Risky Positions Lead to Neutral Rating for This Bank-Loan Fund
Oppenheimer Senior Floating Rate has strengths, but the fund’s meaningful risks temper our enthusiasm.
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Oppenheimer Senior Floating Rate boasts an experienced team and low fees, and the addition of more-defined risk limits is a positive. However, the fund holds relatively large positions in a number of higher-risk securities, including some going through bankruptcy restructuring. Concerns about the idiosyncratic and liquidity risk introduced by these positions support an Morningstar Analyst Rating of Neutral.
These risks are illustrated by many of the fund’s top 10 issuers. As of December 2017, the largest holding (2.3%) was Clear Channel Capital, also known as iHeartCommunications. The company filed for bankruptcy on March 15, 2018 after reaching a restructuring agreement with most of its creditors. The team argues that the outcome should ultimately be beneficial to the fund, but restructurings require significant resources and introduce sizable risks. Meanwhile, second-largest holding Murray Energy (2.1%) has seen its unsecured bond tumble nearly 50% since February 2017, over concerns that one of its largest customers (FirstEnergy Solutions) is on the verge of bankruptcy. The company was also adversely affected by the cap on net interest deductions in the recent tax bill. The loan appears to have held up better than the bond, but risks to the company remain. Other higher-risk holdings include 1.9% in the equity of Arch Coal (ARCH), and 1.2% in a second-lien loan issued by Western Express.
To be sure, the fund has imposed additional guidelines that should help control risk, such as limits on exposure to equities, second-lien loans, and distressed securities. And the overall portfolio has shifted significantly in the past few years and now holds more cash, fewer second-lien and CCC rated loans, and a higher percentage of large, liquid deals.
The fund does have some strengths. Lead manager Joe Welsh has been at the helm since 1999, making him one of the longest-serving managers in the bank-loan Morningstar Category. He is supported comanager David Lukkes and a stable, experienced group of analysts. They have led the fund to strong record. Still, the fund’s meaningful risks temper our enthusiasm.
Process Pillar: Neutral | Brian Moriarty 03/26/2018
We have had concerns about the risks the fund has taken historically. Some of those concerns have been addressed by new risk guidelines and broad changes to the portfolio, but there is still significant idiosyncratic risk in some of its largest holdings. The fund’s top 10 holdings include relatively large positions in higher-risk names, such as Clear Channel, Murray Energy, Arch Coal, and Western Express. Arch Coal is equity from a restructuring and could have a very different risk profile than a bank loan. The top 10 holdings account for 15% of assets.
The team is comfortable taking multiple holdings through bankruptcy restructurings at the same time, which is a very resource-intensive process. Loans typically have higher recovery rates than bonds, but restructurings don’t always work out in the loanholders’ favor and can introduce extreme performance swings (up or down) that can meaningfully affect returns.
At a high level, the strategy revolves around fundamental credit selection. Analysts look at factors such as profitability, debt serviceability, and covenant provisions, and overall allocation is determined by lead manager Joe Welsh at weekly meetings, with significant input from the analysts. Credit selection appears robust, and the changes to the portfolio and risk guidelines are improvements, but the concentration of higher-risk holdings keeps the Process rating at Neutral.
The strategy is designed to be a pure play on bank loans, which account for the bulk (88%) of the portfolio as of December 2017. But it did have small allocations to fixed-rate corporate bonds (less than 1%) and equities (4.3%). The team doesn’t buy equities outright, but they are often received when holdings go through restructurings. Cash was just under 7%, higher than the long-term average of 2%-3%, although going forward the team expects to maintain this stake at roughly 3%-5% to accommodate the SEC’s new liquidity rules. The currently elevated level of cash is common around year-end as the new issue calendar slows.
While the relatively large stakes in individual lower-rated loans and even equity add risk, the rest of the portfolio has shown signs of moderation, an encouraging sign given that many believe we are in the latter stages of the credit cycle. The fund’s BB rated holdings (which land at the higher-rated end of the below-investment-grade universe), are up to roughly 24% from a recent low of 9% at the end of 2015. Second-lien loans, which can be less liquid than the more common first-lien loans, accounted for roughly 2.5% down from a recent high of 8% at the end of 2014. Holdings in deals larger than $1 billion (the most liquid part of the market) comprised roughly two thirds of the portfolio, up from one third in early 2015.
