August 30, 2012
|Justin Gerbereux and Paul Massaro, co-managers of the T. Rowe Price Floating Rate Fund|
Some investors looking to boost their current income in today's low interest rate environment are adding exposure to floating rate bank debt. Bank loans, also known as leveraged loans, are essentially a subset of the high yield market. They are generally issued by companies with below investment-grade credit ratings and relatively high debt levels. The following reflects the views of Justin Gerbereux and Paul Massaro, co-managers of the T. Rowe Price Floating Rate Fund, as of June 30, 2012.
Demand for higher-yielding securities surged in the first quarter of 2012 as corporate fundamentals improved. However, the market experienced a pullback in May when concerns about the European sovereign debt crisis and U.S. economy worsened. Most of the recent market weakness has been due to factors that are unrelated to bank loan issuers. Overall, these companies remain solid from an underlying corporate perspective, in our view. Bank loans, as measured by the S&P/LSTA Performing Loan Index, returned 4.5% in the six months ended June 30, 2012.
- Assets associated with increased credit risk, such as loans and high yield bonds, can react to news about the European debt crisis or other negative headlines.
- However, the majority of the loan issuers do not conduct business in Europe.
- Thorough credit research is essential in evaluating each company's asset coverage and the recovery rate over different scenarios.
- We work with a talented team of experienced credit analysts and their equity counterparts, giving us confidence and conviction in our credit decisions.
- Our traders are also imperative in assessing pricing and relative value within a single capital structure as well as across an industry.
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 will 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.
- The fundamentals underpinning the asset class have improved substantially over the past several years—we believe that reduced debt ratios and strong corporate earnings and cash flows create a favorable backdrop for loans.
- Active refinancing of outstanding debt has improved the maturity profile of the bank loan market, leading us to believe that defaults will remain below average.
This chart is shown for illustrative purposes only and does not represent the performance of any specific security. Past performance cannot guarantee future results.
As you can see in the 10-year chart, bank loan spreads (the yield differential between bank loans and comparable-maturity, risk-free Treasuries) have remained above average and relatively stable. On June 30, 2012, floating rate loans yielded 569 basis points (100 basis points equal 1.00%) more than comparable-maturity Treasuries, which, unlike floating rate loans, are guaranteed as to the timely payment of interest and the repayment of principal by the U.S. government. At the same time, defaults for the asset class (1.04% on June 30, 2012) were well below their historical average. Despite their below investment-grade status, the asset class currently has a low default rate, which we believe can speak volumes about the fundamental strength of the companies issuing loans.
- Loans are generally situated near the top of the corporate capital structure and secured by assets, offsetting some of the risk in below investment-grade credits.
- Because of the interest rate reset feature, floating rate debt is much less sensitive to interest rate fluctuations than similar-maturity bonds.
- Investor demand and cash flow into the asset class remains strong, which should help support loan prices.
- While bouts of volatility are possible, market weakness has largely been based on macroeconomic issues unrelated to the asset class.
- We think that the potential risk/reward trade-off in loans is compelling compared with other fixed income assets.
Floating rate loans can provide portfolio diversification, as well as an indirect hedge against inflation in a rising interest rate environment. T. Rowe Price has invested substantial resources in its proprietary credit research efforts. We have a deep and talented team of experienced professionals focused on uncovering investment opportunities for our shareholders.
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.
These views are as of June 30, 2012, and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.