The Franklin Limited Duration Income Trust (NYSE:FTF) is a closed-end fund, or CEF, that income-focused investors can use to achieve their goals of receiving a high level of income from the assets in their portfolios. As is the case with most limited-duration funds, the fund aims to reduce its interest-rate risk compared to similar funds, which could be valuable right now. After all, current market pricing still seems to point to expectations that the Federal Reserve will cut interest rates by at least 125 basis points in 2024, but recent economic data, such as today’s GDP report, is far too strong to support this narrative. As such, domestic bond funds in general appear to have a significant amount of risk baked into their current prices and might be primed to decline. The Franklin Limited Duration Income Trust should be able to hold up a bit better than many peers in such an environment.
Unfortunately, the fund’s historic price action would suggest that this fund is still fairly risky. As we can see here, the shares of this fund are down 30.63% over the past five years. This is substantially worse than the 8.38% decline of the Bloomberg U.S. Aggregate Bond Index (AGG) over the same period:
This will almost certainly reduce the fund’s potential appeal in the eyes of just about any investor. After all, nobody wants to lose money to that extent when the index has held up much better. This also somewhat weakens the previous statement about this fund supposedly having lower interest rate risk than the broader bond market.
However, we can see that this fund was impacted to a much greater extent than the broader index during early 2020 when market participants some off just about everything in a flight to safety. The Bloomberg U.S. Aggregate Bond Index quickly regained the level that it previously had, but this fund never recovered to its pre-pandemic levels. That suggests that the fund’s leverage forced it to sell off some of its bonds and realize losses when the market sold off, akin to a massive margin call.
In addition, the fund’s leverage likely amplified the fund’s losses when the market sold off beginning in late 2021 due to rising interest rates. That is an unfortunate problem that we have seen with other limited-duration closed-end funds. In short, the leverage employed by these funds tends to reduce or eliminate the protection against interest rate movements that should accompany an investment in low-duration instruments.
As I have pointed out numerous times in the past, though, a simple look at the share price performance of most closed-end funds gives a rather misleading picture of how investors in said funds actually did. This is because closed-end funds tend to pay out all of their investment profits to the shareholders as distributions, while simply retaining their equity capital and any borrowed money. This is the reason why these funds tend to have higher distributions than nearly any other asset in the market. In many cases, these distributions can be sufficient to offset moderate share price declines.
Even in the absence of a share price decline, these distributions result in the fund’s shareholders doing much better than a potential investor might think based solely on the share price performance. As such, it is critical that we include the distributions in any performance analysis or comparison to have an accurate picture of how investors in the fund actually did. When we do that, we see that investors in this fund actually did better than investors in the broad-market bond index. As we can see here, the Franklin Limited Duration Income Trust delivered an 18.86% total return over the trailing five-year period. The Bloomberg U.S. Aggregate Bond Index delivered a 3.44% total return over the same period:
Thus, looking at the price performance here alone is very misleading. As is the case with many bond funds, this one managed to significantly outperform the benchmark indices over the trailing period due to its much higher yield.
At today’s price, the Franklin Limited Duration Income Trust has an 11.79% yield. This compares very well to most other bond funds, and indeed it is higher than many junk bond closed-end funds. As such, income investors who are willing to hold the fund for an extended period of time might find themselves willing to take a chance on this fund. However, we should naturally investigate the fund a bit more to make that decision.
About The Fund
According to the fund’s website, the Franklin Limited Duration Income Trust has the primary objective of providing its investors with a very high level of current income. This makes a certain amount of sense considering the strategy that the fund employs in order to achieve this objective. As the website explains:
The fund seeks to provide high, current income, with a secondary objective of capital appreciation by investing primarily in high-yield corporate bonds, floating-rate corporate loans and mortgage- and other asset-backed securities.
