Floating rate loans (also known as leveraged loans or bank loans), have historically produced solid returns in rising interest rate environments.
Key portfolio benefits include low correlation to investment-grade bonds, generation of income that reflects the overall rate environment, and a senior position in corporate capital structure.
Investors seeking to reduce duration risk in their portfolio should note that because floating rate loans reset frequently, they essentially have no duration risk.
Following the Great Recession of 2008, many investors aggressively moved to cash and fixed-income securities in a classic flight to safety. Today, however, interest rate risk is a greater threat to fixed-income portfolios. With that in mind, a unique asset class to consider is the floating rate or bank loan market.
Floating rate loans: a primer
Leveraged loans (also known as floating rate loans, bank loans or high-yield loans) are loans extended to companies with higher levels of debt relative to their cash flows. Companies typically borrow in the loan market to refinance existing debt, recapitalize their balance sheet or finance leveraged buyouts. The loans are below-investment-grade credit quality and are secured by assets of the borrower. The interest rate paid on the loan is based on an index, typically the London Interbank Offered Rate (LIBOR), plus a predetermined spread. The total coupon moves as the index fluctuates. Typically, LIBOR resets every 30, 60 or 90 days. This floating rate nature of leveraged loans may protect investors from interest rate risk during rising rate environments and result in a portfolio with extremely short duration.
Key portfolio benefits of leveraged loan investment
- Solid performance in a rising rate environment: Bank loans have a history of generating consistently positive total returns in periods of rising rates, unlike many of their fixed-income counterparts. (For details, please see our white paper on Floating Rate Loans.)
- Diversification: Floating rate loans have historically had low correlation to investment-grade bonds, including Treasuries over the long term.
- Income that keeps pace with the general trend in interest rates: Because the interest income generated by floating rate loans is tied to a market rate of interest, such as (LIBOR), income generally keeps pace with changes in market interest rates.
- Senior and secured: Bank loans are unique in that they are generally the most senior source of capital in a company’s capital structure and typically come with a lien on most, if not all, assets of the issuer. Both of these features differ from the generally unsecured nature of the high-yield bond market.
- Compelling yield and duration: Because floating rate loans reset frequently, they essentially have no duration risk — a measure of the sensitivity of the price of an investment to a change in interest rates. This enables the investor to reduce interest rate risk without sacrificing income.
From a fundamental and technical viewpoint, we believe that the floating rate market is an attractive asset class for many investors. With credit risk muted and financial markets continuing to recover, investors will be focused on maximizing yield relative to duration risk in the years ahead. The structural characteristics of bank loans can act as a hedge against rising rates and diversify an otherwise fixed-rate bond portfolio. The historical long-term profile of the loan market suggests stability, low correlation with other fixed-income sectors and solid performance in a rising rate environment, which is why we see it as a worthy contender in an overall asset allocation strategy, especially now.
The market value of floating rate loans may fluctuate, sometimes rapidly and unpredictably. Risks include but are not limited to liquidity risk, interest rate risk, credit risk, counterparty risk, highly leveraged transactions risk, derivatives risk, confidential information access risk, impairment of collateral risk, and prepayment and extension risk. Generally, when interest rates rise, the prices of fixed income securities fall, however, securities or loans with floating interest rates can be less sensitive to interest rate changes, but they may decline in value if their interest rates do not rise as much as interest rates in general. Non-investment grade floating rate loans are more likely to experience a default, which results in more volatile prices and more risk to principal and income than investment grade loans or securities.