- Floating-rate loans have traditionally performed better when interest rates rise because their coupons frequently reset.
- Loans’ track record suggests they may do well during all interest-rate climates.
- Credit concerns may be eased by the strength of companies’ balance sheets and by loans’ status as senior, secured debt.
With the prospect of rising interest rates, there has been increased interest in floating-rate loans. Historically, these are one of the few debt investments that fare well when rates are climbing. On close inspection, it becomes clear that there are merits to including floating-rate loans in a strategically allocated portfolio during almost any interest-rate climate. Before considering why that is the case, it is helpful to remember the characteristics that set floating-rate loans apart from other income-paying securities.
A distinctive set of characteristics
Floating-rate loans are corporate debt issued to borrowers with lower-than-investment-grade credit profiles. The loans, which generally have maturities of three to seven years, are usually used to finance activities such as a capitalization, an acquisition or a refinancing. What makes these instruments distinctive:
- The loans’ coupon payments float above an agreed-upon base rate, and the coupon payment regularly resets, often as frequently as every three months. The base rate is usually the London InterBank Offered Rate (Libor), and the spread may be 300 to 400 basis points. That means the floating-rate loan may pay about 3% or 4% more than whatever the Libor rate happens to be each time the coupon resets. Because Libor rates are now at a historic low – the current 3-month rate is just 0.23% – many loans now come with Libor floors. These floors set a minimum for the base of the spread. Generally, it’s 100 basis points. So a loan with a 400-basis-point spread would provide a coupon of 5% whenever the Libor rate is below 1%. Effectively, the floors provide a “sweetener” of extra yield when rates are extremely low.
- Floating-rate loans are senior and secured debt. If a company defaults on its interest and principal payments, this senior/secured status gives investors in loans certain advantages, as detailed below.
All of the features that these loans offer investors flow from these characteristics.
Features that can serve investors in a variety of economic climates
1. Attractive yield potential
As below-investment-grade debt, floating-rate loans generally have higher yields than other fixed-income instruments. In fact, at year-end 2013, the yields on floating-rate loans were significantly above those offered by high-grade debt. Among the domestic, income-paying asset classes, only fixed-rate preferred equities and high-yield debt had delivered better yields.
These higher yields on floating-rate loans have been particularly appealing in recent years. With the yields on conservative investments so low and below the inflation rate, floating-rate loans have helped investors to earn high real rates of return, as the next point explains, with less interest-rate risk.
2. Less interest-rate risk than traditional fixed-income securities.
The prices of floating-rate loans have little sensitivity to changes in interest rates because of the frequency with which the loans reset their coupon payments. In other words, the loans have close to zero duration. When interest rates are rising, floating-rate loans don’t experience the price declines that bonds with long durations do. Floating-rate loans may potentially help investors to avoid interest-rate risk.
So effectively, what floating-rate loans can potentially allow investors to do is earn yields that are comparable with long duration fixed-income instruments. And they can do so with less risk that a rise in rates could greatly diminish the value of their investment.
3. An attractive long-term track record through various market environments.
Over the past 20 years through December 31, 2013, floating-rate loans posted the same total return – 5.7% – as the broad universe of domestic fixed income. (For this comparison, the Credit Suisse Leveraged Loan Index served as the measure for floating-rate loan returns, while the Barclays U.S. Aggregate Index represented the overall U.S. bond market.)
On closer inspection of these returns, it is true that the two groups performed differently under various interest-rate scenarios, as follows:
- When rates rise. When rates were rising, floating-rate loans outperformed the broad category of bonds over the past 20 years. That is not surprising, given the declines that the prices of bonds with long durations experience when rates climb. Because floating-rate loans have near-zero duration, their prices are generally not affected by rate hikes. During 94 of the 252 rolling one-year periods over the past 20 years that rates were on the rise, floating-rate loans delivered a total return of 7.35%, significantly higher than the 4.64% total return for the broad universe of U.S. bonds.
- When rates are flat. Floating-rate loans, because they are generally higher-yielding than investment-grade bonds, also outperformed the overall domestic bond market when interest rates were flat. In the past 20 calendar years, there were 59 one-year rolling periods when rates remained stable. During those, floating-rate loans outperformed, delivering a 10.71% total return vs. 7.63% for the collective U.S. bond market.
- When rates fall. Given the price gains that longer-duration bonds realize when interest rates fall, it is, again, perhaps not surprising that floating-rate loans, with their near-zero duration and little price sensitivity to rate changes, underperformed when interest rates were declining. During the past 20 years, there were 99 falling rate periods, and during those, the overall index of U.S. bonds posted a 7.69% total return vs. 2.81% for floating-rate loans.
While each of these interest-rate scenarios played out during the past 20 years, it’s important to remember what the overall climate for rates was during this period. Rates on the 10-year U.S. Treasury note fell from 5.8% to 2.9%. So during a prolonged bull run for the U.S. bond market, floating-rate loans still delivered a return comparable to what the broad bond market provided. Amid all the short-term rate fluctuations during that extended bull market, floating-rate loans actually outperformed the broad universe of bonds 61% of the time (in 153 of the 252 rolling one-year periods).
That performance suggests the potential advantages of keeping a strategic allocation to floating-rate loans, regardless of what interest rates might be doing. Maintaining that allocation helps free advisors and investors from having to second guess which direction rates might be headed next. Staying broadly diversified also makes sense for investors who don’t have the luxury to time when they need access to their money in accordance with whether the current interest-rate climate is favorable or not.
4. Good diversification1 with other fixed-income investments.
Given their characteristic of having near-zero duration, floating-rate loans have historically had a negative correlation with U.S. Treasurys and low correlations with other sectors of the fixed-income market. Because floating-rate loans do not move in lockstep with these other investments, they can be an important component for investors looking to diversify their income-generating holdings.
