In today's investment landscape, the mounting uncertainty about growth and income from traditional investment sources has created a conundrum for yield-seeking investors.
In order to produce sufficient yield, investors have several options which include the following: increase the duration of their fixed income portfolio; reduce the credit standards of their fixed income portfolio; or increase their exposure to the equity markets with the hopes of enhancing a modest dividend yield with capital gains. The prolonged near-zero interest rate environment has increased the risk of rising interest rates and inflation, reducing the attractiveness of increasing fixed income duration. High-yield bonds are producing the lowest yields on record and may not sufficiently compensate investors for taking on more credit risk. Equity markets have recently displayed diminishing equity premiums and heightened volatility. Increasing exposure to equities in many cases does not fit into an investor's risk profile. As a potential solution, floating-rate loans ("FRNs") may provide a compelling yield alternative. FRNs come with near-zero duration, price protection against rising rate scenarios, an income boost in the face of low/flat rates, and portfolio risk reduction in the form of historically low correlations to other asset classes.
FRNs (also known as bank loans, syndicated loans, leveraged loans, and loan-participation funds) are below investment-grade corporate debt secured by collateral such as the issuer's accounts receivable, inventory, property, plant, equipment and/or stock. Unlike a plain-vanilla bond with a fixed interest rate, an FRN offers variable coupons typically based on LIBOR (London Interbank Offer Rate) plus an added "spread." FRN yields typically reset quarterly to the prevailing market rate, but can reset as often as daily. FRNs, which are typically issued by corporations, municipalities, and some foreign governments, represent a well-protected senior layer of the issuer's capital structure and therefore typically have higher priority of claims compared to high-yield bonds and equity. The ability of FRNs to reset their coupon (the interest rate paid to the lender/investor) gives the sector a distinct advantage over other bonds by essentially removing interest rate risk from the equation. Because of the inverse relationship of bond price to yield, as interest rates rise, the market value of bonds with fixed coupons will generally fall. FRNs avoid that issue and do a better job of protecting principal due to the reset of yields to prevailing rates. Conversely, if rates were to fall, FRNs could underperform plain-vanilla bonds because of the reduced attractiveness after resetting to the lower prevailing market rates. Due to the concerted effort by the Federal Reserve and central banks around the world to artificially suppress rates, the current interest rate environment appears to be near a lower bound, leaving very little room for rates to fall significantly further.
The near-zero duration characteristic of FRNs provides income potential that can compete with or even surpass longer-duration fixed-income investments without the interest rate risk. Duration is commonly defined as the price sensitivity of a bond to changes in the level of interest rates. Since FRN rates regularly reset, their prices are relatively stable when rates fluctuate. To achieve the same effect with U.S. Treasury notes, for example, an investor would need to invest in extremely short-term bonds, which are currently offering negative inflation-adjusted returns. In contrast to high-yield corporate bonds which share similar credit profiles and current absolute yields, FRNs exhibit a higher yield per unit of duration. Stated differently, FRNs currently offer more return per unit of interest rate risk than other fixed income alternatives.
This near-zero duration characteristic also contributes to FRNs' negative correlation to U.S. Treasuries and low-to-negative correlation to other fixed-income sectors such as investment grade corporates, agency bonds, and mortgage-backed securities. This provides FRN investors the opportunity to achieve diversification and risk reduction benefits within their fixed income portfolios - lowering volatility and increasing risk/reward efficiency. It should be noted, however, that due to their credit profiles, FRNs exhibit higher correlations to equity investments when compared to their investment-grade counterparts.
FRNs are by definition credit instruments, and their performance is highly susceptible to swings in market perceptions, strengthening or weakening economies, and investor sentiment. If credit conditions weaken significantly, there is considerable risk of tremendous volatility in FRN pricing. For instance, the Financial Crisis of 2008-2009 provided the backdrop for one of the worst credit downturns in history. This was a time that did not bode well for credit sensitive investments, including FRNs, as they were down 29%. Despite today's interest rate environment, FRNs must always be evaluated in the context of the issuer's ability to satisfy its obligations. Similar to high-yield debt investing, credit research is a critical aspect of participating in the FRN market. Although FRNs are typically comprised of senior level debt, issuers tend to have relatively high levels of leverage. The minimal interest rate risk associated with FRNs must be weighed against the magnitude of credit risk.
As the market continues down the path of low-to-flat interest rates with traditional fixed-income strategies providing less yield and protection from inflationary expectations, FRNs may present a persuasive yield alternative. Given their low duration, yield advantage, and diversification benefits, FRNs deserve consideration as a strategic portfolio position in today's investment landscape. Investors must exercise caution, however, as the mitigation of price sensitivity to interest rate fluctuations and attractive absolute yields come at the cost of increased credit risk.
Please feel free to contact a WTAS investment consultant should you have any questions relating to this newsletter article or your investment portfolio.
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