-end funds. This can help provide plenty of liquidity. The higher amount of leverage certainly helps in this case as well.

They use loanwords, which is quite common for CEFs. These are variable rate. They will therefore see their expenses increase as interest rates rise. This will offset some of the higher income we should see from the portfolio, but not enough to offset it completely. The weighted average spread above LIBOR in their portfolio is 5.06%. Here are their comments in the latest report they shared.

Leverage involves borrowing at a short-term floating rate and reinvesting the proceeds at a higher rate. Unlike other fixed income asset classes, the use of leverage in conjunction with Senior Loans generally does not involve the same degree of risk from rising short-term interest rates since Senior Loan income generally adjusts to changes in interest rates, as do the rates that determine the Trust’s borrowing costs. (Similarly, if short-term rates were to fall, borrowing costs would also fall.)

In addition, they have floating rate demand preferred shares. This is a bit more unusual for CEFs, but it reduced fund spending over the period. At the end of the 2022 financial year, the preferred dividends amounted to only 0.21%. The loans had an average interest rate of 1.05% for comparison.

In their last annual report, they showed a comparison of $10,000 growth against a leveraged loan index. What we can see is exactly how leverage worked to impact this fund. The result was significantly higher at the end. However, the journey it took to get there was quite volatile. During the sell-offs, we saw the market value drop below the index. However, on a NAV basis, it never seemed to drop below the index level.

Comparison VVR with Leveraged Loan Index

Comparison VVR with Leveraged Loan Index (Invesco)

Performance – Discount Expansion

Since the last update, we also found that the fund’s performance has not acted as the natural hedge it should be with higher interest rates. Below is the performance since the last release against the S&P 500. It’s not a proper benchmark, but it gives us some insight into what the overall market looked like.

VVR performance

VVR performance (Looking for Alpha)

One of the main reasons for this is the very structure of the CEF. The fund has widened its discount since we last approached the fund. It went from a 3.24% discount to the 8.37% level now. It had nothing to do with his actual total NAV performance during that time.

On a YTD basis, we can see that the total net asset value return reflects the fund’s ability to weather the storm. The overall fund has also rallied with the market lately. The results are still better than the S&P 500 on a YTD basis. At the time of writing, the broader market is down almost 11%.

VVR and NAV prices

Y-Charts

This leads to the second reason why it is also negative right now. This is credit risk. There is an increased possibility that the economy will enter a recession. This increases the risk of the underlying portfolio having defaults and bankruptcies. The fund’s holdings are clearly skewed towards below investment grade funds.

This is not referring to the technical recession we currently find ourselves in. It didn’t show he was slowing things down too much, at least not yet. If fears of a recession start to resurface, we could see more pressure reappear on VVR stocks.

The current discount puts it at a slightly larger discount than its longer-term average. Interestingly, at one point, this fund carried a premium.

Chart

Y-Charts

In fact, if we look at an even longer time frame, we can see that the fund has traded at a premium on several occasions. However, it has been several years since this happened.

VVR discount/premium history

VVR discount/premium history (CEF Connect)

Distribution – More Potential Increases

The latest distribution yield is 7.92%, with a NAV rate of 7.26%. At the beginning of the year, the fund strengthened its distribution.

VVR distribution history

VVR distribution history (CEF Connect)

At first I thought it was a bit unusual. However, when they released the year-end report, it made a little more sense. The NII had increased by 16.6%. That being said, this kept NII coverage mostly stable. It went from 82.3% to 82.33%.

VVR Annual Report

VVR Annual Report (Invesco)

Per share, NII fell from $0.21 to $0.26. They paid $0.31 in distributions for the period. The unrealized gains were sufficient to offset the realized losses and essentially covered the distribution.

For fixed income funds, we would generally want to see 100% NII coverage ideally. That’s why I think management is confident that they should be able to generate an even higher NII in the future. This is believed to be due to higher interest rates and the floating nature of their holdings.

We are already seeing signs of this too. In the last factsheet they published that last month’s earnings were $0.0292 at the end of June 2022. That’s a very short time frame to try to extrapolate, but it would indicate that NII pushes $0.35+ annualized. Considering the distribution amounts to $0.312 annualized on a last month basis, we see that the coverage could be over 100% now.

If the economy does not suffer too much of a downturn, we should expect higher payouts in the future.

VVR Portfolio

In addition to the fund-specific haircut, the underlying loans are haircut that the fund holds. On average, the holding price was $90.31. Unfortunately, they bought them for $97.49. It could be argued that this helps highlight the additional upside potential.

VVR Fact Sheet

VVR Fact Sheet (Invesco)

One of the reasons why these loans are discounted again goes back to the credit risks of these loans. They carry a portfolio that is mostly below investment grade or unrated. We can see that the default rate remains low at the moment.

VVR Fact Sheet

VVR Fact Sheet (Invesco)

The diversification of the fund helps to provide security. They hold 620 positions with 386 different issuers in 34 sectors. Although they are more heavily geared towards the service and aerospace sectors, this does not appear to be overwhelmingly the case.

VVR Fact Sheet

VVR Fact Sheet (Invesco)

A look at a sample of their holdings can give us a better idea of ​​what these floating rate terms look like.

VVR holdings

VVR holdings (Invesco)

Over time, LIBOR is being phased out, so eventually we will see SOFR or another relevant benchmark rate start to appear more frequently.

Conclusion

VVR has seen a huge increase in revenue generated from the wallet. However, this happened before rates even started to rise. Now that the rates have started to rise, we have already seen signs of the NII increasing. This should reward investors with more potential increases in distributions in the future. The attractive valuation and current economic conditions still make VVR a viable investment today. However, keeping an eye on economic conditions is always a risk for these types of funds. With economic conditions slowing, the Fed may be forced to reverse rates and defaults may increase for VVR and all senior loan funds.

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