Doing the Math on Floating-Rate Loans

Boston - With the U.S. economy humming and corporate fundamentals on solid footing, it's perhaps little surprise that markets have been cooperative this year. Investor sentiment remains strong and this has fueled higher-still stock prices, which of course is further supporting positive sentiment. It's a bull market.

On the fixed-income side of portfolios, we see markedly less optimism. Low yields are no fun, and the negative impact of rising policy rates has flattened the yield curve and sent bond prices lower.

Loans a bright spot

Yet, corporate credit sectors have performed well, and senior floating-rate corporate loans have been a bright spot. Year to date, the S&P/LSTA Leveraged Loan Index has returned 4.03% through the first three quarters of 2018, outpacing most bonds by a wide margin. To cite a common bond market proxy, the Bloomberg Barclays Aggregate Index has lost 1.60% over the same period.

Returns, though, are in the rear-view mirror. More important is what's ahead. To that end, we'd offer that coupon income has historically proven to be a reliable forward performance proxy, and for many loan investors that means a base case performance profile of 5-6% today.

The yield on the S&P/LSTA Leveraged Loan Index was 5.76% entering the fourth quarter, and all else equal, this is expected to rise as the Federal Reserve continues on its path to normalize interest rates by lifting short-term rates. That's because loan coupons float over one- or three-month LIBOR (London Interbank Offered Rate‎), and these historically track closely with the Fed.

We believe the simple math supporting the case for loans is compelling today. They have yields rivaled by few other asset classes, while the absence of bond duration helps to diversify fixed-rate positions. Loans are also at fair value, meaning they are trading near their intrinsic value of par, and with credit spreads right at long-term averages. Finally, loans have the help of a Fed on the move.