Deep Dive: Floating Rate Bank Loan Funds
Floating Rate Bank Loan
Funds Overview
Equitas believes that investing in floating rate bank loan funds offers clients the ability to lower interest rate risk on their portfolios while increasing the income potential of invested assets.
Floating rate bank loans (“bank loans”), also called leveraged loans, are loans made by large commercial banks to corporate customers, most of which are below investment grade.
These high yielding loans are called floating rate because the interest rate is not fixed but readjusts every 40-60 days (on average) based on changes in LIBOR. As LIBOR moves up or down, the interest rate the borrower pays also fluctuates, significantly reducing duration risk tied to interest rate moves.
Bank loans are issued to a wide variety of companies in a broad array of industries, from consumer products, to technology, to health care.
Example companies include Heinz, Goodyear Tire, Clear Channel Communications, and Caesars Entertainment.
According to Moody’s these loans have a historical default rate of less than 4% with an average recapture rate of around 80%.
Floating rate bank loan characteristics:
- Yield higher (4.5%-5%)
- Credit quality lower
- Recapture rate higher
- Correlation lower to Treasuries
Floating Rate Bank Loan Funds
Yield and Duration
When comparing bank loans to other fixed income asset classes the floating rate characteristic gives these investments an extremely short duration of 0.24 which can help protect the value of fixed income holdings in a rising rate environment.
Additionally, the yields on these loans are higher (4.5%-5%) than investment grade debt because companies borrowing under these structures are typically rated BBB- to C in credit quality, with the bulk of the loan market in the BB to B range.
Floating Rate Bank Loan Funds
Senior Structure
Although floating rate loans are lower in credit quality than investment grade corporate debt this credit risk is mitigated by their Senior-Secured status at the top of the capital structure.
Because they are lower rated on the credit scale they provide yields similar to those of high yield bonds but are more secure with collateral backing up the loans.
Floating Rate Bank Loan Funds
Default and Recapture
Compared to high yield bonds these collateralized loans have demonstrated a historically lower default rate.
Additionally, the historical recapture rate on defaults for floating rate loans has averaged around 80% over the last three default cycles and is much higher than unsecured debt.
Floating Rate Bank Loan Funds
Effect of Changing Rates
This hypothetical graph shows the potential effect of rising interest rates on both bank loans and the US Aggregate Bond index. A rise in interest rates of 200 bps (2%) would result in a -8.7% loss for the index and a -0.1% loss for floating rate investments.
Floating Rate Bank Loan Funds
Correlation
Among fixed income investments floating rate loans have the lowest correlation (-0.37) to Treasuries and have the most ability to provide diversification within the category.
Floating Rate Bank Loan Funds
Portfolio Composition
Creating a blended portfolio of traditional bond investments and floating rate loans has the ability to reduce the standard deviation of a fixed income portfolio while enhancing its return characteristics at the same time. This is in addition to the potential benefit of reducing the average duration for whole portfolio and limiting the effect of rising interest rates.
In 2002, Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.
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Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.
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