Performance Pillar: Positive | Brian Moriarty 03/26/2018
The fund’s long-term record remains impressive. As of February 2018, its trailing 10-year return of 5.6% annualized landed in the top 10% of the bank-loan category (distinct peers) and comfortably beat the 5.3% return of the commonly used Credit Suisse Leveraged Loan Index. The fund did stumble a bit during the credit sell-offs in 2014 and 2015, thanks to a high allocation to B and CCC rated loans. From June 2015 through February 2016, it lost 6.3% and trailed 75% of peers. The team’s energy picks were a drag on returns that year, despite an underweighting in the sector relative to its JPMorgan Leveraged Loan Index bogy.
Those same qualities led the fund to roar back in 2016, when riskier assets rebounded. It returned 13% that year, far outpacing the 8.9% median peer return and landing in the top 4% of the category. That rebound was driven by a handful of names, such as Arch Coal and Murray Energy, that are still in the fund today. The idiosyncratic risk in these names, which was so beneficial in 2016, could easily turn against the fund if these companies falter.
The rest of the portfolio has shifted in recent years and has taken on a more-defensive tilt. This may change its performance pattern in the future and help it hold up better during future sell-offs. Based on the strong long-term record, the fund earns a Performance Pillar rating of Positive.
People Pillar: Positive | Brian Moriarty 03/26/2018
Joe Welsh has been at the helm since the fund’s September 1999 inception. He has 25 years of investment experience and joined Oppenheimer as a high-yield analyst in 1995. Welsh leads the firm’s senior corporate loan team and is supported by comanager David Lukkes, who has more than 20 years of experience. Lukkes, who retained analyst responsibilities, was named a comanager in October 2015 when longtime comanager Margaret Hui retired.
The two managers are supported by seven dedicated loan analysts, a director of research, and three traders. The director of research is a newly created position that one of the senior analysts took on, and he still contributes to the analytical resources of the team. The team’s structure is differentiated in two ways: Analysts rotate industry coverage every few years, and they are allowed discretion over buy and sell decisions within their industries. The coverage rotation, which just occurred in October 2017, can be a short-term operational headache but also reduces key-person risk among the analysts. Welsh believes the trading discretion encourages analysts to think like portfolio managers, although he and Lukkes must still approve the addition of any distressed companies.
Based on the long experience of the managers and analysts, along with Welsh's significant ownership (more than $1 million), the fund earns a Positive People rating.
Parent Pillar: Neutral 01/22/2018
Art Steinmetz became CEO of OppenheimerFunds in July 2014, the firm’s first from its investment ranks, after managing several of its taxable-bond funds for many years. Steinmetz replaced Bill Glavin, who joined the firm in 2009 to help clean up the mess that occurred following the 2008 financial crisis, when several key Oppenheimer fixed-income funds suffered massive losses due to hidden risks. Since taking over, Steinmetz has been trying to move Oppenheimer forward in a positive way, launching new funds and emphasising offerings that can (he hopes) outperform in areas where passive and index vehicles don't do well.
Overall fund performance has improved since the financial crisis, and the company has made strides in the area of manager ownership of fund shares. More than half of fund assets are run by managers with at least $1 million personally invested alongside fundholders, twice the level of two years ago. And although the firm’s average fee-level percentile still lands in the "average" range for fees overall, it represents continued improvement.
That being said, Oppenheimer still has to show that it can attract and retain top portfolio managers in all parts of its business. It still remains to be seen if Oppenheimer can stand out from the industry set as it transitions from "fix-it" mode to one more of growth and new-product initiatives and one under new leadership.
Price Pillar: Positive | Brian Moriarty 03/26/2018
All of the fund’s share classes are competitively priced and carry Morningstar Fee Levels of Low or Below Average. The Y (Institutional) share class is the largest, with roughly 47% of assets, and charges 0.72%, cheaper than 60% of similarly distributed peers. The relatively inexpensive price tags across share classes earn the fund a Price Pillar rating of Positive.
Brian Moriarty does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.