Floating Interest, Not What You Think

A theme of the past several years has been the need to protect yourself from the bond market selloff, a selloff that seems to have arrived. The idea that you should protect against this has led to the suggestion that you should buy floating rate funds. This sounds like a great idea. Maybe yes, maybe no.

There are two very different kinds of floating rate funds. The first kind, exemplified by ETFs like FLOT and FLRN, hold investment grade floating rate bonds issued mostly by banks. Modest issuance by other sectors makes up the balance. Loan funds are also floating rate, but that’s where the similarity ends.

The investment grade funds will provide you with yields tied to short term rates like LIBOR. FLRN’s yield fully reflects the Fed’s tightening cycle. Each point on the chart shows the yield you would have earned over the prior 12 months. Looking forward, the fund is paying 2.6%, versus the current funds rate of 2.2% or 1.94% more than it was paying before the Fed started raising rates.

FLRNyld

Loan funds pay a juicier yield that is tied to LIBOR, just as in investment grade floating rate funds. That’s where the similarity ends. The yield of the SRLN ETF, where SRLN stands for senior loans, did not follow the Fed as rates rose. It’s up just 0.15%, from 4.29% to 4.44%.

SLRNyld

Loan yields have barely budged as the Fed has tightened

Loans don’t have the call protection of the floating rate bonds held by funds like FRLN. Borrowers take advantage of robust demand from people who are chasing yield. They refinance. The new loans are priced at lower margins.  Issuers can also renegotiate the covenants, or protections, given to lenders. Covenants govern things like the amount of debt a firm can issue or how much interest expense it can have versus its revenues. Currently, the vast majority of new loans are covenant-lite, a term that speaks for itself. Times have been good.

LoanInflows

Plenty of investors seeking yield. Source: Eaton Vance

The rub is that loans expose you to equity-like downside if the economy takes a turn for the worse. SRLN sank -7.6% in the 12 months to March 2016. It reacted to the decline in the stock market at that time. If the latest bout of volatility is a harbinger of an economic downturn, SRLN and its ilk could suffer.

FloatingNAVs

Loans can take on water

Investment grade funds’ principal fluctuates very little because their bonds’ coupons change with short term interest rates, keeping prices close to face value. There is some credit risk, but nothing like that of leveraged loans. The majority of floaters are issued by banks, making these funds sensitive to macro risks in the banking sector. Given the changes in bank regulation since the financial crisis, this risk is not material at this time.

Loan funds’ principal can fluctuate a lot. The leveraged loans they hold are of similar quality to high yield (junk) bonds. These are cyclical firms whose credit quality tends to be centered around a B rating. I have no objection to investing in high yield issuers, but the time for such investment depends upon the economic cycle, not the interest rate cycle.

Default rates and economic distress are currently low and, for reasons I touched on, loan interest rates remain low too.  Just be aware that when the dirty weather blows in, junk rated loans and the vehicles that hold them may not be the best vessels in which to ride out the storm.

RG Phone-93

 

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