As interest rates rise, investors turn to floating rate funds

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The appeal of variable rate loans generally peaks when interest rates rise. But they can help diversify portfolios in any environment.

Variable rate loans are known by many names, including bank loans, senior loans, and leveraged loans. They are usually extended to companies with higher levels ratio of debt to cash flow and therefore carry a higher credit risk than investment grade bonds. But unlike traditional bonds, variable rate loans don’t pay a fixed interest, or coupon, payment for each period. Instead, their coupons reset every 30 or 90 days, floating up or down with changes in prevailing interest rates. This floating feature makes loan prices less sensitive to changes in interest rates, so flows into floating rate loan funds tend to increase when the Federal Reserve actively raises rates in response to a growing economy. and improving the labor market. And, as you might guess, this trend tends to reverse when rates fall.

Historically, variable rate loans have outperformed in rising and flat interest rate environments. When rates rise, the median annual return on floating rate loans, as measured by the Credit Suisse Leveraged Loan Index, exceeds the return on US Treasuries and the Bloomberg US Aggregate Bond Index by more than 6 percentage points. But what is perhaps forgotten is that floating rate loans have also generated attractive absolute and relative performance, regardless of the general interest rate environment. Since yield is such an important component of total return, floating rate loans have also outperformed US Treasuries and the Bloomberg Aggregate Bond Index when rates are stable. It is only when rates fall that floating rate loans underperform.

variable rate loans

Credit Suisse and Bloomberg indices

Variable rate loans can add diversification in any interest rate environment.

Although their interest rate advantages drive investor flows in and out of the asset class, variable rate loans can help diversify a portfolio at any time – and this advantage can be overlooked. Most of the return on floating rate loans comes from their credit risk exposure (corporate exposure), while the Bloomberg US Aggregate Bond Index derives most of its return from duration risk (interest rate sensitivity). ‘interest). So historically they have had a low correlation with each other and behave differently in different market environments.

At the end of the line

Variable rate loans are popular when interest rates rise, but they can have diversification benefits in any interest rate environment.

Disclosures

Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance LP and its affiliates (collectively “Bloomberg”). Bloomberg holds all proprietary rights to the Bloomberg Indices. Bloomberg does not endorse or endorse this material, or warrant the accuracy or completeness of any information contained therein, or make any warranty, express or implied, as to the results to be obtained therefrom and, to the extent maximum permitted by law, shall not have any obligation or liability for any injury or damage arising therefrom.

The Bloomberg US Aggregate Bond Index is a market value-weighted index that tracks the daily price, coupon, payout and total return performance of fixed rate debt securities issues, publicly placed, non-convertible, non-convertible denominated in dollars with at least $250 million outstanding and at least one year to final maturity.

The Credit Suisse Leveraged Loan Index tracks the US dollar-denominated leveraged loan market. It consists of issues rated “5B” or lower, meaning that the highest rated issues included in this index are Moody’s/S&P ratings of Baa1/BB+ or a1/BBB+. All loans are funded term loans with a term of at least one year and are made by issuers domiciled in developed countries.

Indices shown are unmanaged and do not reflect the impact of fees. It is not possible to invest directly in an index.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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