In a market rife with negative rates across a substantial amount of sovereign debt and central banks unlikely to raise interest rates for years, investors seeking yield may feel pressure to look elsewhere. One place they may consider is the floating-rate debt market, particularly floating-rate funds, which can offer a combination of attractive yield characteristics, seniority in the capital structure, active management benefits, inflation-hedging potential, and portfolio diversification.
What is floating-rate debt?
Floating-rate debt is a generally senior obligation of a company whose credit rating is typically below investment grade. It’s called floating because its coupon isn’t fixed but variable, adjusting—floating—based on the current level of short-term interest rates. Investors worried that rates are likely to rise may find floating-rate debt attractive, as it’s less likely than securities with fixed coupons to sustain losses in a rising-rate environment. Companies issuing floating-rate debt bear the risk that rates will move higher, increasing the amount they must pay to debtholders.
Issuers of floating-rate debt usually find easier access to credit from banks than from the public capital markets. Because of the higher degree of credit risk, this market is often referred to as leveraged loans. The income from these loans typically comes from two parts: a short-term reference rate that floats with market conditions and a fixed spread over that rate.
A key advantage: yield potential
With market participants willing to look beyond more traditional sources of income, such as sovereign and investment-grade fixed-rate debt, floating-rate paper becomes an attractive alternative. The S&P/LSTA Leveraged Loan Index (LLI), a comprehensive benchmark for floating-rate funds with 1,160 issuers, had a current yield of 4.7% and a yield to worst of 5.9% as of September 30, 2020.¹
Floating-rate funds typically buy the bank debt of companies with sub-investment-grade ratings. While ratings can vary, they’re typically concentrated in the BB and B ranges. There’s a big gap in the yields available in these segments of the high-yield market—approximately 200 basis points (bps) at the end of October 2020²—implying a wide range of credit risk and opportunity available to investors in floating-rate funds.
Weaker credits boosted by seniority and potential for active management
Although credit can be an issue, with bank loans typically carrying credit ratings of BB and below, they're also secured by a lien on a company’s assets and, therefore, are senior to unsecured debt.³ Notably, the average credit spread for leveraged loans was recently about 50bps wider than for high-yield debt, even though leveraged loans stand above high-yield debt in the capital structure.⁴ This helps support prices during periods of credit spread widening. First-lien recoveries on leveraged loans have historically averaged 66%,⁵ although there's concern that weaker covenant-lite structures may lead to lower future recoveries. The bank loan market is primarily a covenant-lite market, with seniority being the key to protection.
We believe active management can contribute to performance, perhaps more in floating-rate loans than in many other asset classes. Floating-rate debt is generally a less widely followed market, which means that experienced analysts and managers may be more likely to discover value than in higher-rated debt markets. Active managers, while maintaining roughly consistent overall exposure levels, may add to returns by increasing or decreasing risk profiles according to their perceptions of market and economic conditions and by taking advantage of individual pricing changes.
To illustrate the potential benefits of active management, the dispersion in the leveraged loan market shows that 63% of the loans in the LLI recently offered spreads of 150bps or greater in excess of the benchmark’s average.⁶ Perhaps most important, a good active manager can achieve favorable risk-adjusted returns largely by minimizing default risk.
Yet another factor to consider is how floating-rate debt can hedge the potential for rising interest rates. With multitrillion-dollar stimulus packages fighting the economic effects of COVID-19, some investors believe that higher rates may come sooner than expected. Planting the seeds now to protect against inflation later makes financial sense. Because increases in short-term rates will be reflected in floating-rate coupons, this type of debt is far less sensitive to rate rises across the yield curve.
Diversification across the economic cycle
In a severe economic and market downturn, equities, particularly more speculative ones, are clearly vulnerable to volatile shifts in investor risk appetite. Bank loans, despite their seniority, and high-yield debt also are likely to sustain notable losses. The large-cap LLI 100 fell 12.37% in March 2020, but had returned to positive territory for the 12 months beginning November 2019 by August,⁷ thanks in part to the components’ income characteristics.
Bain Capital Credit research looked at how U.S. equities, leveraged loans, and high-yield bonds performed in periods when GDP was flat or negative, moderate, and strong from January 1997 through September 2019. Bain’s research shows that while equities, as expected, outperform high-yield debt and floating-rate paper during periods of strong economic growth, investors in risk assets can benefit from the consistent income-based outperformance of debt in lower-growth regimes.
In these periods, optimism is generally more restrained, and companies borrow less aggressively, keeping overall leverage ratios at moderate levels. For these reasons, some investors consider low- and moderate-growth conditions a sweet spot for credit assets, often resulting in consistent, coupon-like returns for loans and high-yield bonds, and, in many cases, outperformance relative to equities.
1 S&P/LSTA Leveraged Loan Index, 9/30/20. 2 S&P Leveraged Commentary & Data (LCD), 11/10/20. 3 nasdaq.com, 2018. 4 FactSet, Moody’s, October 2020. 5 J.P. Morgan Default Monitor, 11/2/20. 6 S&P LCD, 9/30/20. 7 Morningstar Direct, 11/5/20.