With interest rates at rock bottom and a growing expectation that rates will move upwards over the next year, many investment managers are jumping back into the floating rate bank loan space—an asset class which historically performs very well in low and rising interest rate environments. However, I’ve noticed with my own clients that while the conventional bond space is fairly well understood among experienced investors, the bank loan space is not. Most people don’t know what differentiates these loans from traditional bonds and as a result abandon an asset class which may be a useful, low-correlation diversifier at the moment. So below is my attempt to demystify this asset class.
Floating rate bank loans are short term loans made to companies with below investment grade credit ratings. Many advisors are recommending short-term “low-duration” bonds to their clients right now so that they don’t get trapped holding low-interest bonds when more attractive offerings become available. The rate of interest charged on these floating rate bank loans tends to reset frequently, perhaps once per month or once every three months and is tied to the LIBOR rate. The frequent reset feature acts as protection to investors whereas a typical bond portfolio may continue to price lower as interest rates continue to climb.
If an investor is buying ‘senior’ floating rate investments, these will typically be prioritized in a default scenario over conventional bond issues. Also, because banks are generally lending these loans out for real estate transactions and the like there is collateral protection in the event of a default. Obviously you don’t want or expect a default to happen when you’re buying these loans but it’s good to know that this protection exists.
Typically, the rate of return on floating rate bank loans is determined by LIBOR + the risk premium for the loan, which is mostly based on the possibility of default. For example, if the 3-month LIBOR is paying .5% and there is a 4% risk premium, the bank loan would pay 4.5% to the investor. If LIBOR rises to 2%, the investor would get 6% instead. The risk premium typically does not change during the life of the loan. The point is that these floating rate coupons are very valuable to investors when rates are this low and fear persists about locking into a bond with a low rate of return.
As mentioned above, “senior” bank loans are prioritized, in terms of claims on assets, above subordinated bank loans, above bonds, and above equities. So there you have it. Why look into this asset class right now? Your income potential may be higher than with bonds, you’ve got a solid inflation hedge, and you’re investing in an asset class with low correlation to other asset classes.
Kindly e-mail me with any questions or comments.
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Floating Rate Bank Loans: Liquidity could be limited to certain periods and even though the loans are secured, an investor can still lose money in the case of default.
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.