With interest rates at near-record lows, product manufacturers have been working overtime to put together products that satisfy investors’ hunger for yield.

A new breed of structured products based on U.S. fixed income assets — usually combined with healthy doses of leverage — has hit the market in the past few months.
Initially the assets were high-yield corporate bonds; later preferred securities were added to the mix; then mortgage-backed securities were included. Many are tax efficient — income earned is treated for tax purposes as capital gain — and focus on the long end of the yield curve.

But several new entries focus on the short end. Fairway Capital Management Corp. ’s
Fairway Short Duration Diversified Fund is an example. “The short duration of the portfolio is intended to reduce the impact of changing interest rates on the performance of the fund,” its preliminary prospectus notes.

The fund invests in a mixed bag of assets — global short-term bonds issued by governments (of which at least 80% would be investment grade); mortgage-backed securities (all rated AAA) and corporate debt (which has a minimum credit rating of B-
). At least 25% of the assets are to be invested in each of three asset categories. The
fund is scheduled to wrap up at the end of 2015.

Reflecting its focus, the fund has a relatively short duration — about 1.66 years.
(Duration is the average cash-weighted term to maturity of a bond.) The fund’s leverage is is 1.5 times to 1, meaning for every $100 of equity, the fund will borrow $150.

There is an element of currency risk, given that the manager is purchasing U.S. dollar-denominated assets. However, plans call for at last 90% of the fund’s net asset value to be hedged back from the US$ to the Canadian dollar.

Although interest rates are low in relative terms, the prospectus suggests there are considerable opportunities in the three asset classes chosen. For instance, the annual gross return on the illustrative leveraged portfolio is around 14.9%. The cost of borrowing, the annual operating expenses and hedging costs all have to be deducted from that figure, which brings the return down to 8.1%.

The return will also be affected by the so-called distribution stabilization reserve. That is an amount — in this case, 100 basis points — set aside each year to cover shortfalls in the amount needed to fund the distributions. The reserve will be called upon “to the extent that income from the portfolio is greater than that which would permit the fund to achieve its indicative distribution in any year.”

Shortfalls caused by credit defaults is another reason for the reserve. Such defaults are possible because the manager is investing in non-investment grade securities, a rating category that presumably entails more risk.

The new Fairway product joins several other recently launched funds that focus on short-term senior secured U.S. corporate loans.

Among these are Bayshore Floating Rate Senior Loan Fund from Toronto-based Bayshore Asset Management Inc. The fund raised $85.4 million. Fairway’s Nuveen Senior Floating Rate Income Fund, managed by Chicago-based Nuveen Investments, raised $78.5 million. Investors were attracted, in part, by the 6%-6.25% yield.

This type of fund may have a place in a portfolio. “But it shouldn’t be a core holding
because of the leverage that is being taken on,” says Dan Hallett, president of Windsor-Ont.-based Dan Hallett & Associates. These products “should form a very small portion of the portfolio and small relative to the client’s fixed-income allocation.”

He adds that these funds should be included in a taxable account because of their tax-efficient status. “The capital gains treatment makes them more suitable for tax-paying accounts,” he says. IE