For income-seeking investors, the landscape is changing. With the Federal Reserve consistently raising interest rates, bond yields have increased over the past year, though prices have not followed suit. In these unusual times, leveraged loans, also known as floating-rate loans, have emerged as an attractive alternative, even beating traditional bonds. Let’s explore why this phenomenon is happening and how floating-rate loans could be a viable investment option for the future.
Rising Interest Rates and Bonds: A Dichotomy
As the Federal Reserve continues to grapple with high inflation, interest rates are likely to remain on an upward trajectory, particularly if the economy sustains its growth. Though bond yields have risen, prices, which move in the opposite direction of yields, have remained largely stagnant.
Eric Mollenhauer, manager of Fidelity® Floating Rate High Income Fund (FFRHX), emphasized that leveraged loans returned 10.97% from June 2022 to June 2023, significantly outperforming investment-grade bonds, which returned −0.94%. The current modest economic growth is creating a favorable environment for leveraged loans.
What Makes Leveraged Loans Unique?
Unlike conventional bonds that pay fixed interest rates, leveraged loans adjust their interest rates periodically based on a publicly available, short-term interest rate like SOFR (Secured Overnight Financing Rate). This flexibility gives them a significant advantage over fixed-rate bonds in a rising interest rate environment.
A Closer Look at Leveraged Loans:
- Purpose: Companies often use these loans to refinance debt, fund mergers, or finance projects.
- Risk Profile: Leveraged loans are usually given to below investment-grade companies, indicating higher risk but also higher yields.
- Collateral: These loans are secured by tangible assets like real estate and equipment or intellectual properties, such as brands and trademarks.
- Flexibility: The floating interest rate mechanism allows them to align with key consumer interest rates, offering a hedge against inflation.
The Growth of the Loan Market
The leveraged loan market has witnessed immense growth, swelling from $500 billion in 2010 to roughly $1.4 trillion as of June 2023. This market has attracted large and established borrowers, giving them an alternative to traditional bonds for raising capital.
Why Invest in Leveraged Loans?
- Inflation Protection: As interest rates adjust upward with inflation, leveraged loans provide protection against eroding purchasing power.
- Diversification: Leveraged loans have been historically positively correlated with inflation and negatively correlated with Treasurys, adding diversity to investment portfolios.
- Higher Yields: These loans typically offer high yields due to the additional risk of lending to non-investment-grade borrowers.
The Risks of Investing in Leveraged Loans
Investing in leveraged loans isn’t without its risks:
- Credit Risk: There’s always a chance that the borrower may default.
- Market Liquidity: As unregistered securities, leveraged loans can encounter periods of imbalance between buyers and sellers, leading to fair value trading difficulties.
- Non-Guaranteed: Unlike bank accounts, these investments are not guaranteed by banks or the FDIC.
How to Invest in Leveraged Loans
Individual investors can access leveraged loans through professionally managed mutual funds or ETFs. These funds offer daily liquidity, diversification, and the potential for returns.
- Fidelity Funds: Fidelity® Multi-Asset Income Fund (FMSDX), Fidelity® Floating Rate High Income Fund (FFRHX)
- Non-Fidelity Funds: T. Rowe Price Floating Rate Fund (PRFRX), BlackRock Floating Rate Income Portfolio (BFRAX), PGIM Floating Rate Income Fund (FRFAX)
Conclusion
In a world where the Federal Reserve seems determined to combat inflation with higher interest rates, leveraged or floating-rate loans have proven to be an attractive option for income-seeking investors. Offering a unique combination of inflation protection, potential for higher yields, and diversification, they have outperformed traditional bonds in the past year.
However, as with all investments, understanding the risks and consulting with a financial professional to align with your risk tolerance and investment objectives is paramount. Leveraged loans could be an exciting addition to your portfolio if used judiciously and in harmony with your overall investment strategy.
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