Christine Benz: Hi, I'm Christine Benz for Morningstar.com. What are floating-rate loans and what role do these investments play in a portfolio? Joining me to discuss this topic and share some favorite funds is Brian Moriarty. He is an analyst in Morningstar's manager research group.
Brian, thank you so much for being here.
Brian Moriarty: Thank you. Happy to be here.
Benz: Brian, let's talk about how these bank loans, or floating-rate loans, work and how they're different from conventional bonds.
Moriarty: So, they are different in a few ways. First and most important is they are traditionally senior in a capital structure. Compared to a high-yield bond, this means they get paid first in the event of any sort of distress or default.
Benz: So, as an owner, you have priority.
Moriarty: Exactly. Correct.
Moriarty: Something else to keep in mind is that they are not securities in the legal sense, which means they're still traded over the counter. And they're actually typically less liquid than high-yield bonds, despite the fact that they're more senior in the capital structure. So, a little bit of a trade-off there.
Benz: So, in hearing that, I'm thinking this is not a marketplace where I'd be wanting to be out there picking individual loans. I'm probably better delegating this to a professional investor, I would think.
Moriarty: Absolutely. Yes.
Benz: So, let's talk about the floating-rate part of these loans and why they are perceived to be a decent place to be in a period of rising yields. I think that was one of the attractions when everyone was sure that yields were just going to climb inexorably higher. Why do these investments stand to perform reasonably well?
Moriarty: Yes. So, the defining feature of a bank-loan fund or bank loan is that they pay a floating-rate coupon. So, what this means is that the coupon is pegged to traditionally three-month Libor plus a spread. So, as Libor moves, the coupon paid out by the loan will also move with it, up or down. Now, this can obviously benefit holders or investors in a rising-rate environment because as Libor increases, the interest rates increase, and the coupon that they're receiving is increased along with it. And this offsets the traditional major risk of fixed-income investing, which is rising interest rates.
Benz: So, if they're not as sensitive to interest-rate risk, let's talk about the other key risks that these investments face, which is credit risk.
Moriarty: Exactly, yes. So, bank loans are traditionally issued by below-investment-grade-rated companies. So, we're talking about BB, single B, CCC, and below. So, they operate in a lot of ways similar to high-yield bonds. Many times, the same companies are issuing both loans and bonds. So, there is a lot of credit risk involved. Traditionally, like we've mentioned earlier, because they're more senior, they tend to hold up a little bit better than high-yield bonds in a distressed period. But they still are liable to lose money. They lost money in 2008, in 2015, and again in 2018. Something else to keep in mind is that the growth of what's called the loan-only capital structure, so this is something that's gotten a lot of headlines recently, and it's where a company only issues a bank loan and there's no debt below that, which reduces or eliminates one of the defining features that we talked about, which was their seniority in the capital structure. If there's nothing below them in the capital structure, that sort of defeats the purpose.
Benz: So, let's talk about how an investor should think about this within a context of a broadly diversified portfolio. It sounds like I definitely want to think of it as part of my risky basket of fixed-income securities. But within a total fixed-income allocation, what's a reasonable percentage of that bond allocation to allocate to bank-loan or floating-rate products?
Moriarty: Sure. I mean, it's a nice diversifier to traditional fixed income, again, because of its floating-rate nature. But it is still credit risk, there is still the potential to lose money. So, it should move up or down depending on your risk appetite, but obviously not something that would be a majority of your fixed-income allocation. So, something to diversify within your fixed-income allocation, but still not the majority, maybe 10% or 15%, what you're comfortable with. But you certainly need to be aware that it's credit risk, it's going to be correlated to the equity markets and so on.
Benz: So, if I'm looking at these products, how do I make good choices? What are the key things to focus on? It sounds like understanding the strategy is key, understanding the risk-taking going on. What else?
Moriarty: Absolutely. So, one thing to keep in mind is that returns within the bank-loan category tend to be tighter than returns within the high-yield bond category. This means the range of outcomes is more limited.
Moriarty: And in an environment like that fees play an even bigger role than maybe traditionally you would expect. So, a low-fee option would be the most important consideration. Knowing what you're getting, as you mentioned, a more traditional or conservative asset manager, who is avoiding maybe the riskiest parts of the loan market, avoiding a lot of those loan-only capital structures, or as we mentioned at the beginning, the less liquid nature of a bank loan, that can actually hurt an investor if they're trying to get their money out at the same time as everybody else, that can have a disastrous impact on the fund or on your returns. So, knowing which managers pay more attention to liquidity or tend to hold a little bit more cash or more-liquid instruments to help manage that risk.
Benz: So, if I'm looking at the yields of these products, is that a rough proxy for the risk-taking that's going on?
Benz: So, if I see a really good yield, I can safely assume that might be a riskier one.
Moriarty: Yes, thank you. That's an excellent point. So, definitely, the higher the yield is a very good proxy for risk. The higher the yield, the more risky whatever the underlying loans are going to be. And vice versa, the lower the yield, you can safely assume that it's a more conservative holding within a portfolio.
Benz: So, let's discuss some of your team's favorite funds within this category. Let's start with one that's Silver-rated. This is one from T. Rowe Price, but you say this is a more aggressive option.
Moriarty: Yes. So, this is T. Rowe Price Institutional Floating Rate. It's the only Silver in the category. Everything else is either Bronze or Neutral or below. And it's an interesting one because the managers have actually done a good job of toggling back and forth between offense and defense. So, they are certainly willing to take on more credit risk than many peers. But they've also done a very good job of cutting that risk in markets where they're not getting paid for it, or where they're getting concerned about valuation. That's a difficult thing to do. But over time, they've done that very successfully. And in addition to the traditional things we like about T. Rowe Price--a strong parent, strong investment team, and attractive fees--that has turned into one of the most attractive offerings in the category.
Benz: How about people who are seeking a more conservative option? I know that there are a few funds that you and the team like of that ilk.
Moriarty: Yes. So, many of the ones that we rate that are Bronze-rated all fall into this more conservative umbrella. So, this would be funds like Voya Floating Rate, Pioneer Floating Rate, Eaton Vance Floating Rate. Eaton Vance has a couple of flavors, but the plain Eaton Vance Floating Rate Fund is more conservative. All of these fall into that conservative umbrella. They pay a lot of attention to liquidity, and you would be well served if that's your risk appetite with one of those offerings.
Benz: Brian, thank you so much for being here today.
Moriarty: Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.