5. A diversifier that can help increase a portfolio’s efficiency.
For advisors and investors who want to optimize the return they can realize for each unit of risk they undertaken, floating-rate loans can help enhance the efficiency of a portfolio, as demonstrated by an Eaton Vance study of bond returns over the past three calendar years. (Again, the two indexes used to represent each category were the Barclays U.S. Aggregate Index for the broad category of U.S. bonds and the Credit Suisse Leveraged Loan Index for floating-rate loans.)
The lowest-risk blended portfolio was 70% overall bonds, 30% floating-rate loans. The optimal portfolio was 60% aggregate/40% loans, which delivered 104 more basis points of return, while lowering the risk of the portfolio, as measured by standard deviation of returns, by 72 basis points to 2.0%.
6. Opportunities to recover money provided if a company defaults.
Floating-rate loans are issued by companies with below-investment-grade credit profiles. Consequently, there is a greater chance than there is with investment-grade companies that these issuers could default on their interest or principal payments.
When defaults do occur, floating-rate loans have traditionally had advantages over other securities. As generally senior in a company’s capital structure, these loans provide investors with a claim on a company’s assets ahead of investors in other securities, including high yield. As secured, floating-rate loans are backed by the full enterprise value of the firm, which may include plants, equipment, inventory and patents. Investors in the loans have a right to liquidate those assets to recover their investments, and historically, recovery rates in the floating-rate loan market have been as high as 70%, according to Moody’s Investor Services.
What’s more, over the past 20 years, defaults have occurred only 3% of the time, according to Standard & Poor’s data, including below-investment-grade issuers. In 2013, the default rate was 2%.
1Diversification cannot ensure a profit or eliminate the risk of loss.
Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index.
The Barclays U.S. Aggregate Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities.
The BofA/Merrill Lynch Preferred Index is an unmanaged index of domestic preferred bonds.
The Barclays U.S. High Yield Index is an unmanaged index of domestic high-yield bonds.
The Barclays U.S. Corporate Index is an unmanaged index of domestic corporate investment-grade bonds.
The Barclays U.S. Treasury Index is an unmanaged index of U.S. Treasury obligations, across the spectrum of maturities from short to long term.
The Barclays U.S. Agency Index is an unmanaged index of securities issued by U.S government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. government.
BofA/Merrill Lynch Indexes: BofA/Merrill Lynch™ indexes are not for redistribution or other uses; provided “as is,” without warranties, and with no liability. Eaton Vance has prepared this report, BofA/Merrill Lynch does not endorse it, or guarantee, review or endorse Eaton Vance’s products.
Eaton Vance: A floating-rate loan leader
Experience One of America’s largest and most experienced loan managers.
A pioneer in the market Launched one of the first floating-rate funds in 1989.
Most investment options Most floating-rate loan mutual funds and share classes.
Size and scale $44.6 billion in floating-rate loan assets as of 12/31/2013.
Expertise Specialized resources dedicated to floating-rate loan investment operations, compliance and recovery management.
Management continuity Scott Page and Craig Russ joined Eaton Vance in 1989 and 1997, respectively.
An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There can be no assurance that the liquidation of collateral securing an investment will satisfy the issuer’s obligation in the event of nonpayment or that collateral can be readily liquidated. The ability to realize the benefits of any collateral may be delayed or limited. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. Borrowing to increase investments (leverage) will exaggerate the effect of any increase or decrease in the value of Strategy investments. Investments rated below investment grade (typically referred to as "junk") are generally subject to greater price volatility and illiquidity than higher-rated investments. As interest rates rise, the value of certain income investments is likely to decline. Bank loans are subject to prepayment risk. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. Changes in the value of investments entered for hedging purposes may not match those of the position being hedged. No Strategy is a complete investment program and you may lose money investing in a Strategy.
About Asset Class Comparisons
Elements of this report include comparisons of different asset classes, each of which has distinct risk and return characteristics. Every investment carries risk, and principal values and performance will fluctuate with all asset classes shown, sometimes substantially. Asset classes shown are not insured by the FDIC and are not deposits or other obligations of, or guaranteed by, any depository institution. All asset classes shown are subject to risks, including possible loss of principal invested.
The principal risks involved with investing in the asset classes shown are interest-rate risk, credit risk and liquidity risk, with each asset class shown offering a distinct combination of these risks. Generally, considered along a spectrum of risks and return potential, U.S. Treasury securities (which are guaranteed as to the payment of principal and interest by the U.S. government) offer lower credit risk, higher levels of liquidity, higher interest-rate risk and lower return potential, whereas asset classes such as high-yield corporate bonds and emerging-market bonds offer higher credit risk, lower levels of liquidity, lower interest-rate risk and higher return potential. Other asset classes shown carry different levels of each of these risk and return characteristics, and as a result generally fall varying degrees along the risk/return spectrum.
Costs and expenses associated with investing in asset classes shown will vary, sometimes substantially. No investment in the asset classes shown is insured or guaranteed, unless explicitly stated for a specific investment vehicle. Interest income earned on asset classes shown is subject to ordinary federal, state and local income taxes, except U.S. Treasury securities (exempt from state and local income taxes) and municipal securities (exempt from federal income taxes, with certain securities exempt from federal, state and local income taxes). In addition, federal and/or state capital gains taxes may apply to investments that are sold at a profit. Eaton Vance does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision.
About Eaton Vance
Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors. For more information, visit eatonvance.com.
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Scott Page, CFA, is Director for the Floating-Rate Loan Group at Eaton Vance
Craig Russ is Director of Credit Research for the Floating-Rate Loan Group at Eaton Vance
Christopher Remington is Director for the Product & Portfolio Strategy Group at Eaton Vance