Floating rate loans offer fixed-income investors a unique potential source of higher income along with additional advantages, including:
Floating rate loans — also known as senior secured loans, bank loans or leveraged loans — are debt obligations that corporations typically issue to finance leveraged buyouts, recapitalizations, mergers, acquisitions, stock repurchases and other transactions. Large institutions were once the only investors who could participate in the floating rate market. Today, all investors can participate through ETFs, mutual funds and closed-end funds.
The interest rates on these securities reset every 90 days, which means their yields change with prevailing rates.
Higher yield with potential protection from rising interest rates: Floating rate loans’ yields are comparable to those of high-yield bonds. They carry less interest-rate risk, however, because their interest rates reset periodically based on market rates. As a result, floating rate loans may not lose value when interest rates increase—unlike traditional fixed-income instruments. This quality makes floating rate loans a potential replacement for the high-yield component of a fixed-income portfolio. However, higher interest rates increase a company’s cost of borrowing, which could affect its ability to meet existing obligations.
Lower credit risk: Floating rate loans are issued by below-investment-grade corporations, which may not be able to repay their debt obligations. However, loan holders are generally preferred creditors with seniority over investors holding other forms of equity and debt (including high-yield bonds). Translation: If the issuer defaults, floating rate loan owners are paid first. As a result, floating rate loans have a 10% lower default rate on average than high-yield bonds, and nearly twice the recovery rate in the event of default.
Portfolio diversification: Floating rate loans may improve portfolio diversification and smooth returns over complete market cycles.
Floating rate loans are unique assets within the fixed-income class and require special expertise. Look for investment managers with experience performing tasks such as analyzing loan covenants, which are essential to assessing potential risks and value in the floating-rate market.