Five Reasons to Consider Floating Rate
One of our themes for 2017 is rising rates. In episodes where rates have risen in recent decades, floating rate notes have outperformed a core bond benchmark (see Figure 1). While past performance is not a guarantee of future results, we recently checked in with Art Torrey, Portfolio Manager of MainStay Floating Rate Fund. We wanted to compare notes on an asset class that has grown from $126 billion in 2001 to almost $1 trillion today.1 Here are some of the key takeaways from our conversation:
Figure 1 – Bank Loans (Floating Rate Notes) Have Outperformed the Bloomberg Barclays U.S. Aggregate Bond Index during Past Periods of Rising Rates
Source: Morningstar 12/30/2016. Floating rate loans are represented by the S&P/LSTA Leveraged Loan Index. Investment-grade bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index. An investment cannot be made directly into an index. Past performance is no guarantee of future results.
1. Reasonably Valued
Floating rate note valuations are priced at a discounted margin over the London Interbank Offered Rate, better known as LIBOR. At 4.55% by the end of 2016, the discount margin for the asset class is close to its long-term average.2 But, this only tells part of the story.
2. Higher-Quality Credit Rating Trend and Historically Low Defaults
Art believes current valuation readings offer an attractive entry point, when taken in conjunction with a context of historically high credit quality and low default rates. Since 2009, the floating rate note market has trended towards new issues of higher credit quality, as the economy recovered. The latest data shows 92% of the market being BB- or B-rated, versus just 77% being as highly rated back in 2009.3 An improved credit profile is one of the factors behind default rates being at low levels, by historical standards. The current trailing default rate, at 1.5%, is approximately half of its long-term average.4
An important characteristic of floating rate notes is their senior position in the capital structure, relative to other debt obligations, preferred shareholders, or common shareholders. The loans are typically backed by working capital, fixed assets, intangibles, and other investments.
3. Limited Exposure to Energy, Metals, and Mining Sectors
For many investors, the decision to obtain commodity-sensitive exposures is a tactical one and can be obtained in a targeted manner. By contrast, the floating rate loan market is 96% ex-energy, metals, and/or mining, limiting the potential sector impact of unintended exposures.
4. Portfolio Diversification
The strategic asset allocation case for floating rate notes is rather straightforward. Since 1995, the asset class has generated a relatively low .57 correlation to equities and a negative .38 correlation to 10-year Treasurys.5 For those concerned about the prospects for government bonds ahead, the negative correlation afforded by floating rates may be an attractive feature.
5. Prospect for Increased Income as Interest Rates Rise
As the Fed raises interest rates, LIBOR and floating rate note rates should increase, too, all other factors being held constant. Most floating rate notes today have at- or in-the-money LIBOR floor features, so as rates rise from current levels, they should generate additional income for investors. In addition, floating rate notes should be able to hold their value in a rising rate environment better than longer-duration, fixed-coupon bonds.
Rising interest rates have historically been a headwind for fixed-income investments. But, not all bonds are equally sensitive to interest rates. Floating rate notes have characteristics that are relatively well-suited for a rising rate environment.
1. Source: Credit Suisse Leveraged Loan Index, 12/31/15.
2. Source: Credit Suisse Leveraged Loan Index, 12/31/16.
3. Source: S&P Leveraged Commentary and Data, 9/30/16. The S&P/LSTA Leveraged Loan Index (the Index) is a market value-weighted index, designed to measure the performance of the U.S. leveraged loan market, based upon market weightings, spreads, and interest payments. An investment cannot be made in an index.
4. Source: JP Morgan, 12/31/16. Past performance is no guarantee of future results. Floating rate loans are represented by the JP Morgan Leveraged Loan Index, which is designed to mirror the investable universe of USD institutional leveraged loans, including U.S. and international borrowers. High-yield bonds are represented by the JP Morgan Domestic High Yield Index, which is designed to mirror the investable universe of the U.S. dollar, domestic, high-yield, corporate debt market, including issues of U.S. and Canadian domiciled issuers. An investment cannot be made directly into an index. Rolling Last Twelve Months (LTM) Defaults by Principal Amount.
5. Risk/Reward Sources: S&P and Merrill Lynch. Correlations Source: S&P LCD, 9/30/16. Past performance is no guarantee of future results. Floating rate loans are represented by the S&P/LSTA Leveraged Loan Index, a market value-weighted index, designed to measure the performance of the U.S. leveraged loan market, based upon market weightings, spreads, and interest payments. High-yield bonds are represented by the BofA Merrill Lynch U.S. High Yield Index, which tracks the performance of U.S.-dollar denominated, below investment-grade, corporate debt publicly issued in the U.S. domestic market. An investment cannot be made directly into an index.
