problem-opportunity

Like bonds, floating-rate loans represent an obligation between a borrower and a lender.

The terms of the loan typically include information about coupons, principal, and maturity, says David Wong, executive director of investment management research at CIBC Asset Management. He oversees sub-advisor selection and monitoring for Renaissance Investments, including the Renaissance Floating Rate Income Fund.

Unlike bonds, however, the loans also have a floating-rate component. That means “they have virtually no interest-rate risk associated with them, for the simple fact that they have no duration attached to them,” he adds.

Read: Floating-rate debt structure suits rising-rate environment

Wong notes, “When interest rates increase at the front end of the yield curve, the coupon adjusts such that [clients would] get an increase in the coupon when short-term interest rates rise.”

But floating-rate loans have higher levels of credit risk. That’s because the market is below BBB.

Still, says Wong, “We’re talking about loans that are rated BB, B and CCC. The average quality of a loan is about B+. In terms of where [they] fit on the capital structure, these loans are the highest on a company’s capital structure.” That means they’re “afforded more protection in downside scenarios than bonds or equities.”

Read: A progressive approach to fixed income

So, if clients are concerned about the lower ratings of the loans, explain that floating-rate loan risk is partially mitigated since “loans [are] first in line to get any sort of payout in the event of a company defaulting,” he suggests.

Also, “floating-rate loans have covenants attached to them. These [protect] the loan holder by limiting the amount of additional debt a company can borrow. Therefore, the characteristics are known to the lender in advance [and] the borrower can’t increase its amount of debt outstanding without breaching the covenant.”

In contrast, “bonds, in general, can increase the amount of leverage [they] have for things like acquisitions since they’re not protected by…covenants.”

Read: How to create a yield cushion

Floating-rate loan universe

Wong says there’s more than $800 billion of floating-rate loans outstanding in the leveraged loan market, which is mostly U.S.-based. “That makes it considerably larger than the Canadian corporate bond market,” which is about $300 billion strong.

Further, investors can get more diversity out of the leveraged loan market. That’s because issuers come from a wide range of industries, such as the healthcare, energy and media sectors.

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Originally published on Advisor.ca

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