Floating Rate Loans—A Relative Calm in the Storm
After years of relative tranquility, financial market volatility has returned with a vengeance, impacting both stocks and bonds alike. Given uncertainties surrounding the economy, future Federal Reserve (Fed) monetary policy, global trade agreements, and other issues, the volatility we’ve seen could continue for some time. Yet, one asset class has held up fairly well: floating rate loans. To better understand the asset class’ resiliency through recent market turbulence and its prospects going forward we spoke with Art Torrey, Portfolio Manager of MainStay Floating Rate Fund.
A Floating Rate Loan Primer
Floating rate loans are debt obligations issued by banks and other financial institutions that consist of loans made to below investment-grade companies. An important characteristic of floating rate loans is their senior position in the capital structure versus other debt obligations, preferred shareholders, and common shareholders. These loans are typically backed by working capital, fixed assets, intangibles, and other investments. The interest rate paid by floating rate loans typically resets quarterly and, as such, floating rate loans have less interest-rate risk and a near-zero duration. As the Fed raises interest rates, London Interbank Offered Rate (LIBOR) and floating rate note rates should also increase, all other factors being constant.
Potential Tailwinds for Floating Rate Loans
1. Lower Interest Rate Risk
As expected, the Fed raised rates at its meeting in March 2018, with two—or possibly three—additional hikes expected during the year. While monetary policy tightening has negatively impacted certain types of credits, including investment-grade and high-yield bonds, floating rate loans were relatively spared. This was partially due to the latter’s lack of interest rate sensitivity, given their floating rate nature. As you can see from the chart below, floating rate loans have outperformed high-yield bonds for six consecutive months, and generated better results than investment-grade corporate bonds during five out of the last six months.
Floating Rate Loan Monthly Performance vs. Bonds
Source: Morningstar, as of 3/31/18. Chart created by NYLIM. Floating Rate Loans are represented by S&P/LSTA Leveraged Loan Index; High-Yield Bonds are represented by the ICE BofAML US High Yield Constrained Index; Investment-Grade Corporate Bonds are represented by the Bloomberg Barclay US Corporate Bond 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.
2. Rising Income Potential
Three-month LIBOR (the interest rate most floating rate loan coupons are tied to) has continued to rise. As the Fed further raises rates, floating rate loan coupon income should also increase. This explains why floating rate loans can be attractive versus other types of fixed-income investments during a rising rate environment.
Source: Bloomberg, as of 4/9/18. Past performance is not indicative of future results.
3. Low Defaults
Floating rate loan defaults remain low—currently around 2.5%—versus their average of approximately 3%, according to JPMorgan.1 While rising rates will increase borrowing costs for loan issuers, we believe this will be offset from continued economic growth. This, in turn, should help improve issuers’ cash flows and ability to meet their debt obligations. Against this backdrop, we expect default rates to remain below average as the year progresses.
4. Improving Demand
The floating rate loan market has also been supported this year by solid demand from both retail investors and collateralized loan obligations (CLOs). Retail investors typically access the bank loan market via mutual funds. While these funds experienced $4 billion in outflows during the fourth quarter of 2017, there were inflows of $3.7 billion during the first quarter of 2018. CLOs are basically pools of bank loans that are bundled together—similar to pools of mortgage-backed securities—and typically sold to institutional investors, such as pension funds. Year-to-date through the end of March, CLO issuance was $62 billion.
Increasing Monthly Inflows during Q1 ($bn)
Source: JP Morgan, as of 4/2/18.
5. Senior in the Capital Structure
While we expect fundamentals in the asset class to remain on solid footing, should they falter somewhat, investors can take solace in the fact that floating rate loans are senior in the capital structure, versus high-yield and investment-grade bonds, as well as equities. The seniority of the capital structure represents the order in which investors get paid in the event of a bankruptcy. Having seniority in the capital structure coupled with the fact that loans are secured by specific assets have resulted in fairly high recovery rates for floating rate loan investors compared with investors of other asset classes.