The S&P/LSTA U.S. Leveraged Loan Index is designed to reflect the performance of the largest facilities in the leveraged loan market.
Standard & Poor’s Leveraged Commentary & Data (LCD) Flow-Name Composite is designed to reflect the prices of the most liquid loans in the market.
The BofA Merrill Lynch U.S. Corporate Master Index (the Merrill Lynch High-Grade Corp Index) includes publicly issued, fixed-rate, non-convertible investment-grade, U.S. dollar-denominated, SEC-registered corporate debt having at least one year to maturity and an outstanding par value of at least $250 million.
The BofA Merrill Lynch U.S. High Yield Master II Index (the Merrill Lynch High Yield Index) tracks the performance of below investment-grade, but not in default, U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P.
The S&P 500® Index is a broad-based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general.
A basis point is a unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes, and the yield of a fixed-income security.
Correlation is a statistic that measures the degree to which two securities move in relation to each other. Correlation coefficient indicates the strength and direction of the relationship between the movement of two investments. If two securities are perfectly correlated—that is, they have a correlation of 1.00—their prices move in lockstep with one another. Diversifying a portion of the portfolio with securities that are not highly correlated may help reduce volatility in the portfolio. Generally, a correlation of 0.70 or less would indicate that the two investments are not highly correlated. If the correlation coefficient is negative, the two investments will move in opposite directions from one another. A correlation coefficient of -1.00 would indicate that two investments move in exactly the opposite direction from one another.
Credit Ratings: AAA credit ratings apply to the underlying debt securities and are rated by an independent rating agency, such as Standard & Poor’s (S&P), Moody’s, and/or Fitch. S&P rates borrowers on a scale from AAA to D. AAA through BBB represent investment grade, while BB through D represent non-investment grade. Moody’s rates borrowers on a scale from Aaa through C. Aaa through Baa3 represent investment grade, while Ba1 through C represent non-investment grade. Fitch rates borrowers on a scale from AAA through D. AAA through BBB represent investment grade, while BB through D represent non-investment grade.
LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It stands for IntercontinentalExchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world.
LIBOR floors – The London Interbank Offered Rate (LIBOR) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. LIBOR floors provide a guaranteed minimum yield on loans no matter how low the benchmark 3-month London interbank offered rate fell. Today, most loans offer a 1% LIBOR floor, and the 3-month LIBOR rate stands at 0.25%, meaning a loan with a LIBOR floor gives investors a yield base that’s three-quarters of a percentage point higher than a floorless loan (loans vary in terms of how much additional yield, or spread, they offer above either LIBOR or the floor rate).
Treasury securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity. Interest income on these securities is exempt from state and local taxes.
All mutual funds are subject to market risk and will fluctuate in value. Before considering an investment in a floating rate fund, you should understand that you could lose money.
Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, borrower industry concentration, and limited liquidity. Securities purchased by the Fund that are liquid at the time of purchase may subsequently become illiquid due to events relating to the issuer of the securities, market events, economic conditions, or investor perceptions. As a result, an investor could pay more than the market value when buying Fund shares or receive less than the market value when selling Fund shares.
The Fund may not be able to pay redemption proceeds within the allowable time period because of unusual market conditions, unusually high volume of redemptions, or other reasons. To meet redemption requests, the Fund may be forced to sell securities at an unfavorable time and/or under unfavorable conditions.
Liquidity risk may also refer to the risk that the Fund may not be able to pay redemption proceeds within the allowable time period because of unusual market conditions, unusually high volume of redemptions, or other reasons. To meet redemption requests, the Fund may be forced to sell securities at an unfavorable time and/or under unfavorable conditions.
Past performance is no guarantee for future results, which will vary.
The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only, and is not intended to constitute the giving of advice or the making of a recommendation. The investments or strategies presented are not appropriate for every investor and do not take into account the investment objectives or financial needs of particular investors. An investor should review with its financial advisors the terms and conditions and risks involved with specific products or services and consider this information in the context of its personal risk tolerance and investment goals.
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Fixed Income Investors is a multi-product fixed-income investment manager and a division of New York Life Investments. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, New Jersey 07302.