Beware the Libor floor.
During the month of August, bank-loan (also called senior-loan and floating-rate-loan) open-end and exchange-traded funds took in $7.6 billion of inflows. Over the last year, investors have poured nearly $54 billion into these funds. Looking at bank-loan closed-end funds, 19 of the 25 funds are currently fairly valued on a one-year basis. It's clear that with the prospect of rising rates many retail investors have flocked to these funds in the hope of catching some extra income as rates rise. Unfortunately, this line of thinking is flawed. (For a primer on bank-loan funds, read this article.)
Yes, long-term interest rates are rising and may continue to rise, though the pace of future increases remains under much debate. The Fed's postponement this week of what many thought would be a first round of tapering caught many investors by surprise. As we've discussed before, floating-rate bank loans make coupon payments based on short-term rates, such as three-month Libor, and the Fed has said it will keep short-term interest rates low for some time (many believe it could be early 2015 before the Fed begins to raise short-term rates). In addition, it's important to understand the role Libor floors have played in the bank loan marketplace.
Beware the Libor Floor
Following the 2008 market crash, issuers of senior loans faced a shortfall of interested buyers. In an effort to entice buyers, firms began to include pro-buyer covenants, one of the most popular being a Libor floor (nearly all the loans issued following the market crash included a floor). A floor sets a minimum payment amount even if the reference rate (here, Libor) falls below the specified floor. For example, a loan may have a 3% coupon plus a 2% Libor floor (instead of a 3% coupon plus the absolute value of three-month Libor). This means the holder receives a 5% coupon until Libor drifts above 2%, at which point it will reset to a higher rate. While this has been a boon for income generation in a low-yield environment, the future of income generation is murkier. Many believe that short-term rates may not begin to rise until 2015, and even then, rates are starting from a historic low point; this means that reaching some of the higher Libor floors will take some time. In other words, even as short-term rates rise, income generating power is unlikely to increase in tandem with Fed-mandated rates.
Libor floors on loans issued in 2008 and 2009 generally have much higher floors than loans issued more recently as demand has picked up, though some of these older issuances may have been refinanced at lower rates. The current level of demand for senior loans has essentially offset the need for Libor floor covenants to entice buyers, so new issues are likely to offer a lower coupon than existing loans of the same credit quality. What's more, increased demand has also led to shoddier protections for buyers and has enticed highly leveraged and very low-quality firms into the new issue market. Robust credit analysis has become even more important in the current environment.
Big Demand May Not Mean Big Returns
From a total return perspective, it's important to note that bank loans are callable at par, essentially pinning the market price at or near par. This makes capital appreciation (a component of total returns) unlikely. High-yield bonds, on the other hand, can experience tremendous price appreciation as demand picks up, which helps boost total returns. This was the case over the last few years as yield-hungry investors took on more and more credit risk, bidding up market prices of junk bonds to levels well above par. For bank loans, fund managers must rely on income from coupon payments to meet distributions and avoid defaults to beat competitors on a total return basis.
Finally, repricings (refinancing outstanding debt at a more attractive rate) are also an issue for future distribution payments. As short-term rates not only remained low, but fell, and demand picked up, firms could bring new issues with better terms (for them) to the market to replace outstanding issues. However, after a peak in the first quarter of 2013, repricings have slowed. Unless short-term rates fall further, repricing activity should remain tepid.
Right now you're probably thinking, "So what? I don't care if my distribution doesn't increase. I will happily collect a 6%-7% distribution rate from my senior loan CEF--I don't need any increases. Also, I don't have to worry about too much NAV (and potentially share price) erosion as long-term rates rise because these funds essentially have no duration." Unfortunately, the story continues.
Here we get into the nitty gritty of leveraged CEFs. Until now, the discussion has applied to bank-loan open-end funds, unleveraged CEFs, and ETFs. While investors purchasing bank-loan open-end funds and ETFs with hopes of rising yields in the near future will be sorely disappointed, yields on those funds may stay put. However, when ill-informed investors figure out their yields aren't rising, they may decide to jump ship en masse, forcing open-end funds and ETFs to indiscriminately sell holdings to meet redemptions. This, in general, is a problem for all open-end funds and ETFs and one of the biggest advantages of investing in a CEF.