Unlocking the Potential of FCT in a Rising Rate World: A Risk-Reward Analysis

In a world where central banks are navigating a delicate balance between inflation control and economic stability, high-yield closed-end funds like the First Trust Senior Floating Rate Income Fund II (FCT) offer a unique blend of income generation and risk mitigation. With a monthly distribution of $0.097 per share (11.4% yield) and a portfolio anchored by senior secured loans, FCT has emerged as a compelling option for investors seeking to capitalize on rising interest rates while managing downside risks. But like any high-yield strategy, it comes with trade-offs. Let's dissect the fund's risk-reward profile in today's market environment.

The Rising Rate Tailwind: FCT's Strategic Edge

FCT's portfolio is designed to thrive in a rising rate environment. Over 80% of its assets are allocated to senior secured floating-rate loans, which adjust their interest rates periodically based on reference rates like the CME Term SOFR. For example, loans in the fund's portfolio carry terms such as “1 Mo. SOFR + 2.75%” or “3 Mo. SOFR + 3.00%.” This means that as the Federal Reserve hikes rates, the fund's income from these loans automatically increases. In a 2022–2023 tightening cycle, large U.S. banks saw net interest margins (NIMs) rise by 2.5–3.5% due to similar floating-rate structures, and FCT's strategy mirrors this dynamic.

The fund's leverage strategy further amplifies this effect. By borrowing at one rate and investing in higher-yielding assets, FCT aims to boost returns. However, leverage is a double-edged sword—while it can enhance gains in a rising rate environment, it also magnifies losses if rates reverse or defaults spike. As of November 2024, FCT's leverage was balanced with a net asset value (NAV) of $10.87 and a market price of $10.44, trading at a 3.96% discount to NAV. This discount suggests the market is pricing in risks, but it also creates a potential upside if the fund's credit quality holds.

The Allure of the 11.4% Yield: Sustainability or Mirage?

FCT's current yield of 11.4% is among the highest in the fixed-income space, driven by its focus on below-investment-grade debt. The fund's distributions, which include net investment income and return of capital, have remained consistent since its inception in 2004. However, this consistency is not without caveats. The fund's top 10 issuers account for 19.3% of its portfolio, with significant exposure to the insurance sector (16.9%) and software (17.6%). While diversification is a strength, heavy bets on specific industries can amplify losses during sector-specific downturns.

Moreover, the fund's yield is partially supported by return of capital, which does not represent income and may reduce the NAV over time. For income-focused investors, this raises a critical question: Is the 11.4% yield sustainable? The answer hinges on FCT's ability to maintain its current credit quality and manage defaults.

Risk Factors: Credit, Liquidity, and Market Volatility

1. Credit Risk: FCT's portfolio is weighted toward non-investment-grade securities, with 37% in B-rated and 19.2% in B- rated debt. These issuers are more vulnerable to economic downturns. As of 2025, U.S. corporate default risk has risen to 9.2%—a post-crisis high—according to recent data. While FCT's senior secured loans offer collateral protection, a spike in defaults could erode income and NAV.

2. Liquidity Risk: FCT's discount to NAV (3.96% as of November 2024) reflects market skepticism about its liquidity. The fund's leverage and concentrated holdings may make it harder to liquidate assets quickly in a crisis. Additionally, trading volume data for the recent quarter is sparse, suggesting limited market participation.

3. Market Risk: Rising rates are a double-edged sword. While they boost income from floating-rate loans, they also increase borrowing costs for the fund's leverage strategy. If rates stabilize or decline, FCT's income could shrink, and its discount to NAV might widen.

Investment Thesis: A High-Yield Gambit with Caveats

For income-seekers willing to accept higher risk, FCT offers an attractive combination of rising rate benefits and a robust yield. Its senior secured loans provide a buffer against credit losses, and its leverage strategy could enhance returns in a prolonged tightening cycle. However, the fund's exposure to non-investment-grade debt and its current discount to NAV warrant caution.

Key Considerations for Investors:
- Diversification: FCT's sector concentrations (insurance, software) should be balanced with broader portfolio diversification.
- Credit Monitoring: Track the fund's default rates and credit quality. A widening discount to NAV could signal deteriorating confidence in its portfolio.
- Rate Outlook: If the Federal Reserve pauses or cuts rates in 2026, FCT's income could falter. Investors should assess macroeconomic trends and Fed policy.

Conclusion: Balancing Income with Prudence

The First Trust Senior Floating Rate Income Fund II (FCT) is a high-yield, high-risk proposition in a rising rate world. Its 11.4% yield and floating-rate loan structure position it well to capitalize on the current interest rate environment, but its credit and liquidity risks cannot be ignored. For investors with a medium-term horizon and a tolerance for volatility, FCT could serve as a compelling addition to a diversified income portfolio—provided they remain vigilant about its credit quality and macroeconomic headwinds.

Final Take: FCT is not a “set it and forget it” investment. It requires active monitoring of interest rate trends, credit spreads, and the fund's own leverage. But for those who can navigate these complexities, the rewards may well justify the risks.