Floating rate: Hedging the interest rate risk in your fixed-income portfolio
May 17, 2011
Following the Great Recession of 2008, many investors aggressively moved to cash and fixed-income securities in a classic flight to safety. In early 2009, we could point to a historic opportunity — spanning across various sectors of the bond market — to capture significant total return, as yield premiums corrected and the market’s perception of credit risk normalized. Much of that correction has already occurred and valuations across the fixed-income market have largely recovered.
At this juncture in the business cycle, credit risk has declined dramatically, as evidenced by defaults that are running below long-term averages, robust new issuance and demand for bonds, and healthy corporate balance sheets and earnings. Today, interest rate risk is a greater threat to fixed-income portfolios. With that in mind, a unique asset class to consider is the floating rate or bank loan market.
- Solid performance in a rising rate environment: Bank loans have a history of generating consistently positive total returns in periods of rising rates, unlike many of their fixed-income counterparts (see Figure 1).
- Diversification: Floating rate loans have historically had low correlation to investment-grade bonds, including Treasuries over the long term (See Figure 1).
- Income that keeps pace with the general trend in interest rates: Because the interest income generated by floating rate loans is tied to a market rate of interest, such as London-Interbank Offered Rate (LIBOR), income generally keeps pace with changes in market interest rates.
- Senior and secured: Bank loans are unique in that they are generally the most senior source of capital in a company’s capital structure and typically come with a lien on most, if not all, assets of the issuer. Both of these features differ from the generally unsecured nature of the high-yield bond market (see Figure 5).
- Compelling yield and duration: Because floating rate loans reset frequently, they essentially have no duration risk — a measure of the sensitivity of the price of an investment to a change in interest rates. This enables the investor to reduce interest rate risk without sacrificing income.
The interest rate environment — an expiring tailwind
Over the last 30 years, the overall interest rate trend has greatly rewarded bondholders. Since September 1981, fixed-income investors witnessed 10-year U.S. Treasury rates fall from 15.32% to 2.50% by mid-2010. This backdrop represented a significant tailwind, boosting portfolio performance. To put things into context, from 1981 to 2010, Treasury bonds returned an annualized 9.40%, and during that stretch there were only four years during which performance was negative.1 Overall, not a bad environment to be a buy-and-hold fixed-income investor.
1 Federal Reserve database in St. Louis (FRED). The Treasury bond is the constant maturity 10-year bond, but the Treasury bond return includes coupon and price appreciation. It will not match the Treasury bond rate each period.
After two rounds of the Federal Reserve’s (the Fed) Quantitative Easing Program, signs of economic growth are reappearing. As the economic environment continues to improve and inflation risk re-emerges, rates are poised to move higher. Since 1994, we have seen the 10-year U.S. Treasury increase over 100 basis points insert (bps) on several occasions. During each of those periods, leveraged loans provided consistently solid total returns (see Figure 1).
Importantly, however, the 10-year Treasury rate and the federal funds rate do not necessarily move in tandem as we just recently witnessed. With the fed funds rate near 0%, it’s appropriate to study distinct periods of Fed tightening and the impact Fed action has had on various sectors of the bond market. The results are interesting (see Figure 1). Again, the leveraged loan market — as represented by the Credit Suisse Leveraged Loan Index — provided investors with consistently positive performance, whereas other sectors of the bond market struggled.
In every market environment, portfolio duration, credit exposure and yield are all considerations in setting an appropriate asset allocation to fixed income. As investors prepare for rising rates, however, principal stability becomes a heightened concern and shortening duration can keep volatility in check. In most cases, shortening a portfolio’s duration will decrease an investor’s ability to generate yield. Bank loans are the exception. With their regularly resetting coupon features, bank loan yields tend to maintain pace with the current market environment and are higher than many of their short-duration counterparts because of the underlying credit quality of the issuers, which is below investment grade. (Generally speaking, an issuer with a lower credit quality rating will need to pay a higher interest rate to attract investors due to increased default risk.) Because the frequent rate resets reduce interest rate risk, the price of bank loans tends to fluctuate more with the market’s appetite for risk than with shifts in the yield curve.
A more thorough understanding of the asset class and the risks and benefits of adding it to an investment portfolio will help determine if it’s an appropriate choice.
Floating rate loans — a primer
Leveraged loans (also known as floating rate loans, bank loans or high-yield loans) are loans extended to companies with higher levels of debt relative to their cash flows. Companies typically borrow in the loan market to refinance existing debt, recapitalize their balance sheet or finance leveraged buy outs. Money center banks and other financial institutions are the primary arrangers of these loans, which are then syndicated (i.e. sold) to investors. The loans are below-investment-grade credit quality and are secured by assets of the borrower. As the most senior source of capital in a company’s capital structure, these secured, leveraged loans are paid down first in the event of a bankruptcy or liquidation (see Figure 5). The interest rate paid on the loan is based on an index, typically LIBOR, plus a predetermined spread. The total coupon moves as the index fluctuates. Typically, LIBOR resets every 30, 60 or 90 days. This floating rate nature of leveraged loans may protect investors from interest rate risk during rising rate environments and result in a portfolio with extremely short duration.
2008–2009: A historic period for the loan market
The leveraged loan market has grown significantly since the mid-1980s. Just prior to the financial crisis beginning in 2006, leveraged loan issuance outpaced high-yield bond new issuance. Outside of the recession in 2002 and the credit crunch in 2007–2008, loans have traded relatively close to par.
