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.
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.”
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.”
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.