Floating rate loans — Leading the pack in a rising rate environment
Many portions of the fixed income market are experiencing headwinds as the Federal Reserve (Fed) continues to raise interest rates. Despite this challenging backdrop, floating rate loans have generated solid results this year1. To learn more about the asset class and its outlook as the year progresses we spoke with Arthur Torrey, Managing Director with Fixed Income Investors and Portfolio Manager of MainStay Floating Rate Fund.
Floating rate loan features
While the floating rate loan market recently surpassed $1 trillion—putting it on par with the size of the high-yield corporate bond market—it remains somewhat of a mystery to many investors. In short, floating rate loans are debt obligations issued by the same or similar companies that issue high yield bonds. As their name implies, these loans pay a floating rate that can reset on a periodic basis – usually 3 months – and is tied to an underlying market interest rate, known as LIBOR. As the Fed raises rates, LIBOR and floating rate loan rates may also increase. In addition, these loans have a senior position in the capital structure versus other debt obligations, as well as preferred and common shareholders.
A positive backdrop
As shown in the chart below, through the first nine months of the year floating rate loans have outperformed the overall fixed income market, as well as corporate bonds. While it’s not possible to predict whether this trend will continue, there are a number of factors that could support the floating rate loan market going forward.
Floating Rate Loans Outperformance YTD
Source: Morningstar as of 9/30. Past performance is not indicative of future results. An investment cannot be made in an index.
- Strong demand/rising yields: Demand for the asset class has been robust as investors look for income generating opportunities and protection in a rising rate environment. As the Fed continues to raise rates, the yields offered by floating rate loans should increase as well, potentially resulting in further solid demand.
3 Month LIBOR
Source: Bloomberg as of 9/30. Past performance is not indicative of future results. An investment cannot be made in an index.
- Positive fundamentals: Corporate profits in the U.S. have been exceptional, with the Commerce Department reporting that after-tax profits rose 16.1% in the second quarter versus a year earlier. This represents the largest year-over-year gain in six years. With tax cuts and accelerating growth in the U.S., this could prolong the current credit environment which is supportive for the floating rate loan market.
- Low defaults: Not surprising given the positive economic and corporate profit backdrops, floating rate defaults have been relatively benign. According to JPMorgan, the loan par-weighted default rate was 1.77% at the end of September, versus their 3.0-3.5% long-term average.
Floating rate covenants: perception vs. reality
While the floating rate loan market appears to be on very solid footing, some pundits have expressed concerns over the lack of maintenance covenants on loans. It’s important to distinguish between maintenance and incurrence covenants. Floating rate loans still have incurrence covenants, just as bonds do, whereas “covenant-lite” loans do not have maintenance covenants. These covenants have historically allowed lenders to step in if a company did not maintain certain financial ratios. To be sure, covenants can be a positive feature. But the reality is, 70-80% of the floating rate market is now “covenant-lite,” meaning there are less restrictions on a company’s ability to incur additional debt. What’s more, based on our analysis, many of the loans currently being offered with covenants are from organizations that we would avoid given their weak fundamentals.
Not all loans are created equal
Given the size of the overall floating rate loan market, along with the lack of covenants, we believe it’s critical to understand the underlying fundamentals associated with individual loans. This has become increasingly important due to the uptick in leverage and rising corporate borrowing costs given Fed rate hikes. In addition, the average loan size has grown from approximately $400-$500 million in 2007 to around $1 billion today—making it essential to differentiate between the winners and the losers. One way to judge to the effectiveness of a floating rate loan manager is to look at the short- and long-term default rate of their portfolio.
Floating rate loans: part of a diversified portfolio
We believe floating rate loans can be used to supplement and diversify an investor’s overall fixed income holdings. Floating rate loans have historically had low correlations versus other types of fixed income securities, including a negative correlation with U.S. Treasuries. What’s more, floating rate loans have lower interest rate risk than fixed coupon bonds because their rates can reset if and when short-term rates change.2 As such, fixed coupon bonds could lose value as rates rise. In conclusion, floating rate loans can provide a buffer in a rising rate environment and play a complementary role in an overall fixed income portfolio.
1. Morningstar, data as of 10/08/18
2. Morningstar, data correlations as of 9/30/18
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. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life 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.
Neither New York Life Investment Management LLC, nor its affiliates or representatives provide tax, legal or accounting advice. Please contact your own professionals.
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
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.
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.
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.
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.
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
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.
For more information about MainStay Funds®, call 800-MAINSTAY (624-6782) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing.
New York Life Investments engages the services of MacKay Shields LLC, an affiliated, federally registered advisor, to subadvise several mutual funds. New York Life Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities are distributed by NYLIFE Distributors LLC, located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.