The appeal of floating-rate loans usually peaks when interest rates are rising. But they may help diversify portfolios in any environment.
Floating-rate loans are known by many names, including bank loans, senior loans and leveraged loans. They’re typically extended to companies with higher levels of debt relative to cash flow, and because of this, they carry greater credit risk than investment-grade bonds. But unlike traditional bonds, floating-rate loans don’t make a fixed-interest payment, or coupon, each period. Instead, their coupons reset every 30 or 90 days, floating up or down with the changes in prevailing interest rates. This floating feature makes loan prices less sensitive to shifts in interest rates, so flows into floating-rate loan funds tend to increase when the Federal Reserve is actively raising rates in response to a growing economy and improved labor market. And, as you can guess, this trend tends to reverse when rates are falling.
Historically, floating-rate loans have outperformed in rising and flat interest-rate environments. When rates are rising, the median annual return for floating-rate loans, as gauged by the Credit Suisse Leveraged Loan Index, has exceeded the return on U.S. Treasuries and the Bloomberg U.S. Aggregate Bond Index by more than six percentage points since 1993. But what’s possibly overlooked is that floating-rate loans have also delivered attractive absolute and relative performance regardless of the broader interest-rate environment. Because yield is a significant component of total return, floating-rate loans also have outperformed U.S. Treasuries and the Bloomberg Aggregate Bond Index when rates are flat. It’s only when rates fall that we have seen floating-rate loans underperform.
Floating-rate loans may add diversification in any interest-rate environment.
Although their interest-rate-related characteristics are what drive investors’ flows into and out of the asset class, floating-rate loans can help diversify a portfolio at any time — and this benefit can be overlooked. Most of the return in floating-rate loans comes from their exposure to credit risk (exposure to corporations), while the Bloomberg U.S. Aggregate Bond Index gets most of its return from duration risk (interest-rate sensitivity). So, historically they’ve had low correlation to each other and behave differently in different market environments.
Floating-rate loans tend to be popular when interest-rates are rising, but they may have diversification benefits in any interest rate environment.