VVR: Will Continue To Deliver A 12% Yield Until The Fed Cuts

SpiffyJ/E+ via Getty Images Thesis The Invesco Senior Income Trust (NYSE:VVR) is a fixed income closed end fund. The vehicle is one of our favorite plays in the leveraged loan market, having covered it for a while now. In our last article 12 months ago, we highlighted the robustness of the structure in light of a high rate environment and assigned a ‘Hold’ rating to the name. The fund has delivered ever since for holders: Prior Rating (Seeking Alpha) The total return since our last piece is outstanding, and speaks well to the structure and its ability to pass high floating rates to holders. In this article we are going to revisit the name, its performance and holdings, and highlight why it is still a security to hold until the Fed starts cutting rates. Floating rate funds work VVR contains a pool of floating rate leveraged loans, with an additional layer of leverage on top of the structure: Holdings (Fund Website) The fund is mostly composed of 1st lien loans (86% of the fund) which are the safest form of credit via their high recovery rates. ‘1st lien’ simply refers to being first in line to get a recovery in a case of a default: A lien is a claim on collateral pledged to secure the financing. The first lien debt has the first claim on collateral, while the second lien has a second priority claim. Revolvers, also a form of senior debt, can be secured by their own pool of assets or share collateral with first lien debt. The CEF is overweight single-B names and has a fairly sizable slice of not rated debt: Ratings (Fund Website) Floating rate collateral has done a tremendous job in passing to investors higher floating rates, with a yield which has been enhanced by the leverage the fund has on top of the structure. Analytics AUM: $0.66 billion Sharpe Ratio: 0.73 (3Y) Std. Deviation: 4.3 (3Y) Yield: 12% Premium/Discount to NAV: 6.9% Z-Stat: 1.5 Leverage Ratio: 33% Composition: Fixed Income – Lev Loans Duration: below 0.5 yrs The premium to NAV is the only concern Just like any successful CEF, VVR has seen its premium to NAV move to high historic levels: Data by YCharts The fund has historically traded at a slight discount to NAV, but has now moved to a high 6.95% premium to NAV. This is a concern, and we would have much more liked to see the fund flat to NAV. When the Fed ultimately starts cutting rates, we are going to see (in our opinion) a move from a premium to being flat to NAV. Lower rates mean lower yields, which in turn will make VVR slightly less appealing. As we have said many times before with the CEF structure, large premiums or discounts are a direct result of a fund manager’s success or failure at obtaining robust results in their sector. VVR has been outstanding in the past three years, and Invesco has been rewarded by the market with a premium to NAV from a discount. This is how the CEF space works. Distributions – good coverage for its yield The fund has a well covered distribution: Distributions (Fund Website) As of the April 2024 payment date, on a fiscal calendar year, the CEF covered its distribution from investment income to the tune of 88%. That is a good figure, and it implies only minimal ROC utilization for the name. There are many CEFs, especially fixed assets CEFs, which have high, unsupported distributions. Names with ROC figures above 30% should be avoided, all else equal (i.e. there is nothing in the structure that can move the NAV up significantly). Most CEFs are income plays, meaning an investor buying into the structure expects dividends rather than NAV appreciation. When is the Fed going to cut? This is the million-dollar question. Once the Fed starts cutting, we are going to have a twofold impact on VVR. On one hand, we are going to get lower SOFR rates, which in turn will result in lower distributions on the underlying leveraged loans and the fund itself. The secondary impact (in our opinion) will be from a decrease in the premium to NAV. Once rates are lower, floating rate assets will be less attractive, thus a lower premium for the CEF. We anticipate the CEF moving to flat to NAV or even at a slight discount once rates are substantially lower. Currently, the market is split when it comes to the first-rate cut: Fed Rate Cuts (WSJ) While some investment banks have September as the month when the first cut is penciled in, some have December or even 2025. We are in the December camp, since inflation has proven to be stickier than expected, and we do not think the Fed wants any political assumptions around monetary policy decisions. With that in mind, 2024 still shapes up to be a good year to be in floating rate assets, irrespective of the exact timing. Even if the Fed does its first cut in September, we are looking at roughly 50 bps of cuts in 2024 under an aggressive scenario. That level still translates into high SOFR levels, and kindly keep in mind there is a transmission lag between Fed Funds and the rates on the underlying loans. Risk Factors The largest risk factor for this CEF is a strong recession, which would both prompt the Fed to aggressively lower rates and the underlying leveraged loans to lose value. In a soft landing scenario, the Fed path lower is smooth. In a situation where the economy deteriorates suddenly, the Fed has to take drastic action, a scenario which can see much lower rates very fast. The current credit spread environment is also a slight concern for this name, with credit spreads very low currently (and high prices on the underlying loans). If credit were to dislocate, we would see a pressure on the CEF’s pricing, although its low duration would mitigate some of that move. Conclusion VVR is a fixed income CEF. The fund contains a portfolio of leveraged loans with a very low duration, and has been able to deliver outstanding results in a high rate environment. The fund is a golden standard in the leveraged loan CEF space, and the market has rewarded the fund with a premium to NAV. We are of the opinion the name will continue to deliver robust results until the Fed starts cutting rates. At that stage, we will see both a lower distribution on the name and a move lower to flat to NAV for the premium. The CEF is a hold until then.

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