Growth in the bank loan market was driven primarily by demand from investors such as Collateralized Loan Obligations (CLOs) and hedge funds, which accounted for approximately 60% of the buyer base.2 Both types of investors used leverage to purchase loans, but hedge funds utilized the equivalent of up to 95% margin credit. In 2008, the market landscape became overshadowed with concerns of rising defaults, lower corporate earnings and a freeze in bank lending. In addition, the contagion of the subprime crisis spread to all structured products, including CLOs, and starting in late 2007, the CLO market essentially shut down. Institutions began to deleverage and were forced to sell risky assets in an attempt to avoid credit downgrades. In addition, hedge funds — levered up to 20 times through the large banks — were also forced to sell their loan holdings to meet margin calls. Magnifying the supply of loans on the market was new issuance. By that point in time, large banks had already underwritten over $250 billion in loan commitments backing leveraged buyouts and refinancings. The market was flooded with these large scale sales, demand was weak and loan prices in the secondary market collapsed from an average bid of approximately $95 at the end 2007 to approximately $62 by the end of 2008. As a result, the bank loan market witnessed its worst one-year performance in history — the Credit Suisse Leveraged Loan Index fell 28.75%. The leveraged loan asset class, which had historically displayed minimal volatility and a low correlation with other indices, was now performing in line with both equities and other traditional high-yield fixed-income investments.
2 S&P Leveraged Commentary & Data, January 2009
Since the credit crunch, investors have recognized that falling prices were largely due to technical factors. Prices rebounded sharply in 2009, as the leverage in the market unwound and an appetite for bank loans resumed. Returns on the Credit Suisse Leveraged Loan Index rebounded, up 44.88% in 2009 and another 9.97% in 2010. Over $14 billion of investor capital flowed into leveraged loan funds in 2010.3 On the supply side, new issuance has recovered, and in 2010 new loan volume was four times the 2009 level. With rates low, cheap financing is expected to continue driving buyout firms into the loan market and bank loan issuers will likely continue to refinance pending maturities. The supply/demand ratio appears to be more balanced. Importantly, the primary investor in the loan market today is an unlevered buyer and the volatility has declined as a result.
3 AMG/Lipper data as cited in a December 16, 2010 Bank of America report
Fundamentals are also better and defaults greatly improved. As shown in Figure 3, after spiking at an all-time high of 14.18% in 2009, defaults have declined to below the long-term average of 4% and, as J.P. Morgan states below, are expected to stay low over the next few years. Companies continue to deleverage, effectively cutting expenses during the downturn and being very cautious about adding staff and increasing expenditures.
Key portfolio benefits of leveraged loan investment
Diversification — historically low correlation
Historically, leveraged loans have displayed low correlations to more traditional asset classes, which can help reduce volatility in an investor’s portfolio.4 The correlation between high-yield bonds and leveraged loans is worth noting, however, and is largely owing to fact that the underlying issuer in both markets is below investment grade. Still, there are several important distinctions between the two asset classes.
4 Correlation measures how asset classes perform in relation to each other. Perfect positive correlation (+1.0) indicates that the asset classes move together up or down. Perfect negative correlation (-1.0) indicates that the asset classes move opposite each other, when one goes up, the other goes down. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random.
Interest income that paces with the rate environment
The coupon on bank loans resets regularly to mirror a market interest rate (typically LIBOR, which resets every 30–90 days). As a result, bank loans generate income that reflects the overall rate environment plus a premium that is set at origination. The premium or spread reflects the underlying credit quality of the issuer as well as technical factors in the market at the time of issuance: the market’s appetite for risk, liquidity, the default environment, etc.
Capital structure — senior and secured
Bank loans are generally the most senior source of capital in a company’s capital structure and are paid down first in the event of a bankruptcy or liquidation. They offer collateral protection with a first lien on most, if not all, assets of the issuer, have more robust documentation and have financial covenants that are regularly monitored by the lenders. As a result, bank loans have experienced a much higher recovery rate in default situations (historically, about 80%) as compared to other types of securities.5
5 Moody’s Investors Service, Moody’s Ultimate Recovery Database 1988, Q1 2011
Compelling yield-duration relationship
Floating rate loans have near-zero duration, such that their principal value remains largely unaffected by interest rate changes. Typically, an investor has to give up yield in exchange for low interest rate risk. Floating rate loans offer a higher yield with lower duration because the underlying issuers are below-investment-grade credit quality. If investors are comfortable with the underlying credit risk — which can be mitigated by the aforementioned structural features of the asset class — they can achieve a yield that keeps pace with the overall trajectory of interest rates and are less likely to not suffer the price declines typically associated with other fixed-rate investments.
From a fundamental and technical viewpoint, we believe that the floating rate market is an attractive asset class for many investors. With credit risk declining and financial markets continuing to recover, investors will be focused on maximizing yield relative to duration risk in the years ahead. The structural characteristics of bank loans can act as a hedge against rising rates and diversify an otherwise fixed-rate bond portfolio. The events of 2008 and 2009 should not be totally discounted, however, and are a good reminder that the asset class does come with some risk. Understanding the drivers of that performance and reflecting on the overall financial landscape at that time can help put that underperformance into context. The historical long-term profile of the loan market suggests stability, low correlation with other fixed-income sectors and solid performance in a rising rate environment, which is why we see it as a worthy contender in an overall asset allocation strategy, especially now.
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