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Floating-rate basics

This table is for illustration only. The table shows general properties for different types of bonds, assuming all other characteristics including maturity are the same. Individual bonds will vary.

A higher-yield/higher-risk option

All else being equal, floating rate loans are typically higher-yielding than most investment-grade short-duration investments because they have lower credit quality.

The historical default rate for floating-rate loans is about 3.4%, versus 0.1% for investment-grade bonds and 5.0% for high-yield bonds, according to research by Moody’s. One protection investors enjoy with floating-rate loans is that floating-rate loans sit at the top of the firm’s capital structure. In case of default, they are paid back before bondholders. While that may reduce the risk that investors in floating-rate loans will not be paid back,  it doesn’t eliminate it—some portion of floating-rate loans have historically defaulted.

Mollenhauer says that today’s low interest rates may help keep defaults at bay. “Low interest rates use up less of a company’s cash flow,” he notes, “so these companies are generating more free cash flow than they were before. And that makes them a little healthier.” In the floating-rate loan market as a whole, Mollenhauer adds, “credit quality is still pretty good.”

A pricey market

Still, Mollenhauer notes that strong demand has bid prices higher. “Almost 80 percent of the market is now trading above par,” Mollenhauer says. “It’s definitely a market where the loan issuers have more control, given the strong demand for loans. That means it’s time to be conservative. I am looking to take some risk out of the portfolio and wait for opportunities to pick up some credits a little cheaper down the road.”

All the same, Mollenhauer thinks the market retains its appeal. Both the high-yield bond and leveraged loan markets have been affected by investors looking for yield in a low interest rate environment. “A lot of what’s driven the floating-rate loan market up, in terms of investors looking for yield, has driven the high-yield market up as well.” This has caused the spread between the yields of the two asset classes to compress, and has made floating-rate loans look pretty attractive compared with high-yield bonds,” he says. “Even if spreads come down, there is some comfort in being on top of the capital structure, with floating-rate loans secured by the company’s assets. At some point in the next 10 years, I would have to guess, rates are going to rise, and if that happens, you could start to benefit from the floating-rate component alone.”

Floating-rate in today’s market

Depending on one’s risk tolerance and needs, floating-rate loans may make sense as part of a larger fixed income strategy. Floating-rate loans are held by institutional investors. Individual investors can own these securities by investing in floating-rate loan mutual funds (sometimes called bank loan funds ) or exchange-traded funds (ETFs). This asset class may play a useful role for risk-tolerant income investors who seek higher yield from non-investment-grade short-duration securities—while also offering some protection for those who think rates will rise in the future. In addition, floating-rate loans can offer diversification benefits for long-term investors because of the loans’ low correlations to traditional asset classes like stocks and investment-grade bonds.