26 January 2021 / VIDEO
Three Reasons to Favor Floating Rate Loans in Today's Market
Our Asset Allocation Committee is overweight to floating rate loans
Our asset allocation committee is overweight to floating rate loans because they offer certain potential advantages in today’s market. Their shorter duration profile would likely offer some degree of insulation from higher interest rates. They are subject to increased credit risk, but their higher position in the capital structure could result in higher recovery rates in default situations, offering risk-adjusted access to high-yield issuers. And leveraged loans have favorable relative value over other high yielding investments.
In our recent Global Market Outlook for 2021, one of my colleagues, David Giroux, highlighted floating rate bank loans as offering potential advantages in today’s market. David is our CIO of Multi-Asset and Equity and a highly respected Investment Pro, so when he mentions an opportunity, we all listen very closely.
Our asset allocation committee holds a similar view on floating rate loans. Within our fixed income allocations, we have reallocated a portion from high yield into floating rate loans. Let me explain our thinking.
To start let me give a quick definition: Floating rate bank loans, they’re just another form of corporate debt, similar to high yield bonds, although they have some unique features. They’re called floating rate because bank loan coupons adjust to reflect short-term interest rates, typically every 90 days.
There are three reasons why we like leveraged loans right now.
Shorter duration. A higher standing in the capital structure so lower credit risk than many high yield bonds. And attractive relative valuations.
First, the shorter duration profile.
Duration is a key measure of interest rate risk, and the floating rate feature of bank loans gives them a very low, sometimes even negative, duration profile, which means they could do well in a rising rate environment especially relative to other fixed income asset classes.
This matters now because short‑term rates are at or close to zero while prospects for the recovery continue to improve. In that environment, loans would likely offer some degree of insulation from rising rates while delivering attractive yields.
Second. A higher standing in the capital structure.
Leveraged loans are generally secured and have higher repayment priority than many high yield bonds if the issuer defaults. Historically, this has resulted in higher recoveries in default situations. At the end of last year, high yield default rates stood at around 6%, while loan default rates were significantly lower at around 4%*. So we believe loans can give you good risk-adjusted access to high yield issuers.
Third reason: attractive relative valuations.
Today, you have favorable relative value in floating rate loans. Yields on bank loans and high yield bonds have essentially converged**. So if you can own two securities at the same price, why not own the security that should behave more defensively in this environment?
There are risks to bank loans. They can become illiquid, especially in moments of market stress and of course they are subject to credit risk. Assessing credit quality requires identifying the winners and avoiding losers through credit analysis, or active management.
Overall, however, I see a compelling case for bank loans in the current environment. I’d agree with David Giroux’s assessment.
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