Income vs. Volatility
What do these tailwinds mean for floating rate loan investors? Historically, floating rate loans have generated fairly high levels of income, particularly when taking into account the risk undertaken to generate that income. As shown in the chart below, floating rate loans exhibit a fairly similar standard deviation as other fixed-income investments, however, currently yield considerably more. Further, when compared with high yield, the incremental yield earned by bond investors may not be commensurate with the increased volatility. That lower volatility can be explained by the senior secured nature of the securities along with the adjustable coupon. As volatility picks up across risk assets, the nature of floating rate loans may make sense for investors seeking income, but wary of the large daily swings seen in other asset classes.
Yield Comparison Chart (%) – Fixed-Income Yield vs. Volatility
Sources: Bloomberg Barclays, ICE, Morningstar, as of 3/31/18. Past performance is not indicative of future results. An investment cannot be made in an index. Volatility is measured by standard deviation. Standard deviation is a measure of the dispersion of a set of data from its mean. It is calculated as the square root of variance by determining the variation between each data point relative to the mean. If the data points are further from the mean, there is higher deviation within the data set. In finance, standard deviation is a statistical measurement; when applied to the annual rate of return of an investment, it sheds light on the historical volatility of that investment. The greater the standard deviation of a security, the greater the variance between each price and the mean, indicating a larger price range. For example, a volatile stock has a high standard deviation, while the deviation of a stable blue-chip stock is usually rather low. Yield represented is yield to maturity. Index definitions can be found at the end of this blog post.
The Importance of Credit Analysis
We maintain our positive outlook for the floating rate loan market. That being said, not all loans are created equal, and it’s important to conduct thorough analysis on individual credits. In particular, given the increase in leverage, it’s imperative to carefully review an issuer’s debt structure, as well as its sensitivity to rising interest rates. In addition, the overwhelming majority of new loan activity is issued without maintenance covenants, commonly known as “covenant-lite” or “cov-lite” loans. This does not mean that there are no covenants or restrictions on the issuer. Rather, this means that there are only incurrence covenants in place for investors, which are the same protections in place for bondholders. So, while covenants are a good thing and we’d rather have them, the fact is the vast majority of the par loan universe has been covenant-lite for so long, they’re here to stay. In fact, year to date, 86% of new loan activity has been covenant-lite (as of 3/28/18). This, again, demonstrates the value of credit analysis and security selection.
Source: Morningstar, as of 3/31/18. Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management. Index definitions can be found at the end of this blog post.
Complementing One’s Fixed Income Portfolio
In our view, floating rate loans can play an important role in a well-diversified portfolio. As shown in the chart above, floating rate loans have historically had low correlations versus other types of fixed-income securities and equities. This could take on added importance in a rising-rate environment. What’s more, with less credit and interest-rate risk than high-yield bonds, floating rate loans can play a complementary role in one’s below investment-grade bond exposure. In conclusion, while market volatility may be the new norm, floating rate loans may provide an opportunity to temper a portion of the market’s ups and downs.
1. JP Morgan, 4/2/18. 19-year average default rate.
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.
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 is a measure of the dispersion of a set of data from its mean. It is calculated as the square root of variance by determining the variation between each data point relative to the mean. If the data points are further from the mean, there is higher deviation within the data set. In finance, standard deviation is a statistical measurement; when applied to the annual rate of return of an investment, it sheds light on the historical volatility of that investment. The greater the standard deviation of a security, the greater the variance between each price and the mean, indicating a larger price range.
BofA Merrill Lynch U.S. High Yield Constrained Index – The index measures the performance of high yield bonds.
The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
BBgBarc Aggregate Bond Treasury – Sub-index of Bloomberg Barclays Global Aggregate Index
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
Bloomberg Barclays U.S. Corporate Bond Index – The index measures the investment-grade, fixed-rate, taxable corporate bond market.
JPMorgan EMBI Global Diversified Index – The index is an unmanaged, market-capitalization weighted, total-return index tracking the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.
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.
Bloomberg Barclays 1-5 Year U.S. Treasury Index – The index includes all publicly issued, U.S. Treasury securities that have a remaining maturity of greater than or equal to 1 year and less than 5 years, are rated investment grade, and have $250 million or more of outstanding face value.
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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