Today’s Floating Rate Loan Market
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)
We are high yield debt investors. While our focus over the decades has been on investing in high yield bonds, we also do allocate a portion of our portfolio to floating rate bank loans. We see the inclusion of loans primarily as a way to expand our investment universe. When a high yield issuer comes to market, they have the option of issuing loans or bonds or both. In some cases a company may elect to issue only loans. For instance, over the years we have seen many of the companies that we hold bonds in decide to take out the bonds with a loan, leaving loans as the only option in the capital structure. Having the ability to invest in loans enables us to continue investing in a company that we like and accessing companies that are loan-only issuers.
Including loans in our portfolio also gives us the flexibility to invest up and down the company’s capital structure, wherever we believe the best opportunity for yield relative to risk is offered. In some cases, this has resulted in us investing in the secured loans at the top of company’s capital structure rather than the bonds.
A secondary benefit of floating rate loans is that they are, well, floating rate. So this means that they carry a much lower duration and can be used as a means to lessen the interest rate risk within a portfolio. It should be noted that the floating rates are generally based off of short-term LIBOR, not Treasury rates (with the 5- and 10-year Treasuries as the more relevant rates for high yield bond investors), and many loans carry LIBOR floors.
As we look at today’s floating rate loan market, there are a few notable dynamics. We’ve talked at length in the past about some of the ramifications of recent regulation on the high yield bond market; however, there is another regulation that is currently having an impact on the loan market. This is the “risk retention” rules as part of the Dodd-Frank rule. As a bit of background, CLOs, or collateralized loan obligations, historically have been among, if not the, largest buyers of leveraged loans. Effective December 24th, 2016, as the rule now stands, CLO issuers will be required to hold 5% of their CLO structure. Managers are already in the process of working to comply, and it has resulted in a significant drop in CLO issuance as some would be or existing issuers may not have the capital to comply with this rule.
We have seen a slowdown in this natural source of CLO demand, but that has been coupled with the fact that many have sold out of the loan market as they don’t expect rates to be increasing significantly anytime soon. With this pressure on demand, we believe the floating rate loan market has become a bit less “efficient,” whereby creating what we see as some attractive opportunities for investment. We are seeing loans at discounts with reasonable yields.
By and large the high yield bond market has historically outperformed the loan space, and has also outperformed so far this year, and we have and continue to make the high yield bond market as our primary area of focus for investment. However, our active strategy allows us the flexibility to take advantage of the selective opportunities that we see within the floating rate loan market, whereby we can expand our investment universe, invest up and down the company’s capital structure depending upon where we see the best return relative to risk, and take advantage of some of the attractive discounts and yields that we see in the loan space, all the while helping to reduce duration (interest rate risk).