This description simply states that the Franklin Limited Duration Income Trust is a bond fund. As I have explained numerous times in the past, bonds are by their nature current income vehicles. After all, a bond is purchased at face value when it is first issued, and it is also redeemed at face value when it matures. As such, these securities do not deliver any net capital gains over their lifetime. Rather, the only returns that a bond will deliver over its entire lifetime are the coupon payments that serve as a source of income for their holders. While it is true that bonds experience price changes with interest rates that allow for the potential of earning some trading profits, over the lifetime of the bond, these fluctuations will all net out to zero. An investor who purchases a new issue bond and holds it until maturity will only earn a total return that is equivalent to the coupon payments.
One of the factors that set this fund apart from an ordinary closed-end bond fund is the fact that this fund invests in low-duration assets. Duration is a measure of a bond’s sensitivity to interest rates, so in theory, this strategy should result in the fund’s portfolio being less affected by interest rates than an ordinary bond fund. The website outright states this:
The fund’s goal is to provide relatively high yield while maintaining a relatively low correlation to interest rates. Top-down sector allocation and bottom-up security selection drive portfolio construction.
The floating-rate securities that the fund’s objectives and strategy state that it will invest in certainly fulfill this objective of reducing exposure to interest rate risk. As I pointed out in a previous article, floating-rate loans do not usually move much at all when interest rates move. We can see this by looking at the iShares Floating Rate Bond ETF (FLOT), which tracks the Bloomberg U.S. Floating Rate Note < 5 Yrs. Index. As we can see here, the index fund has been almost perfectly flat over the past decade:
We can clearly see that the interest rate changes that occurred over the period had nearly no impact on the price of the index fund. In fact, the only event that had any real impact on the fund was the panic around the outbreak of the COVID-19 pandemic. This panic was short-lived though, and the index quickly recovered. As such, we can clearly see that the Franklin Limited Duration Income Trust’s inclusion of these securities in its portfolio should reduce the impact that interest rate movements have on the portfolio.
However, as of the time of writing, floating-rate loans only account for 29.06% of the fund’s assets. This is the second-largest individual asset type in the fund, after its 31.05% exposure to junk bonds:
As such, this fund will still have somewhat more exposure to interest rate movements than a pure-play floating-rate loan fund such as the Eaton Vance Floating-Rate Income Trust (EFT) or the Apollo Senior Floating Rate Fund (AFT). Even a hybrid fund like the Ares Dynamic Credit Allocation Fund (ARDC) will have a bit less interest-rate exposure than this fund due to its higher allocation to floating-rate securities.
However, junk bonds are generally going to be less impacted by interest rate movements than investment-grade bonds. For example, let us look at the Bloomberg U.S. Aggregate Bond Index, which only contains investment-grade bonds, against the Bloomberg High Yield Very Liquid Index (JNK), which only contains below-investment-grade bonds. Here is a chart showing the performance of the two indices over the past three years:
We can certainly see that neither index delivered great performance over the period, but for the most part, the junk bond index holds up a bit better than the investment-grade bonds. This is because junk bonds have a lower duration than investment-grade corporate bonds due to their higher yields. One way to think about duration is that the lower the duration of a given asset, the faster the asset will give the investor its investment back. Due to the fact that an investor gets their money back more rapidly, the bond will not decline as much when interest rates rise. The reverse is also true, as a low-duration bond will generally not increase in price as much as a high-duration bond.
We can clearly see that more than half of the total assets of the Franklin Limited Duration Income Trust consist of floating-rate securities or junk bonds. As such, the fund’s portfolio should theoretically be less affected by changes in interest rates than most bond funds. This is clearly visible by looking at the fund’s average duration, which sits at 1.31 years as of the time of writing. The iShares Core Aggregate Bond ETF has an average duration of 6.05 years today. This difference should make this fund a better holding for investors who are looking to limit their interest rate exposure, although its leverage will still have an impact on its performance.
