In this uncertain interest rate environment, what can investors make of floating rate loans?
In today’s environment, everyone is trying to determine what will happen to interest rates. Will the Fed keep rates higher for longer? Will they start decreasing rates over time? What does each decision mean for a portfolio of floating-rate loans?
As a refresher, floating-rate loans have their yields set to a specified amount above a reference rate, usually London Interbank Offered Rate (“LIBOR”) or Secured Overnight Financing Rate (“SOFR”). If interest rates increase or decrease, the loan yields will move in tandem, while providing current income above the risk-free rate. Most floating-rate loans are held to maturity and have minimal interest rate risk. Interest rate risk (also known as duration risk) is when a fixed rated loan or bond value deteriorates with interest rate fluctuations.
Rising interest rates result in higher interest payments for the borrower in a floating-rate loan. In today’s rate environment, senior secured core middle market floating-rate loans are generating high double-digit yields1. When interest rates decrease, floating-rate loans still offer yields over traditional fixed-income securities, as their yields are set above the risk-free rate. In the core middle market, first lien loans spreads have historically been set to 500+ bps above the SOFR 2.
Traditional fixed-income securities have an inverse relationship to the risk-free rate. As the risk-free rate increases, the value of the fixed-income security decreases, and vice versa. As such, traditional fixed-income securities are exposed to significant interest rate risk. For this reason, floating-rate private credit funds can act as a complement to an investor’s fixed-income portfolio, providing a hedge against interest rate risk.
As demonstrated by the following graph, floating-rate loans also benefit from an inverse relationship between the risk-free rate and the loan’s interest coverage ratio. The higher a loan’s interest coverage ratio, the greater the likelihood that the borrower can pay the contractual interest rate, and the lower the risk of payment default.
1BofA Q4 2023 Chartbook – 2024
2LSEG LPC’s Middle Market Connect – 4Q2023
At PennantPark, we seek to invest in floating-rate loans in the core middle market. We target loans with lower leverage, higher yields, stronger covenant packages, and greater recovery rates, as compared to the upper middle market / broadly syndicated loan market.
We believe conservative underwriting provides ample downside mitigation. Even in today’s high-rate environment, PennantPark investments have a high average interest coverage ratio of 1.9x. We welcome a conversation; please contact invest@pennantpark.com or the professionals listed below.
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