Floating Rate Debt: A Distinct Asset Class

Not only has the corporate landscape undergone a notable and dramatic improvement since the bottom of the financial crisis, but the high expectation of corporate default that accompanied the crisis proved to be wildly overestimated. Instead of the anticipated rate of 25%, actual default rates were closer, in fact, to 11%, and today they stand at a three-year low of 1.1%.  This post-crisis realignment of risk expectations occurred against a backdrop of abnormally lax monetary policy. This confluence of events has focussed investor attention en masse to products like inflation index-linked bonds which, in turn, drove indexed yields down. As a result, a market hungry for income is now ready to look more closely at alternative Floating Rate Debt products. An important asset class in their own right, leveraged loans are a viable option. 

Floating Rate Debt, which is usually linked to LIBOR, provides a stable current income investment alternative to more traditional fixed income allocations.  Government real return bonds, for instance, have appreciated so much that their real yield above the rate of inflation has become marginal.[1] This has spurred both individual and institutional investors to look for higher yielding buffers against inflation. In the US, Floating Rate Debt mutual funds have attained $71 billion in assets, an increase of $18 billion since the end of 2010 and well above the pre-crisis peak of $47 billion. European markets are similarly gaining momentum.[2] As inflation anxiety increases with excessive quantitative easing in the US, Mercer estimates that 80 percent of European pension schemes will increase their allocation to inflation-linked and inflation-sensitive assets, including Floating Rate Debt. 

With the increased interest in Floating Rate Debt, let us examine more closely the inflation protection provided by T-Bills and LIBOR. 

SBBI’s 85-year history suggests that LIBOR and T-Bills produced a real return of 0.6 percent over and above the rate of inflation.  If you look at the real rates of return for T-Bills over each of the past decades, they were positive in 6 out of 10 decades.  

1920s

1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s

2010s

+4.8%

+2.6% -5.0% -0.3% +1.4% -1.1% +3.8% +2.0% +0.3%

-0.1%

 Based on Federal Reserve data, Ben Inker shows that real returns on T-Bills, as a proxy for LIBOR, were +3.7 percent for the period of 1920-1940, -0.1 percent for 1941-1981 and +2.0 percent for 1982-2009.[3]

In other words, LIBOR and T-Bills provide a reliable inflation protection over the long term, despite imperfection over the short and medium term. This is confirmed by the significant, though not perfect, correlation between CPI and T-Bills. [4]  

Unlike sovereign real return bonds, Floating Rate Debt instruments, like leveraged loans, generally involve a greater element of credit risk. As such, investors in Floating Rate Debt have to be very credit conscious because these loans are mostly made by banks that do not necessarily have the same underwriting and credit analysis skills as the Private Placement departments of life insurance companies and specialty firms like Cordiant.  Cordiant, over its 10-year history, has only had one minor write-off (less than 0.02%) and only one percent per annum in non-performing loans, the majority of which are very likely to be successfully recovered.

 With an expectation of normalization in developed world monetary policy and the subsequent real risk of accelerating inflation, Floating Rate Debt products will continue to receive increased attention. As we move through the next stage of economic recovery, market participants will no longer be rewarded for simple macro directional strategies like sovereign real return bond plays. They will instead generate alpha through credit differentiation and fundamental analysis. As such, Floating Rate Debt accessed through funds like those managed by Cordiant becomes an attractive asset class for pension funds and foundations who require absolute returns to meet their fiduciary responsibilities.

 June 2011

 


[1] On May 10, the Canada 4.25% of 2021 yielded 0.5%; the UK 2.4% of 2024 yielded 0.6%; the US 3.625% of 2028 yielded 1.5%

[2] Financial Times, Floating Rate Loans Have Their Moment in the Sun, Steve Johnson, April 24, 2011

[3] Ben Inker, The Dangers of Risk Parity, The Journal of Investing, Spring 2011

[4] SBBI 2011 Yearbook, page 44