Eliminating duration risk and increasing yield with floating rate loans

Investors looking for an opportunity to increase yield while rates remain historically low, and simultaneously position their portfolios for potentially rising rates, may want to take a closer look at floating rate loans. Floating rate loans are liquid, shorter-term assets that carry a floating rate coupon and can provide compelling income with zero duration risk.

Because loans are senior to high-yield bonds in a firm’s capital structure, and come with stronger covenants, they typically offer investors a lower interest rate. But given the continuing demand for high-yield bonds, investors can now purchase floating rate loans at yields that are comparable to those found in the high-yield market—while also gaining protection from rising rates.

As the loans carry floating rates, they present negligible interest rate risk and have an effective duration of zero, although investors are subject to prepayment risk as loans can be prepaid at par at any time.

For investors concerned about the ramifications of the inevitable end of extraordinarily accommodative monetary policies, loans could prove particularly appealing as they have historically outperformed most other fixed income sectors during periods of central bank tightening.

As with any fixed income instrument, investors are subject to the credit risk of the issuer and thus need to perform in-depth analysis of non-investment grade companies prior to committing capital. In terms of liquidity, floating rate loans are more liquid than many other types of credit fixed income instruments and typically carry shorter maturities.

Investors may have the opportunity to sell their loans in the secondary market prior to maturity if they so desire, but that market can be subject to irregular trading activity, wide bid/offer spreads and extended trade settlement periods.

In addition to increasing yield and reducing duration, an allocation to loans can help to diversify a traditional fixed income portfolio, as these assets tend to exhibit low correlations with core holdings such as government and investment grade bonds. Additional benefits may include the ability to pursue differentiated sources of alpha, as well as the chance to own some relatively low-volatility assets.

While the hurdles to investing successfully in non-core segments of the fixed income market can’t be ignored, the risk-adjusted rewards for casting a wider net appear compelling. By taking a diligent approach to constructing a well-diversified portfolio that meets both their investment objectives and liquidity requirements, investors may be able to achieve better outcomes in today’s low-rate world, as well as in the rising-rate environment that will eventually follow.