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Fixed-Income Insights

Answers to four key investor questions about bank loans and the floating-rate funds that invest in them


In Brief

With the prospect of higher interest rates in 2014, including the possibility of an increase in the fed funds rate, investors may have questions about bank loans and the floating rate funds that invest in them, such as:

  • Why do bank loans offer such a high yield? The relatively high yield of floating-rate funds reflects the below investment-grade credit quality of their bank loan investments.

  • Why have bank loans historically displayed such low volatility? This reflects the regular three-month resetting of interest rates on underlying bank loans.

  • How do bank loan rates adjust? The interest rate on bank loans typically is the sum of a credit spread and a reference rate. As these rates move up or down, the rate on bank loans adjusts accordingly.

  • Why shouldn't investors just wait for short-term interest rates to rise? Investors may have to wait a significant amount of time for the three-month LIBOR rate to rise above 1.0%, the most common floor rate for bank loans today. They may miss out on an attractive income opportunity in the meantime.

  • The key takeaway—Bank loans and floating-rate funds have retained their attractive qualities in the current market, and they present investors with a potentially attractive income opportunity regardless of when key interest rate benchmarks change.

 

The appeal of bank loans and, by extension, the floating-rate funds that invest in them, seems simple enough. They appear to combine two highly desirable historical traits: relatively high income and low volatility. The expectation that bank loans will adjust higher in income as interest rates rise, without falling in price like most bonds, would seemingly qualify the asset class as fixed-income's "Holy Grail."

But as the legend of King Arthur shows, the quest for the Grail is never as easy as it seems. Likewise, bank loans are not without their risks, and the adjustment to higher rates may not be exactly what many investors expect. Recognizing those risks and understanding the rate-adjustment process likely can improve investors' comfort with their allocation to bank loans—and their expectations of the performance of the asset class over the next several years.

Here, we'll try to answer some of the key questions investors may have about the asset class, and how it is affected by rising interest rates.

1) Why do bank loans currently offer such a high yield?
According to Morningstar data, at the beginning of March 2014, the average current yield at net asset value (NAV) of the funds in the Morningstar bank loan fund category was 3.69%. The relatively high yield of floating-rate funds reflects the credit quality of their bank loan investments. The loans generally represent senior liens on companies rated below investment grade. Accordingly, an economic slowdown or recession could increase bank loan investors' concern that some companies would be adversely affected.

However, the Federal Reserve, the International Monetary Fund, and most private-sector economists project the U.S. economy to grow, albeit slowly, for the next several years. Consistent with such forecasts are expectations for corporate bankruptcies to remain well below historical averages for 2014 and 2015, according to JP Morgan. That could spell good news for bank loan investors.

2) Why have bank loans historically displayed such low volatility?
The relatively low level of volatility among floating-rate funds reflects the regular three-month resetting of interest rates on underlying bank loans. Because the rate is adjusted regularly every three months, it is almost as if investors regard the maturity of the loan as the reset date, rather than the actual term of the loan; through this lens, the loans offer a maximum maturity of three months.

The upshot is that a floating-rate bank loan generally allows interest-rate volatility to be absorbed by a new coupon or interest rate, not by an adjustment to principal or market value as with longer-dated fixed coupon bonds. That's not a bad design for investors comfortable with the credit risk inherent in the asset class. So instead of the traditional bond mantra "as rates rise, prices fall," it seems that with bank loans, "as rates rise, income rises."

While this view of bank loans is essentially accurate, understanding which rate needs to rise and when the income will adjust will lead to more accurate investor expectations and more appropriate application of bank loans as part of a total portfolio strategy. [Floating-rate loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan's value.]

3) How do bank loan rates adjust?
The interest rate on bank loans is typically the sum of a credit spread, which varies with the borrower's credit quality, and a reference rate. The reference rate is generally a short-term interest rate such as the rate on three-month Treasury bills or, most frequently, three-month LIBOR (London Interbank Offered Rate). As these rates move up or down, the rate on bank loans adjusts accordingly. Because there is nearly 100% correlation between LIBOR and the benchmark fed funds rate, an increase in the fed funds rate is likely to be reflected in LIBOR. (See Chart 1.)
 

Chart 1. Data Show a Tight Correlation Between LIBOR and the Fed Funds Rate
Effective fed funds rate and three-month LIBOR (based on U.S. dollar), July 1, 1954–March 13, 2014

Source: Federal Reserve Bank of St. Louis, 2014, research.stlouisfed.org
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment. 