The fact that over half of the fund’s assets are invested in junk bonds and leveraged loans might be concerning to more risk-averse investors. After all, both types of securities are issued and backed by companies that tend to have weak cash flows, and balance sheets, or have other issues that make them more likely to default on their debt obligations than companies that are able to issue investment-grade securities. As defaults typically mean that the bondholders lose their money, it is understandable that some investors might be concerned. Fortunately, we can increase our comfort level by having a look at the credit ratings that have been assigned to the securities in the fund’s portfolio. Here is a high-level summary:
An investment-grade security is anything that is rated BBB or higher, along with cash & cash equivalents. As we can clearly see, these securities account for 24.33% of the assets in the fund’s portfolio. Thus, just under a quarter of the fund’s assets consist of investment-grade securities. This should prove at least a little bit comforting, however, it still leaves almost three-quarters of the fund’s total assets as junk debt. However, we can see that 50.80% of the fund’s assets are invested in BB or B-rated debt. According to the official bond ratings scale, debt that is issued with one of these two ratings is backed by a company that has a sufficiently strong balance sheet and cash flow profile to support its current debt even in the event of a short-term economic crisis. Thus, the risk that a BB or a B-rated issuer will default on its debt is not that much higher than an investment-grade issuer so we should not need to worry too much. In addition, the fund has 575 total holdings so the actual weighting of any individual issuer in the portfolio should be low enough to not have a noticeable impact on the fund as a whole.
As such, the biggest risk that we need to worry about with respect to the Franklin Limited Duration Income Trust appears to be interest rates. That risk should be lower than many comparable funds, but it still exists, and we should not ignore it.
Interest Rate Projections
As everyone reading this is no doubt well aware, the market as a whole is expecting that the Federal Reserve will reduce interest rates at a fairly rapid rate this year. This is the reason why interest-rate-sensitive assets delivered very strong appreciation during the final two months of 2023. This fund was not an exception, as its shares went up 4.01% over the period from November 1, 2023, through December 29, 2023:
This is somewhat less than the aggregate bond index, as we can see above. This is not unexpected, however, as the inherent protection of the fund’s low-duration assets works both ways. In short, this fund should theoretically decline less than the market when interest rates go up and gain less when interest rates go down. Admittedly, it does not always work that way though due to the fact that closed-end funds do not always trade in line with the performance of their underlying portfolios and the fact that this fund’s use of leverage will cause some performance distortions. For the most part, though, we can see that the fund exhibited less interest rate sensitivity than the market as a whole during the final two months of 2023.
This year, the market has arguably started to cool off a bit. There have been various statements from Federal Reserve officials since the start of January that suggest that the market is wrong about its 2024 interest rate projections. In addition to this, recent economic data shows that the economy continues to run hotter than the Federal Reserve really wants, which has reduced the case for interest rates. As a result, we have started to see long-term interest rates trend up. As of the time of writing, the yield on the ten-year U.S. Treasury (US10Y) is 4.12%. It was at 3.8660% back at the start of the year:
However, the market’s projections for interest rates still could be too optimistic.
In previous articles, I pointed out that the market expects a total of five or six cuts in 2024 with the first cut coming in March. That is no longer accurate, which suggests that my previous statements about the market being overly accurate were correct. As of today, the federal funds futures market is expecting a total of 1.324 percentage points of cuts in 2024 with a 35.9% chance that the first cut will be in March:
The projected 1.324 percentage points of cuts still suggest five or six cuts to the federal funds rate in 2024. It is difficult to see how that will be possible if the Federal Open Market Committee does not cut the federal funds rate at the March meeting. The Federal Open Market Committee only has eight meetings in 2024 and the March meeting is the second one. Therefore, in order to achieve the five or six interest rate cuts that the market expects, the Federal Reserve would have to cut rates at every remaining meeting if it does not cut in March. That suggests an economy that is descending into a pretty severe recession right as the nation is heading into a presidential election.
It seems unlikely that any public official will want to admit that the nation is following into a recession considering how contentious the 2024 election is likely to be. It also seems likely that the current incumbent politicians in the White House and Congress will use fiscal policy to the fullest extent possible to prevent a recession. In the absence of a recession, the Federal Reserve will almost certainly not cut five or more times since it has only done that once in history.
