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Investors have added a floor to the LIBOR floating reference of loans
Investors have regarded leveraged loans (BKLN) as an excellent alternative to high yield bonds (HYG) since, given their floating-rate interest, their prices don’t drop like a rock when interest rates shoot up.
Due to the very low LIBOR (London Interbank Offered Rate) levels—currently around 0.3%—investors have added a floor to the LIBOR floating reference of loans. This structural change started when the economy weakened and LIBOR dropped significantly. The LIBOR floor ensures a minimum interest income for the investor no matter how low LIBOR flows.
As the fixed income market rallied last year and through the beginning of this year, LIBOR floors started to decrease, falling from approximately 1.5% to 0.75% two months ago. Currently, floors are back up to 1.00% given fixed-income investors’ push-back after Bernanke spooked the markets.
LIBOR floors make LIBOR spot rate irrelevant
Additionally, since most loans (BKLN) have a LIBOR floor that currently usually ranges from 0.74% to 1.25%, it will take a couple of years until the forward curve catches up to the current LIBOR rate of 0.3%.
For this reason, there’s no strong reason to reprice existing loans up to reflect a higher interest income.
Loans are behaving like bonds
And finally, the fact that the LIBOR floor won’t be reached for a couple of years and the fact that the spread for leveraged loans is far higher than the floor mean that the loans really look like a bond paying a low coupon. For example, a loan paying L+300bps with a 1.00% floor behaves like a bond paying a 4% bond since the floating part is stuck at 1% and the spread is fixed at 3%. So the reduced duration benefit is much lower than expected.
Still, most loan investors don’t think about loans this way—though their behavior seems to reflect this approach.
© 2013 Market Realist, Inc.