Loans: The Floating Rate
By Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)
As we have previously noted (see our piece “Today’s Floating Rate Loan Market”), we see investing in the loan market as predominantly a way to expand our investment universe. Again, high yield debt issuers have the option to issue bonds, loans, or both. We see cases where companies take out bonds with loans or vice versa, take out loans with bonds, so by having the option to include both, investors are able to access companies with attractive metrics and yield no matter the security, and in cases where a company issues both bonds and loans, loans are secured and rank higher the company’s capital structure so can allow for the ability to invest in a lower levered piece of the capital structure.
However many see loans primarily as a way to reduce your interest rate risk. Yes, loans are floating rate securities and provide the portfolio with a duration benefit given this floating rate. Yet, investors must understand to what the “floating” rate is tied. Bank loans are generally based on short-term LIBOR rates, which doesn’t tie very closely to longer term 5- and 10-year Treasury rates, the more relevant rates for high yield bond investors. And in turn, those Treasury rates are reflective of interest rate moves and the Fed speak we see here at home.
So again, while the 5- and 10-year rates are the more relevant rates for high yield bond investing, the chart above clearly shows that these rates here in the U.S. don’t closely correspond to 3-month LIBOR rates and the two rates don’t necessarily move in the same direction, as evidenced by the volatility we have seen in U.S. Treasury rates over the past three years, all the while LIBOR was flat until starting its spike upward a year ago.
Over the past few weeks we have seen LIBOR move to its highest level since 2009. While such a rapid rise is certainly not a good sign, as the spike could be seen as an indication of concerns about the financial system and interbank funding, there is a bit more going on right now. Rather LIBOR is currently being impacted by some market regulations for money market mutual funds that go into effect in October. This is resulting in a currently lower demand for short-term securities now that we are in the 90 day window before these regulations become effective, which is in turn pushing up LIBOR rates—as with most securities, when demand goes down, higher yields are often offered to attract buyers.
Many, if not most, floating rate bank loans have LIBOR floors, generally ranging from 0.75-1.5%. This means as short-term LIBOR rates hit 0.75%, this is starting to have an impact on the rates floating rate loans are paying, so while Treasury rates remain near historic lows and many, including us, are skeptical as to whether we’ll see any material move in domestic interest rates anytime soon, we could actually start to see rates on these LIBOR-based loans start to increase. For instance, LCD recently noted that by count of loans, 227 of 1225 or 18.5% have floors of 75bps.3 So a loan investor may have coupon income that is increasing despite no interest rate moves by the Fed, and if and when we start to see rates increase here at home, it is anyone’s guess as to what LIBOR will be doing.
As we have noted in previous writings, despite the belief by some that rising rates spell doom for all fixed income investing, high yield has actually performed well during rising rate environments (see our piece “High Yield Bonds and Rate: Duration and Yield” and “Strategies for Investing in a Rising Rate Environment” for further details and data). For instance, in 2013, the last annual period in which we saw a meaningful increase in US Treasury rates, floating rate loans returned 5.3% versus 8.2% for high yield bonds.4 Even with the 10-year Treasury yield increasing by over 1.2% and the 5-year Treasury increasing over 1.0% (both over 50% from the beginning of year yield)5 in 2013, the high yield market, helped by higher initial starting yields, still outperformed the loan market.
While these are floating rate securities, we don’t see investing in floating rate loans as the perfect panacea to rising Treasury rates/domestic interest rates given that different dynamics impact these rates versus the LIBOR rate to which floating rate loans are tied. However, currently we are seeing attractive prices/yields/discounts in selective loans and increasing rates in some cases. As a whole the loan market has historically offered lower yields relative to bonds (given the priority of loans versus bonds in a capital structure), yet we still see selective, attractive opportunities within this market. We believe the flexibility to include loans in our portfolio allows us the ability to expand the investment universe to virtually all high yield debt issuers and purchase where in the capital structure we see the best risk/reward balance as we take advantage of the attractive opportunities for active investment we see in both today’s bond and loan market.
1 Data based on 10-year Treasury level of 2.29% on 7/29/15 versus a level of 1.57% as of 7/28/16. Data from U.S. Department of Treasury.
2 Data as of 7/28/16, LIBOR data sourced from Bloomberg. Treasury data sourced from the U.S. Department of Treasury website, Daily Treasury Yield Curve and LIBOR data sourced from Bloomberg.
3 Park, Andrew, “LIBOR rates rising above 75 bps to impact 24% of LL100 loans,” Leveraged Commentary & Data, https://www.lcdcomps.com/.
4 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Leverage Loan Market Monitor,” J.P. Morgan North American High Yield and Leveraged Loan Research, January 2, 2014, p. 1, https://markets.jpmorgan.com/?#research.na.high_yield.
5 Data sourced from the U.S. Department of Treasury website, Daily Treasury Yield Curve Rates, comparing 12/31/13 to 12/31/12.