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Does minimizing interest-rate risk in your bond portfolio have to mean lower yields? Floating-rate loans are different from other bonds.
Floating-rate loans are known by many names, including bank loans, senior loans and leveraged loans. These loans are typically extended to companies with higher levels of debt relative to their cash flows 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, 60 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.
Floating-rate loans are an exception to the rule.
Rising interest rates are a challenge for fixed-income investors, because it generally means falling bond prices.
A common tactic is to invest in bonds with shorter time horizons to make a fixed-income portfolio less sensitive to interest rate changes. But in most cases, a shorter duration also results in a lower yield and less income.
Floating-rate loans are an exception to this rule. Regularly resetting coupons give floating-rate loans an extremely short duration — generally no longer than the time between reset dates. And despite the short duration of floating-rate loans, their yields tend to be relatively high, commensurate with their credit risk. Floating-rate loans are unique in this combination of characteristics.
On the chart below, one dot stands out from the rest: Floating-rate loans have a yield similar to high-yield bonds, but with less sensitivity to interest rate changes.
LOOKING FOR A MORE IN-DEPTH ANALYSIS?
As fixed-income investors try to navigate the new interest rate regime, it can be increasingly challenging to generate reliable income. Generally, reducing interest rate risk in a bond portfolio means investors have to accept lower yields. But floating-rate loans are an exception, offering low interest rate risk along with higher yields.