In rising-rate environments, floating-rate loans can be solid investments.
That’s because these loans don’t have durations, says David Wong, executive director of investment management research at CIBC Asset Management. He oversees sub-advisor selection and monitors Renaissance Investments, including the Renaissance Floating Rate Income Fund.
So when rates rise, any price impact to the loan will be minimal. Compare this to bonds, which will underperform because they have duration and, therefore, rate sensitivity.
And, “given the floating-rate nature of [the] loans, there’s an increase in coupons when rates rise.”
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Currently, the loans may be good for portfolios since interest rates have nowhere to go but up. However, investors should know the borrowers are below investment-grade quality. As a result, “an advisor would need to sit down with their client [and ask] what their risk preferences and tolerances are with respect to [the] credit risk” of the loans, says Wong.
Also, they’d need to explain that floating-rate loans are defensive securities. For example, “when the economy is strong and equities do really well, we would expect equities to provide returns over and above [those of] floating-rate loans,” says Wong.
“But when the economy falters, we’d expect the downside protection of [the] loans to significantly enhance return[s] relative to equities.”
On the upside, the standard deviation of the loans is fairly low—lower than that of equities and of high-yield bonds, he adds.
So, “the impact they can have on an investor’s overall portfolio [is] reduced because [they’re part of] a lower-standard-deviation asset class. Also, the correlation [that floating-rate loans] share with equities and traditional bonds is quite low.” Compared to a traditional bond, for example, the correlation of a loan is actually negative due to its floating-rate feature, says Wong. With equities, there’s a slightly positive correlation, but it’s still low since the loan typically has downside protection due to its high place in a company’s capital structure.