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.
T + 7 for Loans, at Least