 

However, if other interest rates move, there is not necessarily an adjustment in the bank loan interest rate. A jump in Brazilian interest rates, for example, likely will not affect the short-term benchmark rates upon which U.S. bank loan rates are based. Similarly, a move in yields on the 10-year U.S. Treasury note may not affect the short-term interest rates upon which bank loans are based. This last comparison may be especially relevant later in 2014 if the Fed's tapering of monthly bond purchases results in higher yields on 10-year Treasuries while Fed guidance on short-term interest rates keeps fed funds and LIBOR rates unchanged from their current levels.

Indeed, according to Bloomberg data, if Fed tapering results in a rise in 10-year Treasury yields, from 2.7% in mid- March to 3.7% by year-end, and short-term interest rates remain unchanged, bank loan rates would not adjust higher. Keep in mind that since May 2013, the 10-year Treasury yield has already moved higher by 110 basis points (bps) through mid-March, based on Bloomberg data, without a corresponding increase in short-term interest rates or in bank loan rates.

So the rise in interest rates that would produce a rise in bank loan rates generally means an increase in the most commonly used reference rate, three-month LIBOR, which historically has been highly correlated to Fed funds. But should LIBOR rise, the initial increase may not immediately produce the higher bank loan rates that investors expect. This is because the construction of most bank loans includes a floor benchmark rate that is higher than three-month LIBOR, called a LIBOR floor. The most common LIBOR floor today is about 100 bps, or 1%. This LIBOR floor ensures that investors receive a minimum level of 1% plus the credit spread of the bank loan.

Without the LIBOR floor of 100 bps, over the past year investors would have received an average three-month LIBOR rate of about 0.23% (based on data from Mortgage-x.com) plus the bank loan credit spread, instead of the LIBOR floor of 100 bps, or 1.00%, plus the bank loan spread.

The construction of a LIBOR floor in bank loans allows higher income during periods of low short-term interest rates as well as less interest-rate volatility, especially as short-term rates decline. The corollary, however, is a delay in bank loan rates adjusting to rising short-term interest rates. For example, if the LIBOR floor is 100 bps and LIBOR is 0.25%, or 25 bps, three-month LIBOR will have to adjust at least 75 bps, to more than 1.00%, before the rate on bank loans will increase. Beyond that point, however, every adjustment higher in LIBOR will generally be reflected, point for point, in the bank loan rate. (See Table 1.)
 

Table 1. How Would Bank Loan Rates Adjust When LIBOR Changes?

Interest-rate changes based on prospective adjustments in LIBOR 

Source: Lord Abbett.
*Depicts a representative credit spread above the reference rate.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment. 


4) Why shouldn't investors just wait for short-term interest rates to rise?
If a key attraction of bank loans is their adjustment feature when short-term interest rates rise, why not wait until LIBOR is at or above the LIBOR floor before investing? While waiting until LIBOR exceeds the bank loan floor will assure investors their income will increase as short-term interest rates or LIBOR move higher, the wait time may be significant—and investors may miss out on an attractive income opportunity in the meantime.

Using the latest projections (December 2013) of the Fed's Federal Open Market Committee (FOMC), most committee members do not expect the first move to a higher fed funds rate until sometime in 2015. By year-end 2015, the target fed funds rate projected by the 17 FOMC members at that December meeting was slightly more than 1.0% on a weighted-average basis. At that level, three-month LIBOR is likely to be slightly above the 1.0% floor common to many bank loans.

For some investors, this may seem an appropriate entry point to the bank loan asset class in order to capture any further increases in short-term interest rates. But investors who are keeping their powder dry until LIBOR exceeds the 1.0% floor may be missing an opportunity, as the current LIBOR floor structure plus the credit spread still provides a relatively attractive yield.

As we mentioned earlier, the current yield at NAV of the average bank loan fund was 3.69% at the beginning of March 2014, according to Morningstar. Such an income stream, if maintained throughout 2014 and 2015, compares favorably with other fixed-income investments, many that involve substantial interest-rate risk. It is true, however, that the rates on bank loans and floating rate funds, like other fixed-income investments, have declined over the past several years. Yet, the current yield on this asset class remains relatively attractive, helped in part by the floor construct of most bank loans.

So while it may take time for Fed policy to push short-term interest rates and, in turn, bank loan rates higher, investors would still be "paid to wait" for a fixed-income investment that can potentially respond to higher interest rates with a higher coupon payment while at the same time not suffer price erosion as other fixed-income vehicles likely would.

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The Fund seeks to deliver a high level of current income by investing primarily in a variety of below investment grade loans.

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