First Trust Senior Floating Rate Income Fund

Moat: 1/5

Understandability: 1/5

Balance Sheet Health: 5/5

First Trust Senior Floating Rate Income Fund is a closed-end fund that aims to generate a high level of current income by investing in a portfolio of senior secured floating-rate loans and other floating-rate debt instruments.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Description:

FCTF operates as a closed-end fund, meaning it issues a fixed number of shares at an initial offering and then trades those shares on the open market. Unlike mutual funds, which are continuously traded at net asset value, a closed-end fund’s share price fluctuates independently from its net asset value (NAV).

  • Revenue Distribution: FCTF generates its income primarily from the interest payments it receives on the senior secured floating-rate loans it holds in its portfolio. These loans are often made to below-investment-grade companies. There is no other main revenue stream for the business.
  • Industry Trends: The market for floating-rate loans is influenced by interest rates and credit spreads. When interest rates rise, the income generated by the fund also generally increases, as the loan rates adjust upwards. Credit spreads will often increase during poor economic times. These affect the underlying value of the loans in a non-linear way. This asset class is also quite popular with institutions.
  • Margins: As FCTF is a fund, and not an operating company, its “margins” are best understood as the difference between the interest earned on its loan portfolio and its operating expenses and management fees. This is not a typical margin like gross margin, operating margin or net margin. FCTF’s expense ratio is around 1.1%.
  • Competitive Landscape: The closed-end fund space is competitive, with a wide variety of funds offering exposure to floating-rate loans. The level of competition is intense and usually dependent on the management and the returns the fund is able to generate. These funds do have to compete with other income-producing instruments. The underlying assets themselves also have competition between the companies that acquire them.
  • What Makes FCTF Different: FCTF’s competitive advantage is its management team, and their ability to identify the most profitable loans in the credit market. This is hard to quantify or measure. The underlying asset class itself is also unique in its characteristics and is difficult to replicate.

Moat Assessment:

FCTF has a very narrow moat, which we rated as 1 out of 5 for the following reasons.

  • Lack of Barriers to Entry: The closed-end fund industry has relatively low barriers to entry. Anyone with access to money and credit can set up a similar fund. There isn’t any specific and unique proprietary or intellectual property that this fund possesses, it is just a collection of loans.
  • Replicability of Strategy: The strategy of investing in senior floating rate loans is easily replicable by other investment firms. While the management’s ability to select loans might vary, there is a lack of any real differentiation, which means there are no sustainable competitive advantages.
  • Lack of Pricing Power: FCTF does not have pricing power, and cannot charge more for its services based on some type of moat. Its fees are determined by the competitive market forces. The demand for floating-rate securities depends on the interest rate and credit cycle; FCTF has no control over its own revenues.

Risks to the Moat and Business Resilience:

Despite its solid financials, there are many risks to the business of FCTF and its investment moat:

  • Interest Rate Risk: FCTF’s income is directly linked to interest rate movements. A decline in interest rates would hurt income for the fund and therefore negatively affect the fund’s returns.
  • Credit Risk: Floating-rate loans are typically made to companies with higher credit risk than investment grade companies. If loan defaults or credit downgrades become more prevalent due to economic contraction, FCTF’s portfolio will suffer. This is typically the main risk for FCTF and usually impacts share price by a high magnitude.
  • Management Risk: FCTF’s performance is largely dependent on the management’s ability to select the right investments and their risk assessment skills. A poor management selection can have serious negative consequences for the business.
  • Liquidity Risk: While the senior secured loans are generally seen as higher-quality credit, there may be times when their liquidity becomes very limited, resulting in significant drops in market value.
  • Economic Downturns: FCTF’s performance is tied to the broader economy. Economic downturns tend to result in lower interest rates and more credit defaults, both of which would negatively impact the fund.
  • Lack of Operational Diversification: The fund operates in one asset class, and lack of diversification makes it vulnerable to changes in that specific market.

Financials:

FCTF maintains a solid financial position. Its main assets are its investments, and the primary financial obligation are the operational and management expenses.

  • Balance Sheet Health: FCTF boasts an extremely healthy balance sheet. Its debt-to-equity ratio is nonexistent, as it does not rely on leverage. Its asset base is liquid in nature. We rate it a 5 out of 5 on Balance sheet health.
  • Expenses: The most important expenses that FCTF faces are management fees (approximately 1.1%), and various operational expenses which are extremely low.
  • Performance: Performance is largely dictated by the macroeconomic and credit market conditions.

Understandability Rating:

The business is exceptionally easy to understand, and we rate it a 1 out of 5. The mechanics behind a fund are easy to understand and the investment mandate is simple as well. FCTF’s financial health is straightforward and easy to analyze and understand.

Controversies and Recent Problems:

We haven’t identified any recent controversy or major issues facing FCTF. The price action has been volatile due to the changing economic conditions; as a whole though, FCTF has kept up its performance relative to the market.