Floating-Rate Loans

Senior, secured corporate loans are debt, generally issued by the same cohort of companies that issue high yield bonds. But they have two very important differences:

Unlike fixed-rate bonds, whose value drops as interest rates increase, floating-rate loans have coupons that are re-adjusted periodically, usually every three months, so your income stream increases as interest rates rise.
Loans are senior obligations, secured by collateral, whereas bonds are typically unsecured or even subordinated, so the borrowers’ assets are used first to pay off loans in the event of default or bankruptcy, before bondholders receive anything; as a result, credit losses on loans average less than half the losses on high yield bonds.
What many investors like about floating-rate corporate loans is that you can invest in a “pure” credit instrument, without also having to buy an embedded “interest rate bet” along with it. The interest rate bet was a nice additional feature for the 30 years from 1980 to 2010, because interest rates trended down – ultimately way down – during that period, providing a big extra boost to returns on top of just the coupon. But with rates at record lows as they are now, it seems like the interest rate bet embedded in bonds is more likely to be a headwind and a drag on earnings than a headwind going forward.

Buying loans, where 100% of the coupon is a return on taking credit risk, seems like a much better bet at this time in the cycle. In addition, loans pay investors more for taking the credit risk. According to Standard & Poor’s and Dow Jones, the average current yields on loans and high yield bonds are 4.5% and 6.8%, respectively. But 2.76% of that high-yield bond yield is actually a premium for taking the fixed rate interest rate bet. We’re using the 7-year treasury bond yield (2.88%) minus the yield on the 3-month treasury bill (12 basis points) to determine what the market pays you for taking pure interest rate risk for the 6 ¾ year difference in duration between floating rate loans and fixed rate high yield bonds.

What this analysis shows is that when you remove the portion of the high yield bond coupon that actually pays the investor for interest rate risk, what’s left – 4% – is less than what loan investors get paid for lending to the same cohort of borrowers. And the loan investors are lending higher up the balance sheet, so they are actually getting paid more to take less risk. When the higher recoveries (and therefore lower credit costs for loan investors) are factored in, the gap between loan and high-yield bond returns becomes even greater: 3.9% for loans vs. 2.8% for bonds, assuming a fairly typical annual default rate of 2%. (If you are more pessimistic about the future credit environment and assume a higher default rate, the relative advantage of loans over bonds becomes even greater.)