Bank Loans: What Happens If the Fed Cuts Rates?

Bank loan income may decline if the Federal Reserve cuts interest rates. That doesn't mean investors should avoid them altogether, but it's important to understand the risks.

The Federal Reserve is expected to lower its benchmark interest rate this year. As a result, investors holding short-term bonds that are maturing soon may face lower reinvestment rates.

Fed rate cuts should also mean declining coupon rates for investments with floating coupon rates, like bank loans. Bank loans are a type of corporate debt with a number of unique characteristics that differentiate them from traditional corporate bonds. They go by a number of different names, including "leveraged loans" or "senior loans."

Bank loans generally offer higher yields than many other fixed income investments, but those higher yields come with greater risks. This article will provide a broad overview of bank loans so investors can have a better understanding of how they work and how they may fit into a portfolio.

The basics of bank loans

Bank loans are a type of corporate debt with a number of unique characteristics:

  • Sub-investment-grade credit ratings: Bank loans tend to have sub-investment-grade credit ratings, also called "junk" or "high-yield" ratings. Junk ratings are those rated BB+ or below by Standard and Poor's, or Ba1 or below by Moody's Investors Services.1 A sub-investment-grade rating means that the issuer generally has high credit risk, or a greater risk of default, so bank loans should always be considered aggressive investments.
  • Floating coupon rates: Bank loan coupon rates are usually based on a short-term reference rate plus a spread. The short-term reference rate can vary, but it's usually the one- or three-month term Secured Overnight Financing Rate, or SOFR. For years, the reference rate was generally the three-month London Interbank Offered Rate (LIBOR), but that rate was retired in June 2023. The spread on the reference rate is the compensation for lending to a riskier company. Since bank loans come with increased risks—keep in mind that they're junk-rated—investors demand higher yields in case the issuer cannot make timely interest or principal payments. For example, a bank loan's coupon rate might be one-month term SOFR rate plus 3%. If the SOFR rate was 5%, then the annualized coupon rate would be 8%. Spreads can vary by each loan issue, depending on the creditworthiness of the issuer. Spreads can be as low as 1.5% for issues rated in the BB/Ba area by S&P or Moody's, respectively, and can be over 5% for riskier issues.