I have had some discussions lately with some prospective clients about the place senior loan holdings have within our strategic income portfolio. Essentially how they work, and how they fit into our portfolio design. The striking revelation I came to is that there are a lot of misconceptions on exactly what happens to senior loans and other floating rate securities when "interest rates rise". A generalization that has been inserted into many main-stream financial media headlines for the last month and a half.
The investors I had conversations with simply believed that when treasury rates rise, floating rate securities would ultimately benefit. This is largely false. One quasi-truth to that statement, is that when treasury rates rise, floating rate securities aren't severely impacted. The second would be that when treasury rates rise, floating rate securities may benefit.
From my perspective, the misunderstanding stems from some participants believing senior loan coupon rates carry a spread to treasury rates. When in fact, loans typically carry a nominal spread to 30, 60, or 90 day LIBOR rates. As a hypothetical example, a loan might carry a coupon rate that reflects L+400, or LIBOR plus 400 basis points (a basis point is 1/100th of a percent). Looking below at a chart of 3 month LIBOR, in this example the loan would pay a coupon rate of roughly 4.268% for the duration of the reset period.
Now looking at the price data of LIBOR in comparison to the price data for the benchmark most participants are acquainted with: 10-year Treasury note rate. The divergence is obvious, and it began with the Federal Reserve's now infamous tapering remarks.
One might assume without looking at a chart that since treasury rates have risen, fixed coupon bonds have become more attractive than floating rate notes at current levels. With LIBOR rates hovering near their lows, naturally senior loans would look less attractive as there hasn't been any jump up in cash flow that many participants were expecting?
Many loans carry a floor so that even if LIBOR rates remain low for extended periods, the lender would still receive the floor rate. Envision it as a small insurance policy against persistently low or falling LIBOR rates, just keep in mind the floor is often low considering the average borrower's credit rating. However, this can be an added benefit for investors assuming rates don't move so low the borrower can then refinance to better terms. This is why loans often exhibit "negative convexity", which is another way of saying the borrower has the flexibility to refinance if their credit rating improves or if the prevailing finance rate improves. This can oftentimes result in loans you want to hold within your portfolio being called away from you. Conversely, this can also lead to investors getting "trapped" in loans they wouldn't want to hold as a borrower's credit rating deteriorates and financing is no longer available to them.
The primary reason loans haven't been severely impacted by recent changes in treasury rates is that their coupons typically reset at the very same time intervals: 30, 60, or 90 days. In fact, when I analyze a typical senior loan ETF or mutual fund portfolio, the average reset time is usually right in the realm of 45-60 days on an aggregate basis. Resulting in a duration of roughly 0.2-0.3 years. Much less than your everyday high yield or intermediate term bond fund. Which is why loan funds have gone mostly untouched during this recent back up in treasury rates. Not as a result of their coupon rates adjusting higher thereby making a less creditworthy borrower more attractive and less likely to refinance.
It's true there is a caveat to almost every investment theme, and as I wrote about back in April, most senior loan portfolios have average credit ratings below investment grade. So as fears culminated over the possibility of a world without quantitative easing, all of a sudden investors began to actually focus on a creditor's ability to repay its debt, rather than the lack of securities available in the market. This is what largely contributed to the small correction we witnessed in loans during the May-June timeframe. As evidenced by the chart below, when compared to the correction in the average fixed-coupon high yield bond category, The iShares High Yield Corporate Bond ETF (HYG), loans presented much less volatility. This behavior is primarily attributable to the fact that loans typically trade very near to par, usually at a slight discount, and don't get bid up excessively due to falling treasury rates.
Understanding how loans work and how to use them will allow you to identify changes in the market, alongside any potential risks. The time you want to purchase loans is typically during a credit selloff when discounts to par widen. That way you have the opportunity for improving credit fundamentals (price improvement), in addition to the potential for higher coupon rates in the future. A few of my favorite loan vehicles include the actively managed Fidelity Floating Rate High Income Fund (FFRHX) and the First Trust Senior Loan Fund (FTSL). In addition to the passively managed PowerShares Senior Loan Portfolio (BKLN). I think they all offer a great value proposition in their ease of use for individual investors to gain exposure to senior loans.
In conclusion, I will point out an interesting alternative for more aggressive investors. Many closed-end funds offer senior loan strategies that are typically leveraged by 20-30%. A compelling argument could be made for using a CEF wrapper since senior loans typically track the same index as the borrowed money for leverage of the fund. The concept removes the risk of the cost of leverage exceeding the cost of a fixed coupon portfolio's income. So in essence, an investor would be able to receive an additional 2-4% in income per year and remove one of the risks associated with holding a leveraged portfolio. However, said investor would also need to be comfortable with the CEF's market price fluctuation vs. the fund's NAV. A few of my favorite funds include the Nuveen Floating Rate Opportunity Fund (JRO) and the Invesco Senior Income Trust (VVR).
In my opinion those who adopted senior loans early enough have endured a successful investment outcome even in light of the most recent selloff. The bottom line is that the interest rate rise we experienced coincided with a correction in credit, which in turn was the determining factor in the pullback of senior loan funds. Although you're not going to be able to predict every shift in credit and interest rates. I believe loans have largely lived up to investors' expectations for insulation from rising treasury rates.
Additional disclosure: Fabian Capital Management and/or its clients may hold positions in the ETFs or mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.