By Yvonne Stevens, Co-Head of Leveraged Debt Group, Ron Launsbach, CFA, Portfolio Manager, and Katy Brentz, CFA, Product Manager
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Given the significant and rapid move in Treasury yields over the last month, many investors in the floating rate asset class may be expecting to see higher income distributions.
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The presence of LIBOR floors in the leveraged loan market today means that investors may end up waiting a little bit longer to realize an uptick in coupon payments.
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However, relative performance for bank loans has been strong, and this asset class provides important diversification benefits to fixed income portfolios.
Given the significant and rapid move in Treasury yields over the last month, many investors in the floating rate asset class may be expecting to see higher income distributions. After all, floating rate loans are known to protect investors against precisely the interest rate moves that we just experienced. However, the presence of LIBOR* floors in the leveraged loan market today means that investors may end up waiting a little bit longer to realize an uptick in coupon payments.
Many investors may recognize the coupon payments on floating rate instruments as being comprised of an underlying base rate, such as LIBOR, plus an additional credit spread. The credit spread is fixed, but the base rate fluctuates with the broader interest rate environment. LIBOR floors serve to sweeten yields when market rates are low by establishing a minimum level under which the base rate cannot fall. This feature became a fixture in the floating rate market during the Financial Crisis as the ultra-low interest rate environment took hold. When the Federal Reserve anchored short-term interest rates near zero, LIBOR fell in lock-step and bank loan issuers were forced to identify a new way to entice investors to assume their debt. The introduction of LIBOR floors enhanced yields above the going market rate for investors and forced issuers to pay interest at levels commensurate with their individual credit risk.
LIBOR floors certainly benefit investors by ensuring a minimum yield, but they can also act as an anchor until the reference rate breaches the level established by the floor. So long as the underlying reference stays below the floor, loans will behave more like conventional bonds in that coupon payments will remain unchanged. One important caveat is that even while coupons remain static, investors likely will not experience the inverse relationship between prices and yields more traditionally associated with bonds, so rising rates should not cause price deterioration within those loans. As rates continue to rise and the reference rate moves through the floor, the floating rate feature of the loan will kick in and income payments will ratchet higher (Figure 1).
Figure 1
So how close are we to breaking through these LIBOR floors? Unfortunately, not very. By the end of April, 75% of the outstanding universe of leverage loan contained a LIBOR floor, with the average floor being 117 basis points. With 3 month LIBOR currently at 0.27%, we would have to experience an increase of almost 100 basis points to break through the average floor. LIBOR is also highly correlated to the Fed Funds rate, which implies that we may not see a significant spike in LIBOR until the Federal Reserve formally undertakes monetary tightening. However, the Federal Reserve has continually emphasized its intention to keep the Fed Funds rate low into 2015, which further reduces the likelihood that we will see a near-term pick-up in income from bank loans.
On their own, these may seem like reasons to avoid owning the asset class. However, the recent experience in the fixed income markets show exactly why now may be an ideal time to own floating rate loans. Since Treasury yields began to move aggressively upward beginning in May, bank loans have outperformed every major fixed income sector (Figure 2). This is a direct result of bank loans having almost no correlation to U.S. Treasuries and provides important diversification benefits to fixed income portfolios.
Figure 2
Sources: Credit Suisse and Barclays
Past performance does not guarantee future results.
Performance shown is not indicative of the performance of any particular product.
Related reading: Hedging interest rate risk with floating rate loans
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* The London Interbank Offered Rate (LIBOR) is the rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.
The market value of floating rate loans may fluctuate, sometimes rapidly and unpredictably. Risks include but are not limited to liquidity risk, interest rate risk, credit risk, counterparty risk, highly leveraged transactions risk, derivatives risk, confidential information access risk, impairment of collateral risk, and prepayment and extension risk. Generally, when interest rates rise, the prices of fixed income securities fall, however, securities or loans with floating interest rates can be less sensitive to interest rate changes, but they may decline in value if their interest rates do not rise as much as interest rates in general. Non-investment grade floating rate loans are more likely to experience a default, which results in more volatile prices and more risk to principal and income than investment grade loans or securities.
The Barclays U.S. Aggregate Bond Index is a benchmark index composed of U.S. securities in Treasury, government-related, corporate and securitized sectors. It includes securities that are of investment-grade quality or better, have at least one year to maturity and have an outstanding par value of at least $250 million.
The Barclays U.S. Mortgage-Backed Index measures the performance of investment-grade, fixed-rate, mortgage-backed pass-through securities of the Government National Mortgage Association (GNMA or Ginnie Mae), Federal National Mortgage Association (FNMA or Fannie Mae), and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac).
The Barclays U.S. Corporate Index consists of publicly issued, fixed rate, non-convertible, investment-grade debt securities.
The Barclays U.S. Corporate High-Yield Index measures the market of U.S. dollar-denominated, non-investment-grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt.
The Barclays Emerging Markets Index is an unmanaged index that tracks total returns for external-currency-denominated debt instruments of the emerging markets.
The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.