In a landscape of historically low interest rates and broad economic uncertainty, more and more investors are looking for attractive yields and relative stability. And floating-rate loans have captured their attention. After all, the yields on floating-rate loans currently capture about 90% of those available on longer-term, high-yield bonds. Moreover, floating-rate loans are secured by corporate assets, while bonds are generally unsecured and are lower in the capital structure. And, the quarterly adjustment in a floating-rate loan’s coupon means that it can keep pace with a potential jump in interest rates. Finally, the minimal duration of these loans means potentially lower interest-rate risk than might occur with securities that have fixed coupons and longer maturities.

Investors demonstrated their exuberance for floating-rate loans by committing $7.4 billion to the asset class over the course of 22 weeks of consecutive inflows (as of mid-November 2012).¹ The increase in demand has not only pushed prices higher but also has emboldened corporate borrowers to relax the terms on their offerings. This combination has raised questions of whether the loan market has outpaced its fundamentals, thus setting itself up for a possible correction.

But from the perspective of an actively managed strategy, a look at the floating-rate loan market suggests that this skepticism is unwarranted, considering the potentially attractive attributes of the asset class remain in place. Indeed, as of mid-December 2012, prices on floating-rate loans continued to trade at a discount to par, while yielding 5.5–6.0%, with the potential for higher yields if benchmark interest rates rise significantly. (See Table 1 below for yield-to-maturity² details across asset classes.)

Meanwhile, the asset class should retain its relative historical stability due to its location at the top of the capital structure, the minimal durations on loans, and the prospects for relatively healthy corporate credit fundamentals going forward.

Relative and Historical Value
Any investment decision involves a risk/reward analysis, and some of the choices for investors in the current environment are displayed in Table 1. For instance, investors may choose a money market fund, which historically has been a high-quality selection that was regarded as a way to preserve capital and possibly provide some income.

But in today's environment, the risks facing investors have changed. Investors may indeed preserve their capital by investing in a money market fund, but by doing so, they risk eroding their purchasing power due to minimal yields that are far outpaced by inflation. This equation is one investors face as they consider the opportunities for positive real rates of return by assuming more credit risk, which they would be doing with an allocation of floating-rate loans.

As Table 1 also shows, only high-yield bonds yielded more than floating-rate loans; this is a logical relationship, because unsecured bonds generally present more risk given the lower recovery rates in bankruptcy scenarios. The historically higher recovery rates on loans has meant lower yields, by about 102 basis points (bps), in comparison to high-yield bonds, since 2009.⁹ But the recent separation of only 48 bps between the two asset classes (as of late November) reveals that investors can attain the seniority of loans in the capital structure at an historically attractive price.

In terms of how investors historically have been compensated for the risk on floating-rate loans, credit spreads over three-month Libor in a benchmark index¹⁰ have averaged about 4.5% over the past 20 years, while occasionally dipping below 3.0%. The recent yield spread is more than 5.5%. This historically attractive rate seems even more unusual in the current environment, where defaults are less than half the average historical pace.¹¹

While investor flows into floating-rate loans have not adversely distorted yields or prices, the recent strong demand may have encouraged borrowers to issue loans with less stringent covenants (that is, "covenant-lite"), suggesting to some that investors' exuberance may have tipped the scales in favor of borrowers and to the disadvantage of investors.

Implications of Covenant-lite
Despite increasing frequency of covenant-lite loan offerings, the activity still pales in comparison to the environment of loose underwriting standards that prevailed in 2006 and 2007. During that period, the widespread issuance of loans with relaxed covenants, which can govern overall debt levels or asset sales, for example, was an outgrowth of favorable lending standards, increased private equity financing of leveraged buyouts, and a heightened tolerance for leverage. The environment today, however, is starkly different.

While careful security selection always involves analysis of a borrower's credit quality and the covenants on specific debt offerings, the recent issuance of covenant-lite loans comes in an environment of tighter lending standards, deleveraged balance sheets, and realistic assumptions of slower economic growth. In addition to the benefits of a more conservative credit environment, covenant-lite assets do not automatically assure increased toxicity and higher probability of default. In fact, from July 2007 through March 2011, the cumulative default rate for covenant-lite loans was 590 bps lower than the cumulative default rate for the entire market.¹² [However, there is no guarantee this trend will continue.]

This counterintuitive result may be partially attributed to lenders' willingness to tolerate covenant-lite loans from issuers that have stronger credit quality and to demand better protection in the form of more restrictive covenants from weaker credits. This does not mean, however, that investors can blindly purchase a portfolio of representative loans and expect a return uncompromised by defaults.

The recent emergence of some covenant-lite loans means that investors should continue to require in-depth credit analysis and strategies that can actively adjust exposure to certain companies. With the proper analysis, the reemergence of covenant-lite loans could actually present opportunities to distinguish those issues that are attractive, even without more traditional covenant protection.

The combination of attractive yields, reduced historical volatility, and healthy corporate fundamentals suggest that exuberance for floating-rate loans is an investment approach that is more rational than irrational in the current environment.