Floating Above the Crowd

It’s been an interesting year so far for bond investors. With interest rates plummeting and risk-averse investors flocking to fixed-income instruments, some bonds—particularly short-term Treasuries and agencies—have provided solid overall returns despite extremely low yields. In contrast, other areas of the bond market, like high-yield bonds and mortgage-backed securities, have been decimated.

Unfortunately, this puts many bond investors in a tough position. Where can they find decent yields without getting their heads handed to them if the credit markets continue to unravel? One option may be floating rate loans.

Floating rate loans, also called “senior secured” or “bank” loans, are adjustable-rate commercial loans issued by banks to below-investment-grade corporations in need of short-term financing. The borrowers, which include household names like Ford, Goodyear Tire & Rubber, and Levi Strauss, use the loan proceeds for acquisitions, recapitalizations, and stock repurchases.

Floating rate loans come with a twist, however. The yields on these loans adjust periodically to mirror changes in market interest rates. These changes, which typically occur every 30, 60, or 90 days, are usually pegged to movements in the benchmark London Interbank Offered Rate (LIBOR). This periodic rate adjustment helps floating-rate loans maintain a fairly stable price, even when interest rates rise (which they are likely to do later this year).

So far this year, floating rate loans have held up pretty well. In fact, the Morningstar Bank Loan index, which tracks a broad basket of floating rate instruments, is down less than 2% for the year, albeit with more volatility than usual in the sector.

Over the longer term, floating rate loans have been solid performers in a variety of different market environments. In fact, barring a recovery in the space this year, 2008 will be the first-ever negative year for the Morningstar Bank Loan index since its creation in 1998.

Still, floating-rate loan funds are not for everyone. For example, many floating-rate loan fund managers use leverage to improve their returns. While this strategy can lead to spectacular gains in strong markets, it can lead to additional volatility in challenging environments if not managed correctly.

Also, since floating-rate loans are issued primarily to non-investment-grade corporations, they come with a higher credit risk. This was a particular problem during the 2002 recession when a weakening economy, excessive leverage, and a high loan concentration in the imploding telecommunications sector all combined to drive default rates to almost 8%.

Unlike their high-yield bond counterparts, though, floating-rate loans are considered senior debt and therefore have a priority claim on a borrower’s assets in case of default. And for added protection, most loans are also secured by liens on specific collateral. As a result, the recovery rate following a senior loan default is typically almost double that following a high-yield bond default.

For investors looking to invest in floating rate loans, there are a variety of mutual funds available, including the Fidelity Floating Rate High Income Fund (FFRHX) and the Morgan Stanley Prime Income Trust (XPITX). There are also a wide range of closed-end funds that also specialize in floating rate loans, including the Nuveen Floating Rate Income Fund (JFR), Eaton Vance Floating Rate Income Trust (EFT), and PIMCO Floating Rate Income Fund (PFL).

One note of caution for investors venturing into the floating rate loan market: make sure to read the fine print in the fund prospectus. Some mutual funds billed as “floating rate” are required to invest only a portion of their assets in floating-rate loans. The rest of their portfolios often consist of a mix of fixed-rate, high-yield debt; preferred stocks; and even derivatives like futures and options.

David A. Twibell, J.D., is President of Wealth Management for Colorado Capital Bank, where he directs the bank’s portfolio management and wealth advisory practice. He can be reached at (303) 814-5545 or dtwibell@coloradocapitalbank.com.