For their part, officials at the Federal Reserve are projecting three basis points cuts for a total of 0.75 percentage points reduction in the effective federal funds rate by year-end 2024. That is obviously much less than the market is currently projecting. If this proves to be accurate, bond prices will continue to fall and interest rates rise from today’s levels. That suggests that investors do not want to be in high-duration assets, such as what is held by most closed-end bond funds.
The assets that are held by the Franklin Limited Duration Income Trust should perform much better than long-duration bonds during the rising rate environment that will ensue if the Federal Reserve stands by its previous statements and fails to cut the federal funds rate five or more times during 2024. This morning’s GDP report showed much greater economic growth than economists were projecting, so this scenario seems more likely than before. As such, this fund is probably a better choice for the current environment than many of its peers. It also has the advantage of providing more upside exposure to falling rates than a pure leveraged loan fund in the unlikely event that the Federal Reserve does drastically reduce interest rates for some reason.
As is the case with most closed-end funds, the Franklin Limited Duration Income Trust employs leverage as a method of boosting the effective yield of its portfolio. I have explained how this works in a number of previous articles. To paraphrase myself:
In short, the fund borrows money and uses that borrowed money to purchase junk bonds, leveraged loans, and other income-producing securities. As long as the purchased securities have higher yields than the interest rate that the fund has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. This fund is capable of borrowing money at institutional rates, which are considerably higher than retail rates. As such, this will usually be the case.
However, it is important to note that the use of leverage is less effective at boosting the effective yield of a portfolio than it was a few years ago. This is because borrowing rates today are much higher than they were a few years ago when the federal funds rate was close to zero. The strategy should still theoretically work though since the yield on most junk bonds and leveraged loans should be higher than the rate at which the fund can borrow money.
The use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. This is almost certainly one reason why the fund’s shares have been more volatile than we might expect considering the assets that are in the portfolio. As such, we want to ensure that the fund is not employing too much leverage because that would expose us to an excessive amount of risk. I generally do not like a fund’s leverage to exceed a third as a percentage of its assets for this reason.
As of the time of writing, the Franklin Limited Duration Income Trust has leveraged assets comprising 27.88% of its assets. This is lower than the leverage employed by many other junk bonds or leveraged loan funds. That is fairly nice to see as it suggests that the fund is putting forth a considerable amount of effort to maintain a reasonable balance between the risk and reward of its portfolio. We should not need to worry too much about this fund’s use of leverage right now.
As mentioned earlier in this article, the primary objective of the Franklin Limited Duration Income Trust is to provide its investors with a very high level of current income. In pursuit of this objective, the fund invests its assets in a portfolio that primarily consists of junk bonds and leveraged loans. These assets primarily deliver their total return in the form of direct payments that are made directly to their owners, which in this case is the fund. This fund takes things a step further, as it borrows money to purchase more high-yielding debt securities. That allows the fund to collect payments from more assets than it could control solely with its own equity capital and thus boosts the effective yield of the portfolio. The fund also might be able to earn some money by exploiting the changes in bond prices that accompany interest rate movements. The fund collects all the money that it earns from these various sources and then pays it out to its shareholders, net of its expenses. We might expect that this would result in the fund’s shares having a very high yield.
This is certainly the case as the Franklin Limited Duration Income Trust pays a monthly distribution of $0.0615 per share ($0.7380 per share annually), which gives it an 11.79% yield at the current price. Unfortunately, this fund has not been particularly consistent with respect to its distribution over its history. As we can see here, the fund has both regularly increased and reduced its distribution over its history:
The fund’s distribution even varies a great deal from month to month. We can see this by simply looking at its payments over the past year:
This is something that might prove to be a turn-off for any investor who is seeking to earn a safe and consistent income from the assets in their portfolios. After all, many investors who purchase a fund like this are looking to get a regular distribution that they can use to pay their bills or finance their expenses. It is very difficult to budget when their income varies from month to month. However, it is not exactly a bad thing from the fund’s perspective since the variable distribution helps it to ensure that it only pays out its investment profits and does not destroy net asset value. As everyone reading this likely knows, it is nearly impossible to earn exactly the same amount of money in the capital markets every month.
