Floating Rate Loans: The Floor Is In
Inflation is inching up, the Fed appears poised to gradually raise interest rates, and three-month LIBOR now exceeds 1%. Put it all together, and it looks like “the floor is in” on those floating rate loans that have minimum coupons, according to Portfolio Manager, Art Torrey, who advises MainStay Floating Rate Fund.
A recent string of economic reports pointing towards firmer U.S. economic growth and rising levels of inflation has strengthened the prospect for higher income ahead from floating rate loans, according to Torrey.
Wages are advancing at 2.5% per annum, job formation is occurring at a healthy clip, and consumer price inflation (CPI) is up 2.5% over the past year, the biggest 12-month increase in five years. Exclude food and energy, and the remaining prices, known as core inflation, have risen 2.3% over the past year. Other measures of inflation are inching up as well.
All of this make it increasingly plausible to Torrey and his colleagues that the Fed will indeed raise interest rates three times in 2017, as indicated by the U.S. central bank’s projections. This is a far cry from what happened last year. The Fed opened the year anticipating it would raise rates four times but, in the event, only raised them once at the last meeting of 2016.
Looking ahead, future rate increases should be accretive to the income investors receive from floating rate loans. That’s because three-month LIBOR (the interest rate most minimum coupons or “floors” are tied to) is now just above 1%, the level of many loan floors. As rates go up from here, so too, should coupon income. The potential for increased income is one of the five reasons to consider floating rate loans that we recently discussed.
Reflecting on Total Return Forecasts of 4%-6% for 2017
When asked about the 4%-6% 2017 total return forecasts being made by prominent analysts covering floating rate loans at broker-dealers, Torrey said he would not be totally surprised if such a scenario played out. The combination of subdued defaults, near average spreads, and net inflows makes for a compelling risk-return trade-off.
As shown in the chart below, defaults are currently running near 1.5%, or about half of their historical average. Given the incoming economic data cited, Torrey anticipates defaults will remain below their long-term average throughout the year. However, option-adjusted spreads for the asset class – a measure of value – are close to average historical levels. Achieving 3%-3.5% in return from income and another 1% from price appreciation as money flows into the asset class would get you into the forecasted range.
The Case for Floating Rate Loans – Default Environment, as of 12/31/16
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 12 Months (LTM) Defaults by Principal Amount.
The asset class has received $5.8 billion in year-to-date retail fund flows through February 10.
Picks and Pans
Where are Torrey and the team finding value? Although they focus on specific credits, patterns do emerge from the team’s work. They generally see opportunities in residential building products, business services, and gaming. By contrast, the team has its share of concerns about the prospects of select retailers, hardware/electronics firms, and telecom companies.
Floating rate loans have characteristics that are relatively well-suited for a rising rate environment.
Consumer Price Index (CPI) measures changes in the price level of market basket of consumer goods and services purchased by households. The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.
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 movements 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.
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 Intercontinental Exchange 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 three-month London interbank offered rate fell. Today, most loans offer a 1% LIBOR floor, and the three-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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