When interest rates rise, investors generally expect the yields on senior loans – which frequently reset their coupons – to rise as well. But in recent months, while rates have risen, the yields on senior loan funds have gone down.
The reason for this is that a number of factors, beyond changes in interest rates, can affect senior loan fund yields. These additional factors include:
- Repricings and refinancings – When rates rise, the demand for loans increases substantially. That increased demand enables issuers to either reprice or refinance loans at lower coupons. Senior loan fund managers are not entirely helpless against this circumstance. If a manager believes a repriced or refinanced loan does not have the potential to deliver an attractive risk-return profile, the manager can opt out of the issue and get paid at the face value of the original loan.
- LIBOR Floors – In the aftermath of the global financial crisis of 2008-2009, when interest rates approached zero, most new loan issues – which typically offer a coupon that is a specified number of basis points above LIBOR – began offering a LIBOR floor.1 A typical LIBOR floor, as an example, is 1.0%. These floors help to ensure that the base rate loan issuers use to determine their offered yields always remains above an established minimum. As the LIBOR increased, it still had not yet reached the floor many loans use to calculate their yields, so investors in loans did not immediately see the benefit of increased rates. But by the end of last year and beginning of this year, the LIBOR hit and surpassed the floors many loans use.
- Credit quality shifts – Higher quality loans generally offer lower yields, so any time a fund manager decides to shift to higher quality loans, there will be an accompanying reduction in the yield the fund can pay.
These additional factors may explain why senior loan funds didn’t immediately begin paying higher yields as rates rose over the past several months. While we think senior loans deserve a permanent place in any well-diversified investor’s portfolio, we believe the current conditions are particularly favorable for senior loans. Credit quality is solid, with low default rates in the loan universe, and current loan valuations are attractive. Market technicals, year to date, have also been strong, as there has been a considerable flow of assets from investors into the market.
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- ^LIBOR is a benchmark rate that some of the world's leading banks charge each other for short-term loans. It stands for London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world.