Naturally, it is still important that we have a look at the fund’s finances in order to determine how well it can afford the distributions that it is paying out. After all, we do not want the fund to be unnecessarily depleting its net asset value since such a scenario makes it even more difficult for the fund to sustain its distribution over time.
Unfortunately, we do not have an especially recent document to use for the purposes of our analysis. As of the time of writing, the fund’s most recent financial report corresponds to the six-month period that ended on June 30, 2023. As such, it will not include any information about the fund’s performance over the past six or seven months. This is quite disappointing as a great deal happened during that period. In particular, this report will not provide us with any information about how well the fund handled the summer of 2023, which was a period during which interest rates were rising and bond prices were declining. This report will also not include any insight into how well the fund was able to convert the strong end-of-year market into profits. We will need to wait until the fund releases its annual report, which should occur over the next month or so, in order to have this information. For now, we have to use what we have available to us for our analysis.
During the six-month period, the Franklin Limited Duration Income Trust received $207,240 in dividends and $18,393,498 in interest from the assets in its portfolio. This gives the fund a total investment income of $18,600,738 during the six-month period. The fund paid its expenses out of this amount, which left it with $12,882,623 available for shareholders. This was, unfortunately, not sufficient to cover the $14,432,800 that the fund paid out to its investors over the period. At first glance, this is almost certainly going to be concerning, as we would ordinarily like a fixed-income fund to fully cover its distributions out of net investment income. The Franklin Limited Duration Income Trust clearly failed to accomplish that goal during the six-month period in question.
With that said, there are other methods through which the fund can obtain the money that it requires to cover the distribution. For example, it might be able to earn some trading profits by exploiting the changes in bond prices that accompany interest rate swings. These profits are considered realized capital gains and are not investment income for tax or accounting purposes. However, capital gains still do represent money coming into the fund that can be paid out to the shareholders.
The fund did manage to have some success in earning money from this source during the period. It reported net realized losses of $11,782,370 but this was offset by $14,656,018 net unrealized gains. Overall, the fund’s net assets increased by $1,323,471 after accounting for all inflows and outflows during the period.
The fund therefore did manage to fully cover its distributions during the six-month period, but it had to rely on net unrealized gains to do it. As everyone reading this is no doubt well aware, unrealized gains can quickly be erased by a market correction. As such, we should not depend on them as a reliable way to cover a distribution. In this case, though, it appears to be okay. This chart shows the fund’s net asset value per share since July 1, 2023:
As we can see, the fund’s net asset value per share is up by 1.27% since the closing date of the most recent financial report. This implies that the fund has managed to fully cover all of the distributions that it has paid since the closing date of the report. As such, it does not appear that the fund’s distributions are destructive to its net asset value. This is what we like to see.
As of January 24, 2024 (the most recent date for which data is available as of the time of writing), the Franklin Limited Duration Income Trust has a net asset value of $7.12 per share but the shares only trade for $6.27 each. This gives the shares an 11.94% discount on net asset value at the current price. This is nowhere near as attractive a price as the 13.37% discount that the shares have had on average over the past month. Thus, it might be possible to obtain a better price by waiting a bit. However, as I have pointed out in the past, a double-digit discount generally represents a reasonable entry point for any fund. Thus, investors who are interested in buying might want to begin accumulating shares at the present price.
In conclusion, the Franklin Limited Duration Income Trust could be a reasonable compromise for those investors who are seeking to invest in a portfolio of bonds and earn a high level of income but want to limit interest rate risk. This could be a smart idea right now because bonds are still looking quite overpriced if the United States manages to avoid a recession.
When we consider the strength of recent data and the fact that incumbent politicians will want to protect their jobs, it is rather difficult to believe that the economy will descend into a severe recession that will trigger the rate cuts that the market expects. Thus, it could be a good idea to buy a fund like this rather than one with a higher duration and more risk of losses if the nation avoids a recession.