The Franklin Templeton Floating Rate Fund is a new feeder fund that invests primarily in senior secured corporate loans and corporate debt securities with floating interest rates. These instruments are similar to bonds but with some important differences. (click here to read more about the mechanics of floating rate bonds). One key advantage of investing in floating rate senior secured loans is that they tend to perform well in a rising interest rate environment. In 1994 and 1999, when there were significant interest rate hikes by the US Federal Reserve, the returns for senior secured loans were higher compared to US government bonds. As the US government looks set to raise interest rates further, bond investors may fear that their bond funds will underperform. One way to hedge against that risk is to invest in Franklin Templeton Floating Rate Fund. In this email interview, the fund manager examines the outlook for interest rates and its affect on the fund.

Q: What is your view on interest rates? What will be the effect of a 'gradual rise' in interest rates relative to a 'sudden hike' on these floating rate senior secured loans?

A: With the economic landscape that is currently in place, certainly the Federal Reserve's statement is reasonable. It is difficult to predict the effects of a 'gradual rise' in interest rates versus a 'sudden hike.' However, if we look back at history, the steep increase in short-term rates in 1994 resulted in much stronger performance from the loan asset class than the more modest increase in 1999. This would seem to make sense since loans have very little interest rate risk due to their floating rate nature. As a result, any increase in short-term rates also increases the coupon on these loans. This resetting of the coupon is particularly attractive during periods of rising rates and consequently, increases in short-term rates do not necessarily affect loan prices in an adverse manner. All things being equal then, a larger increase in short-term rates would benefit the income return and thus total return, since prices would be expected to be relatively unaffected.

Q: In contrast to the 1994 and 1999 periods (that Federal Reserve actually hiked interest rates within a short span in time), how is the fund likely to perform this time? What is the time horizon that you recommend for investors that are seeking to hedge away interest rate risks by using this fund?

A: It would be difficult to predict how the Fund will perform this year in comparison to 1994 and 1999, since every year is different. However, for much (if not all) of 2004 (through July), the loan asset class has been outperforming most of the other fixed income asset classes, due to its defensiveness in a rising rate environment and the improving credit quality of the asset class (i.e. lower default rates). Since there is some NAV volatility in this Fund, due to credit risk, a minimum time horizon of one year is recommended, as this asset class is more suitable for longer-term investors.

Q: In a scenario that unemployment rates is persistently high, the number of bankruptcies increase and the economy suffers a downturn, say 2-3 years down the road and the Fed may decrease interest rates again. What kind of strategies is the fund manager going to take in that kind of scenario?

A: In general, the Fund has been committed to having higher credit quality and less risk than the overall leveraged loan asset class. The Fund's goal is to try and deliver more stable total returns over a market cycle with less price volatility. This is so that in a scenario where unemployment rates are persistently high, the number of bankruptcies are increasing, and the economy is suffering a downturn, we would be better positioned against any decline in loan prices. With this kind of positioning, typically the outcome is to underperform versus the asset class in an expanding economy, but to outperform in an economic downturn. In other words, our current strategy is already trying to position ourselves for the scenario you describe 2-3 years down the road.

Q: As the US economy improves, is the fund likely to lower the average credit rating of the portfolio to take advantage on the higher yields for lower grade loans?

A: The average credit quality of the portfolio has generally been higher than the index for our asset class (as represented by the CSFB Leveraged Loan Index), both currently and historically. Certainly, as the U.S. economy improves, there will be selective opportunities in some of the lower-rated loans, which offer attractive yields. However, the Fund remains committed to maintaining a portfolio that carries less risk than our overall asset class, as measured by the credit quality of our portfolio and the relative volatility of the portfolio versus the broad market (i.e. the CSFB Leveraged Loan Index). As a result, we do not anticipate a strong deviation from our current strategy going forward.

Q: 'For floating rate senior secured loans, there are strong covenants in the loan agreement and lenders can usually step in quickly in an effort to recover assets.' In the situation that a few of the loans that you are investing in has the heightened likelihood of going bankrupt, do you usually sell off these loans or wait to recover collateral for the asset? How do you manage the bankruptcy risk for this fund?

A: In terms of managing default (or bankruptcy risk), our decision to sell or hold really varies with each loan. The collateral and circumstances surrounding each of our loans are unique--in terms of where the loan is priced at the time and what we think the loan is ultimately worth. Another way to describe this approach of ours is the expected loss given default. This analysis tries to look at what our expected loan recovery will be--assuming the company goes into default and taking into account the company's capital structure, projected cash flows, and collateral. If our expected recovery is likely to be high and in excess of the current loan price, we generally will hold on to the loan. If not, we generally will sell the loan. Our decision to sell usually means we think it is likely that the issuer will continue to have problems in bankruptcy and that the collateral will continue to decline in market value.

For example, in December 2001, Arch Wireless, the largest U.S. paging company, filed for bankruptcy. In our analysis at that time, we felt that the ultimate worth of the company following the Chapter 11 reorganization would be worth more than the price of the senior secured debt at that time. As a result, we elected to hold on to the loan and let it restructure into new debt and equity. In this situation, our eventual recovery from the increase in value of the new debt and equity was in excess of the initial loan price, supporting our analysis.

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A Fund That Hedges Against Interest Rate Risk

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