Across the first six months of 2011, amid anticipation of a growing economy putting upward pressure on interest rates, investors poured an estimated $21 billion into floating rate loan funds (according to estimated fund flows by Morningstar). That seemed like a good idea until the Fed announced its intention to keep rates low through 2013. Nearly $9 billion immediately flowed out of these same funds in the following two months. We might suggest this was a somewhat fortunate turn of events for those investors (traders?) if they were actually looking to this asset class for protection from rising rates.
The fact is that anyone looking to floating rate loan funds today for inflation protection should be a bit wary, primarily due to a change in the structure of new issuance following the financial crisis in 2008. The asset class simply does not possess the same characteristics it once did, and some funds could actually suffer during the first leg of a rising rate environment. Investors need to understand this change in the market structure as well as the operational peculiarities in the loan market in order to choose the fund that best fits their needs.
The LIBOR Floor
In no small part due the aforementioned financial crisis, total new issuance of floating rate loan funds fell from a peak of $288 billion in 2007 to just $39 billion in 2009, according to data from Standard & Poor’s and JP Morgan. Not too surprisingly, when issuance began to pick up in 2010, unsure institutional buyers demanded more protection in the form of a minimum coupon as well as tighter loan covenants. Issuers solved the minimum coupon issue through a structure referred to as a ‘LIBOR floor.’
Historically, floating rate loans were structured based on LIBOR (the London Interbank Offering Rate) plus a spread, e.g., LIBOR plus 3%, with the spread depending on the creditworthiness of the borrower. In practice, as LIBOR went up and down, so did the coupon payment on the loan, which was usually reset every 90 days. All was fairly good until LIBOR fell below 1% in the aftermath of the financial crisis. At that point, issuers didn’t want to offer loans with 7% to 8% spreads in the event rates went back up, and buyers were not willing to purchase loans with total coupons of less than 3% to 4%.
Enter, then, the LIBOR floor. From there, loans were issued with a minimum rate, usually 1.5%, plus a more common 4% to 5% spread. It’s estimated that roughly half of the loan market today has this kind of structure in place, with virtually all new issuance, now running at roughly $200 billion per year, having a LIBOR floor. While this combination gives investors a better total return in the short term, it takes away one of the major attractive qualities to floating rate asset class, namely the upward shift in coupon as rates rise.
Specifically, with LIBOR hovering between 25 and 50 basis points today, the rate could move up 125 basis points or so and the coupon paid to investors would remain unchanged. This portion of the market, in other words, would offer no rising rate protection to investors. Beyond that, when rates finally rise past the floor, issuers will have a large incentive to refinance the existing debt with new loans without a floor structure. They would likely have to incentivize buyers with slightly higher spreads, say 25 to 50 basis points, but would regain the upside potential if/when interest rates fall.
Trading and settlement in the floating rate loan market is also much more complicated than the traditional bond market. While bond trades typically settle in one to three days, loans take at least seven days and in some cases up to 10 days to settle from the date of purchase. This lag puts a considerable operational constraint on a ’40 Act mutual fund, which by definition has to offer daily liquidity to investors. Floating rate loan funds typically combat this problem by holding higher levels of cash or by keeping a percentage of the fund’s assets in conventional non-investment grade bonds. Both approaches have their shortcomings.
While cash provides a degree of cushion for portfolio managers needing to raise money during periods of significant outflows—August 2011, for example—the cash drag on a portfolio during more normal periods can be high. And conventional high yield bonds, while they do add to the portfolio’s yield, can be subject to poor liquidity during times of stress. To mitigate the problems of each, many floating rate loan portfolio managers use a combination of the two tools to provide liquidity for the portfolio.
One way or the other, the degree to which cash and/or non-investment grade bonds is used in a floating rate loan fund changes its risk/reward profile relative to peers. Investors and advisors need to be aware of which approach is being used and to what extent.
And Yet, Still Worth a Good Look
The bottom line is that floating rate bonds, at least as the current market structure stands, do not provide the same level of inflation protection they used to. And investors and their advisors should closely examine the operational preferences of each fund to see just how the portfolio manager deals with the mismatch between daily liquidity and the longer settlement period for loans.
Still, challenges notwithstanding, the asset class has many attractive features. We believe floating rate loans, with higher current income than investment grade bonds with more safety and security than conventional high yield bonds, are worth checking out.
Author’s disclaimer: Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned.