Want to profit from the credit squeeze on cash-strapped companies?
Mike Bacevich, manager of the $4.5 billion Hartford Floating Rate Fund Ticker:(HFLAX) is doing just that by investing in loans made to single-B- and double-B-rated companies.
“In the relatively small community of bank loan investing we are demanding yield for our investors,” he said.
Indeed, Mr. Bacevich’s portfolio currently holds about 200 corporate loans that are paying an average interest rate of 6.25%.
The floating-rate loans are typically pegged to the London Interbank Offered Rate and are considered a way to take advantage of a rising-rate environment because the interest rate on the loans will adjust with the Libor rate. But because these companies seeking the bank loans have no other cash-raising option beyond issuing junk bond debt, the market has forced a rare trend toward what is known as a “Libor floor” loan that essentially turns the floating rate into a higher-yielding fixed-rate loan.
According to Mr. Bacevich, two years ago, there were no Libor floor loans being made, but so far this year, every loan in the category has been written with a fixed minimum rate on top of the Libor rate.
The Libor floor trend is being driven, he said, by an improving economy and the return of liquidity to refinance existing debt.
The current Libor rate is 0.25%, but the current Libor floor is 1.75%. The total loan rate example of 6.25% is calculated by factoring the credit risk.
Historically, Libor-pegged floating-rate loans have had rates that have fluctuated up or down in relation to the Libor rate, but the Libor floor means the rates can adjust higher only when interest rates start to rise. And as rates start to rise, the Libor floor will decrease and eventually become less common.
The biggest risks of these types of loans — as well as the mutual funds that invest in them — are loan defaults.
Keep in mind that these are loans to below-investment-grade companies. But the loans are secured, and the current default rate, on a 12-month annualized basis, is 4%. That compares with November, when the comparable default rate was 10.5%.
For investors, the emergence of the Libor floor loans makes an attractive strategy even more so because of the higher fixed yield.
“Investors have few alternatives when they’re looking at potential rising-rate environment,” Mr. Bacevich said. “They can go to short-duration bonds or floating-rate loans, and while short-duration bonds have a higher credit quality, they also have lower income.”
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