Floating Rate Loans Are Not What They Seem

Or.. What you don't know can hurt you.

Or.. More bond nerd stuff.

Recently, I've seen a number of recommendations to buy floating-rate bonds and loans because they are "less risky" than fixed-rate bonds. Since the coupon income floats with changes in interest rates, they adjust to rising rates. This boosts your income and, in theory, should keep the prices stable.

Floating rate bonds typically reset their interest rates quarterly. The reset rate is linked to an underlying reference rate, typically a 3-month bank rate, formerly LIBOR, now SOFR, sometimes T-Bills. As the Fed has hiked rates this year, short-term rates have soared and the coupon on floating-rate funds has gone up, tick for tick. Still prices for many floating-rate funds have dropped materially. Why?

Credit risk is the answer, as you probably guessed, but if the rate resets every 3-months what's the problem? The problem is the reset is tied to a "risk-free" rate. The credit spread does not reset. The spread is fixed at issuance. Floating rate bank loans have maturities between five and ten years. This means that they behave just like a fixed-rate bond when credit spreads widen. For example, a bank loan with a 10-year maturity will have a "spread duration" of roughly 6 years. So, if Treasury rates are stable but investors perceive the credit risk of the company has worsened and take spreads wider by 50 basis points, your coupon won't change but the price will drop from 100 to 97. Conversely, if the perceived safety of the company is unchanged, a rise in SOFR by 50 basis points will just boost the coupon but won't change the price.

Below we see (courtesy of Yahoo Finance) three ETF's year-to-date. USFR is a floating-rate Treasury ETF. It has a spread duration of zero and its price is stable. The thick line is SRLN, the SPDR senior loan ETF, down roughly 10%, YTD. Not stable.

A Tale of Three ETFs

For comparison we also see HYLD, a high-yield bond ETF. It has fared much worse than the loan fund YTD. This illustrates the silver lining of this story. Bank loan funds typically invest in the SENIOR debt of a company. This means the loan holders are ahead of the bond holders to get a recovery so we can assume the loans are less risky. That's why SRLN is doing better than HYLD, but there is a caveat I'll discuss below.

In a previous note, I showed how the math of (formerly) low bond yields has meant rising price volatility even if yield volatility is unchanged. This has made the carnage of 2022 even worse. It is worth understanding the math to make informed decisions. The same is true for floating-rate bonds and loans. You should know the "spread duration" of your floating-rate fund. Personally, I think the bulk of Fed hikes are behind us but the bulk of spread widening may not be. If you sell are you closing the barn door after the horse has left? Let's just say there are two guys in a horse costume. The guy wearing the head is out but the rear end guy is still in the barn.

CAVEAT: This is mainly a post about bond math but I need to make an observation about how the loan market has evolved over time. In the old days, the capital structure of a company consisted, typically, of a large slug of equity followed by bonds, followed by bank loans. The loans are most senior so, in bankruptcy, the banks are first in line. The larger the cushion of bonds and equity, the more likely the loan holders are made whole. Today the capital cushion is often much smaller. Private equity firms are financing buyouts with loans and have a slim wedge of equity. There probably are no bonds. The "last loss" piece of the capital structure is closer to "first loss." There also used to be covenants on loans requiring certain protections for loan holders. How quaint! These are largely gone. Twenty years ago the rule of thumb in a credit crunch was that the average recovery on defaulted bonds was around 30 while the average recovery loans was 70 or better. We will see when this cycle ends that those two numbers will be closer together.