Close
ThinkAdvisor

Financial Planning > College Planning > Student Loan Debt

Is It Prime Time for Floating-Rate Bank Loans?

X
Your article was successfully shared with the contacts you provided.

Finding yield and preparing for rising rates in one convenient package

The recent prolonged period of low interest rates has bred a population of fixed income investors thirsty for yield. At the same time, the looming threat of rising interest rates continues to fuel anxieties and send many investors sprinting to shield their portfolios. To these investors, this market feels a lot like being stuck between a rock and a hard place. Enter floating-rate bank loans to pull double-duty in this unique environment—providing much desired yield for income-seekers while offering a potential defense against rising interest rates.

What Are Floating-Rate Bank Loans?

Floating-rate bank loans are arranged by banks and other financial institutions to help companies finance restructurings, acquisitions or other highly leveraged transactions. Companies that access capital through these loans typically don’t have investment-grade credit ratings.

Floating-rate bank loans have been around for more than 30 years, but they have really come into their own in the last decade. Floating-rate loans represented a market of $906 billion as of December 31, 2014.1

(Click to enlarge) Historical Growth of Institutional Loan Market 

Rates Reset for Potentially Lower Volatility

As the name implies, the interest rates of floating-rate loans reset periodically (typically every several months) relative to an underlying benchmark rate, such as the prime rate or the London Interbank Offered Rate (LIBOR). Due to the floating-rate nature of the interest rates on these investments, they tend to be less price-sensitive to changes in market interest rates, which can reduce volatility over time.

Typically First in Line for Repayment

Floating-rate bank loans allow investors to focus on credit risk while lessening their exposure to interest-rate risk. These loans are typically rated below investment grade, due to the higher levels of debt on the issuer’s balance sheet. Also, in return for the potentially higher returns associated with a floating rate, investors are typically subject to having the loans called away at any time.

However, these loans do offer some credit risk protection given the placement of this debt in the issuer’s capital structure. Floating-rate loans are typically the most senior source of capital in a borrower’s capital structure, which places these debt holders first in line for repayment if a bankruptcy or liquidation of assets occurs. Also, the loans are secured by pledged assets that may be sold to satisfy the borrower’s loan obligation, although there is no guarantee that the pledged assets will cover the payment obligations.

  Typical Borrower Capital Structure

A Record of Relatively Low Correlation to Stocks and Bonds

Over the 10-year period ended 12/31/14, floating-rate loans were less volatile as measured by standard deviation (7.49%) than the broader high-yield bond market (9.57%).3

In general, a higher standard deviation means greater volatility. In addition, these loans have displayed relatively low correlations to some major asset classes, including stocks and bonds, which can make them highly effective for overall portfolio diversification. Of course, diversification does not guarantee a profit or protect against a loss.

 Floating-Rate Loan Historical Correlations to Other Asset Classes4

The Evolution of Supply and Demand

In its initial stages, the floating-rate loan market was primarily driven by commercial banks. However, other institutional investors, including insurance companies, mutual funds and hedge funds, have entered the marketplace, driving up demand. Supporting this demand has been an increase in private equity activity and an increased willingness by corporations to utilize this marketplace as a source of financing. This has made the floating-rate loan market quite diverse, with an increasing number of issuing companies that span a variety of industries. Although this situation has provided more volume to the marketplace in recent years, effective due diligence has never been more important, as more aggressive deals have started coming to market. The benefits of professional management and diversification may make a mutual fund that invests in floating-rate loans an attractive way for investors to access the floating-rate bank loan market.

For even more insights into today’s fixed income marketplace, download your copy of the new Franklin Templeton Fixed Income Almanac.

——-

A Note on Risk

All investments involve risks, including possible loss of principal. Floating-rate loans tend to be rated below investment grade. Investing in higher-yielding, lower-rated, floating-rate loans involves greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy. Interest earned on floating-rate loans varies with changes in prevailing interest rates. Therefore, while floating-rate loans may offer higher interest income when interest rates rise, they will also generate less income when interest rates decline.

Investors should carefully consider a fund’s investment goals, risks, charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, talk to your financial advisor or visit franklintempleton.com. Please carefully read a prospectus before you invest or send money.

Franklin Templeton Distributors, Inc.

———-

  1. Source: Credit Suisse, Leveraged Finance Market Update, January 16, 2015.
  2. Sources: Credit Suisse, 2014 Leveraged Finance Outlook, 2013 Annual Review, and Leverage Finance Strategy Monthly, December 31, 2014. 1st Lien Institutional Loan Recovery Rate and High Yield Bond Recovery Rate.
  3. Source: © 2014 Morningstar Direct, Index Standard Deviation Report. Calculated for the 10-year period ended 12/31/14. Floating-Rate Loans are represented by the Credit Suisse Leveraged Loan Index and High-Yield Bonds are represented by the Credit Suisse High Yield Index. Indexes are unmanaged, and one cannot invest directly in an index.
  4. Source: © 2014 Morningstar Direct. 10-Year US Treasuries are represented by the Payden & Rygel 10-Year US Treasury Note Index; Corporate Bonds are represented by Barclays US Credit Index; Emerging Market Bonds are represented by the JP Morgan Emerging Markets Bond Index (EMBI) Global Diversified; High-Yield Bonds are represented by the Credit Suisse High Yield Index; Stocks represented by the IA SBBI US Large Stock TR USD Ext Index and Floating-Rate Loans are represented by the Credit Suisse Leveraged Loan Index. Indexes are unmanaged, and one cannot invest directly in an index.