Floating-Rate Strategies: You Might Not Get What You Want

My colleague and friend Peter Essele, portfolio manager here at Commonwealth, has again put together an interesting piece highlighting the gap that often exists between what investors expect and what the market gives them. Although it’s a bit technical, the point is very important given recent moves in interest rates and the ongoing search for yield by many investors. In this case, even as rates rise, the yield available to investors may not. Hopefully, thinking through this kind of issue will help us all avoid unpleasant surprises. — Brad

The prevailing notion around bank loan funds (or floating-rate strategies, as they’re commonly known) is that an increase in short-term rates will result in a comparable move higher in yields across the asset class. These strategies have been offered as duration-insensitive instruments designed to provide investors with increasing distributions if the Federal Reserve starts hiking interest rates. (In other words, as rates rise, so should the payments to investors.)

Theoretically, this is true, but there’s a little more to the bank loan story.

A quick primer on LIBOR floors

Since the global financial crisis, most loans have been issued with a LIBOR floor. (LIBOR is the London Interbank Offered Rate, a benchmark rate that many banks charge each other for short-term loans.) Because the yields on loans can fluctuate and are based on the prevailing 60-day LIBOR (plus a cushion to compensate investors for credit risk), a decline in LIBOR would mean a comparable move lower in yields on loans. In order to entice investment, issuers put in place LIBOR floors, so that if 60-day LIBOR falls below a certain threshold, investors wouldn’t continue to see a decline in yields.

As of August 31, 2016, roughly 90 percent of the loan market had a LIBOR floor, with a weighted average of approximately 1 percent. For most of the post-crisis period, however, 60-day LIBOR has hovered close to the fed funds rate, at a yield of roughly 0.30 percent to 0.40 percent. Floors are obviously attractive if LIBOR is above the floor. But that doesn’t bode well from a float perspective if 60-day LIBOR is at 0.30 percent and the floor is set at 1 percent, as it would need to move through this level before investors see an increase in yield.

Currently, LIBOR is at 0.93 percent, compared with a level of around 0.40 percent at this time last year. We’re getting close, but we’re not there yet. This invites the obvious question . . .

Should investors expect higher yields once LIBOR moves through the floor?

It’s not as clear cut as one would hope.

Due to the potential for floating yields in the near future, demand has been strong in the space of late. Growing demand in the face of stable supply results in price increases. When issuers in the loan space see an increase in the price of their loans, it can set off a flurry of repricing, with yields reset lower to account for the perception of lower credit risk. (Simply stated, if the market is willing to pay up for loans, then issuers should be able to offer lower yields on existing and new issuance.)

As a result, we could see an interesting dynamic develop, where 60-day LIBOR pushes some yields higher while others are being reset lower, creating a netting yield effect across the asset class. It’s still too early to tell how things will play out once LIBOR moves through the floor, but it’s helpful to at least consider the scenario in the event yields doesn’t reset higher, as one might expect.