High-yield Bonds & Loans: Floored argument
More and more loans are being written with interest rate floors, at lower and lower rates. While these were a great feature over the past five years, Charlotte Moore asks whether they weaken investors’ floating-rate protection for the next five years
While it is proving tricky to predict when central banks will start raising interest rates, there is little doubt that the cost of borrowing in the US and the UK must increase at some point. As bond values will start to fall once rates start to rise, many pension schemes have invested in loans in the belief that their floating rates will provide some protection from this duration risk.
But investors should be aware that many floating-rate loans are issued with interest rate floors, which will have an impact on return profiles once interest rates start to rise.
“The use of floors means there is likely to be a lag between interest rates rising and loan fund distributions increasing,” says Martin Rotheram, bank loan portfolio manager at Neuberger Berman.
Most loan floors are set at 1% and concentrated in a narrow range between 0.75% and 1.25%, says Elissa Johnson, director of loans at Henderson Global investors. That’s lower than it was when they first started to be put in place around two years ago.
“Back then, they were around 1.25% but strong demand for loans has enabled companies to re-price at more favourable rates,” says Johnson.
While the floor might delay how long it takes for loan investors to feel the additional impact of any increases in rates, this does not make them an inherently bad investment characteristic. We are, after all, still living through the most prolonged period of low rates in history.
“These floors have been an important component of loan returns,” notes Rotheram. “In a low-Libor environment, they have helped loans to provide a competitive level of income.”
John Bell, portfolio manager at Loomis, Sayles & Co, agrees: “I think the floor is an unmitigated benefit for loan investors because they receive extra yield while they wait for interest rates to rise.”
Loan floors are not a universal feature across the loan universe – they are far more prevalent in the US market.
Dan Gardner, manager of the M&G European loan fund, says: “Floors became a common feature in the US market because over the past three years a vibrant loan retail market developed in this region, which is worth around $150bn.”
For loan funds to be attractive to US retail investors, they had to compete against high-yield bond funds, which are marketed on their yield. “As high-yield bonds pay fixed rates, the yields can be easily calculated,” says Gardner.
In contrast, the floating-rate nature of loan mutual funds made it harder to predict yields. “As loan mutual fund managers are a powerful constituency in the US market, they demanded a minimum yield which they could then market to retail investors,” Gardner explains.
In Europe, however, there is a very different picture. At the moment, regulatory constraints prevent loans from being offered as a retail product, so only banks and institutional investors are active in this asset class.
“Banks are one of core constituencies of the European loan market and they have little interest in loan floors, as they fund on a floating-rate basis so they lend on a floating-rate basis,” says Gardner.
Johnson estimates that while around 84% of US dollar loans have a floor, it’s much lower for European loans – perhaps as low as 30%, including both sterling and euro-denominated loans.
The European loans with floors tend to come from larger European and US companies that borrow in both dollars and euros. Gardner says: “It is these cross-border deals that introduced floors into the European market, almost by the back door.”
These jumbo deals include floors to attract the US investors, and European investors were able to demand the same terms for the different currency tranches of the deal.
The number of loans with floors, however, is increasing in both regions. “In the quarter ending in May, around 94% of US dollar loans and 40% of European loans issued had floors,” says Johnson.
Gardner adds: “Interest rate floors are unequivocally a good investment feature as they drag forward future income.”
Despite the positive benefit of interest rate floors, some managers have pointed out that long-term interest rates could increase before Libor rises, resulting in longer-dated fixed-income instruments yielding more than floored floating-rate loans.
Bell takes issue with this. “When interest rates on longer-dated bonds rise, their value will fall,” he says. “But the value of bank loans will not fall when interest rates rise. It is not the instantaneous increase in yield on a bank loan that will keep their value stable, it is the soon-to-be-received increase in the interest rate that will keep their price stable. In other words, it’s the fact that they are floating-rate instruments that protect their value.”
Investors have accumulated loans because they provide protection from rising interest rates along with good yield, while investors wait for interest rates to rise.
“Investors will not start to sell them and cause the value of the loans to fall once interest rates go up,” Bell reasons. “They bought them in the first place to provide protection from this duration effect.”
Steven Oh, global head of credit and fixed-income at Pinebridge, agrees.
“While investors might have to wait to receive the initial increases in the cost of borrowing, above that rate they will still receive the full benefit of loans’ floating rate,” he says. “They remain a defensive instrument. Investors are not really concerned about an increase in rates of 75 basis points but they are worried about much higher increases and loans provide an excellent defence against a higher-rate environment.”