October 5, 2011
|Justin Gerbereux and Paul Massaro are co-portfolio managers of the T. Rowe Price Floating Rate Fund and the T. Rowe Price Institutional Floating Rate Fund.|
Floating rate mutual funds, which primarily invest in bank loans, continue to offer yield opportunities in today's low interest rate environment. Funds that invest in floating rate bank debt have seen their assets grow to approximately $60 billion in the second quarter of 2011 from about $15 billion in 2008. While a multiyear rally means that near-term price appreciation could be somewhat muted for the asset class, we believe that bank loans are an attractive investment for investors who need a regular source of income. In this article, we will look at some of the factors that affect this market.
The T. Rowe Price Floating Rate Fund is a higher-risk bond fund that seeks to provide high current income and, secondarily, capital appreciation through investments in floating rate loans and debt securities. Most, if not all, of the loans in which the fund invests will have a below investment-grade credit rating or not be rated by a major credit rating agency. The loans in which the fund invests are often referred to as "leveraged loans" because the borrowing companies have significantly more debt than equity.
Bank loans are often issued by mid- to large-sized corporations that have relatively high debt levels. For this reason, bank loans are exposed to credit risk, or the chance that the borrower will not be able to make payments as promised. However, bank loans tend to fare well when corporate fundamentals are strong.
Corporate earnings have rebounded since 2008, leading to significant balance sheet improvements for this class of companies. In addition, an active new issue market, especially in the first half of 2011, has enabled bank loan issuers to refinance their existing debt at lower rates and extend the maturity due dates. However, as the second quarter came to a close, higher-risk assets, such as high yield bonds, bank loans, and equities sold off as uncertainty about Greece and peripheral European countries continued and U.S. economic data came in weaker than expected. Nevertheless, corporate fundamentals remained solid.
In the immediate aftermath of the financial crisis that started in late 2008, default rates on bank loans spiked to a peak near 11%. Since then, however, defaults have declined sharply. We expect the default rate on bank loans to remain low in 2011 and stay below 2% through 2012.
Source: S&P's LCD Loan Index Publications (data as of August 31, 2011).
This chart is shown for illustrative purposes only.
Past performance cannot guarantee future results.
Part of the reason for this improvement is that companies have had success in refinancing their debt at reasonable rates. Although bank loan investors are focused on the upcoming "maturity wall"—a large amount of outstanding loans are scheduled to mature before the end of 2014—extensive progress has been made. A significant amount of the loans coming due over the next few years has been paid down or extended, contributing to low default rate forecasts over the next year or so.
The Federal Reserve has pledged to keep interest rates extremely low, and investors have gravitated toward higher yielding securities to boost income. Compared with alternative fixed income asset classes, bank loans and high yield bonds currently offer attractive yields and solid long-term total return potential.
While below investment-grade companies are considered to have more credit risk than investment-grade bonds, investors benefit from the senior status of the loans. Bank loans are at the top of a firm's capital structure and stand first in line for repayment should a company declare bankruptcy. Because bank loans require companies to put up collateral, loans represent a more cautious way to generate high current income than high yield bonds. Also, compared with high yield issuers, companies that issue bank debt must comply with stricter covenant agreements on a quarterly basis, which often requires companies to meet certain financial ratios or limit their dividends.
A unique attribute of the asset class is the floating rate structure of bank loan coupons. The interest rates on floating rate loans adjust by a predetermined spread over a reference rate, such as the London Interbank Offered Rate (Libor), which typically moves in sync with the federal funds rate. Funds that invest in floating rate loans may be attractive in a low or rising interest rate environment because the floating rate feature allows the fund's yield to increase when rates rise. This is because the underlying interest rate on most floating rate loans reset after a relatively short period of time, like 30, 60, or 90 days. Because of the rising-rate feature, the asset class can also act as an indirect hedge against inflation as the coupon resets.
To compensate investors for owning higher-risk securities, many recent bank loans have been issued with an income premium, known as a Libor floor (typically 1.25% to 1.50%). If interest rates rise above the loan's floor level, the coupon payments will begin to increase, hence the name floating rate securities. In the current interest rate environment, Libor floors are especially attractive as they provide more interest income than comparable loans without floors.
Unlike traditional fixed income bonds, the market for floating rate loans is largely unregulated and the loans do not trade on an organized exchange, making them relatively illiquid and difficult to value. The underlying loans held by the fund are subject to significant credit, valuation, and liquidity risk. The loans and debt securities in which the fund invests are generally considered speculative. They tend to be more volatile and have a greater risk of default than investment-grade bonds. The fund is exposed to interest rate risk like more traditional bond funds, but credit and liquidity risks tend to be more important. Floating rate loans often have contractual restrictions on resale, which can delay the sale and adversely impact the sale price. Senior loans are subject to the risk that a court could subordinate a senior loan, which typically holds the most senior position in the issuer's capital structure, to presently existing or future indebtedness or take other action detrimental to the holders of senior loans. Floating rate funds are also subject to impaired collateral risk, which means that the value of the collateral used to secure the loan could decline over the course of the loan. The fund's yield and share price will fluctuate. Diversification cannot assure a profit or protect against loss in a declining market.
We view floating rate loans as a complement to any broadly diversified fixed income portfolio. We believe that corporate balance sheet repair and low default levels have created more stability for the asset class. Additionally, the fund could generate higher income than higher quality bond funds and could have greater potential for capital appreciation. Because the loan market can be more sensitive to changes in economic growth than interest rates, the fund may outperform high-quality bond funds when the outlook for the economy is positive.