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
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.
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.