Floating Rate Loans—Slow and Steady Wins the Race
With the U.S. economy appearing to gain momentum—and the potential to further accelerate with the tax reform bill—investors have been keeping a close eye on interest rates, especially in light of the most recent rate increase, and the expectation of further Federal Reserve rate hikes in 2018. With credit spreads in fixed coupon bonds meaningfully tighter, where can investors turn to generate consistent income and shelter themselves from higher rates? In our view, floating rate loans could be the answer. For further insight, we spoke with Portfolio Manager, Art Torrey, who advises MainStay Floating Rate Fund.
A Consistent Trend of Positive Returns…
The “Goldilocks economy”—not too hot and not too cold—has been a positive backdrop for risk assets. And floating rate loans are no exception. As seen in the chart below, through November 2017, floating rate loans have posted positive returns during 18 of the last 20 months. This steady ascent has been a blessing for investors seeking regular income.
Floating Rate Loan Returns over the Past 20 Months
Source: Morningstar Direct, as of 11/30/17. Floating Rate Loans are represented by S&P/LSTA Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
…and Relatively Less Volatility
In addition, since floating rate loans are senior in the capital structure and are secured by assets, they have greater recovery rates than high-yield bonds. Because of their seniority coupled with their floating rate nature, loans have shown to be less volatile than both equities and high-yield bonds.
Quarterly Rolling One-Year Standard Deviation of Floating Rate Loans, High Yield, and Equities
Source: Morningstar Direct, as of 9/30/17. Chart created by NYLIM. Floating Rate Loans represented by the S&P/LSTA Leveraged Loan Index; High Yield represented by the BofAML US High Yield Master II Index; Equities represented by the S&P 500 Index. Index definitions can be found at the end of this blog post. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Multiple Layers of Demand
The floating rate loan market has also been a beneficiary of strong overall demand. This largely comes from two sources: retail investors and collateralized loan obligations (CLOs). Retail investors typically access the floating rate loan market via mutual funds. CLOs are essentially pools of loans that are bundled together—similar to pools of other asset backed securities (like mortgages, car loans, and student loans to name a few —and usually sold to institutional investors, such as pension funds. While demand from these two sources ebbs and flows, collectively, it has been solid in recent years, a trend we expect to continue.
The fundamentals in the floating rate loan market remain on solid footing overall. Generally speaking, these issuers have stable cash flow characteristics, strong balance sheets, and reasonable leverage. Floating rate loan defaults also remain low—currently around 1.5%1—which is roughly half of their historical average. In our view, the current economic expansion should be supportive of the asset class and allow issuers to continue to service their principal and interest obligations.
Rising Income Potential
Three-month LIBOR has risen sharply this year and is now well above 1.5%. As the Fed continues to raise rates, floating rate loan coupon income has the potential to rise as well. This demonstrates how floating rate loans can be attractive versus other types of fixed coupon bond investments during a rising rate environment.
Source: Bloomberg, as of 12/15/17.
Credit Selection Is Key
While floating rate loan fundamentals remain attractive as a whole, there are still issuer-specific trouble spots to avoid. In addition, certain sectors are experiencing pockets of weakness. Take retail, for example. The Amazon effect is well-documented in the retail sector and the company continues to take market share from traditional brick-and-mortar stores. Yet, there are other retailers, such as dollar-type stores and specialty retailers, that continue to do well. As such, conducting thorough credit analysis on individual issuers is key to identifying compelling opportunities in the marketplace—and to avoid those issuers with weakening fundamentals.
Floating rate loans have given investors a smooth and consistent ride in recent years. What’s more, a combination of continued economic growth, solid issuer fundamentals, and rising LIBOR could provide a positive backdrop for the loan market in 2018. That being said, given their strong results over the last two years, it could be more of a coupon-clipping environment in 2018, with less opportunities for price appreciation similar to other risk assets. In addition, issuer-specific research will take on added importance at this stage of the credit cycle.
1. JP Morgan, as of 11/30/17.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
This material is provided for educational purposes only and should not be construed as investment advice or an offer to sell or the solicitation of offers to buy any security. Opinions expressed herein are current opinions as of the date appearing in this material only.
All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.
Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. A bond’s prices are inversely affected by interest rates. The price will go up when interest rates fall and go down as interest rates rise.
Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, non-diversification, borrower industry concentration, and limited liquidity.
High-yield securities carry higher risks, and some of the Fund’s investments have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.
The Amazon effect is the ongoing evolution and disruption of the retail market, both online and in physical outlets, resulting from increased e-commerce.
A collateralized loan obligation (CLO) is a security backed by a pool of debt, often low-rated corporate loans. CLOs are similar to collateralized mortgage obligations, except for the different type of underlying loan.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
The London Interbank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is a primary benchmark for short-term interest rates around the world.
Interest-rate risk is the risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest-rate relationship.
Standard deviation measures how widely dispersed a fund’s returns have been over a specific period of time. A high standard deviation indicates that the range is wide, implying greater potential for volatility.
The BofA Merrill Lynch U.S. High Yield Master II Index tracks the performance of U.S. dollar-denominated below investment-grade corporate debt publicly issued in the U.S. domestic market.
The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock market performance.
The S&P/LSTA Leveraged Loan Index is a broad index designed to reflect the performance of U.S. dollar facilities in the leveraged loan market.
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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. NYLIFE Distributors LLC is a Member FINRA/SIPC