The Floating Rate Loan Market: More to Consider
For those concerned about interest rates rising, turning to the floating rate loan market may seem like it could be a great alternative. Over the past few weeks, as we have seen the expectation for higher rates firmly take hold and a spike in Treasury yields, floating rate loans (also called leveraged loans) are once again becoming a popular trade. We have seen substantial inflows into the asset class, with last week’s inflow among the largest on record, only slightly surpassed by the inflows we saw during the summer of 2013 “Taper Tantrum.”1 Investing in loans is a currently hot strategy and to some maybe even a no brainer—if rates go up, the coupon payment you get goes up so you can't lose, right? But of course, like most things in investing, it is not that simple. We see a few challenges with this market.
First, is valuation/potential capital appreciation. With the recent flood of interest into the loan market, this now leaves over 75% of the loan index trading at $99.50 or above.2 Unlike in the bond market, we generally don’t see large call premiums in the loan market and minimal call/prepayment protection. The issuer may have to pay a slight premium ($101) to call during the first 6mos to couple years, but nothing compared to the call restrictions and much higher premiums faced in the bond market. This means for the loan market, most loans can be called at any time after issuance right around par or very slightly above, which in turn limits the pricing upside for loans. Thus, with such a large portion of the market already right around par, we would see limited ability for capital appreciation in the loan market as a whole, curtailing an important component in generating total returns.
Our second consideration/challenge, is the floating rate coupon itself. Most of the floating rate loans are tied to 3-month LIBOR, with the coupon resetting every 3 months. Many, if not most, loans also have LIBOR floors of 1-1.5%, meaning 3-month LIBOR needs to move above this level before the loan even begins to float. Ever since August when investors began preparing for new money market regulations to go into effect, we have seen 3-month LIBOR move up significantly and is currently now right around that 1% level.3 So, we going to be hitting floors and rates paid on these loans will be going up. On one hand, that is good news for investors who are betting on this as a way to play rising rates. However, on another hand, that means the interest cost for the issuers is increasing, in some cases significantly. Investors need to be paying attention to the higher interest rate bill and the company’s ability to handle it, especially in very loan-heavy capital structures, as well as assess the impact on cash flow generation and the company’s ability to invest in the business—paying more in interest means that the company now has less funds available for things such as capital spending and debt paydown.
On the flip side of the rising coupon due to the floating rates, is the risk of a lower coupon, as massive interest in and demand for loans creates an environment whereby financially strong issuers look to re-price their loans. With the currently hot market and minimal prepayment protections on loans, we are already seeing a huge wave of loan repricings, where by issuers are coming back to the market to lower the rate they have to pay on the loan, leading to a lower coupon for the investor. We have seen issuers undertake multiple repricings on a single loan within a year, and even one issuer came back to the market for a repricing recently after just issuing the loan a month ago. Approximately 13% of the loan universe has re-priced since May and $117bn in total re-pricing volume year-to-date, with $51bn of that in just the last quarter. This compares to $63.5bn in repricing volume in all of 2015.4 So just because the underlying rate is “floating” up, that doesn’t mean that the company won’t look to lower the spread and in turn lowering the income investors receive.
The final issue to consider is the lack of correlation between LIBOR and US Treasury bond yields. Investor are seeing the 5- and 10-year Treasury rates increasing and many see floating rate loans as a way to capitalize on rising rates. However, they need to keep in mind they are talking about different “rates” that are driven by different factors. As noted above, the floating rate on loans are generally based on 3-month LIBOR. LIBOR is a global rate (London Interbank Offering Rate), while Treasuries are driven by domestic factors. Looking over the past few years, we have seen spikes in Treasury rates, such as in 2013 and mid-2015, all the while LIBOR barely moved. LIBOR began it accent upward several months ago (due to regulation changes, see our piece “Loans: Understanding the Floating Rate“), at the same time Treasury yields were hitting multi-year lows.5