Why do floating rate notes, or FRNs, differ from leveraged loans?

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Leveraged loans

A leveraged loan is a commercial loan provided by a group of lenders. Typically secured, the loan is structured, arranged, and administered by investment and commercial banks (the arrangers). It is then syndicated to other banks or institutional investors.

 

FRNs are usually issued in capital markets, whereas leveraged loans are arranged by commercial and investment banks. While FRNs are typically unsecured and investment-grade, leveraged loans are secured and fall into the below–investment grade category. While both leveraged loans and FRNs pay floating rate coupons and have similar durations (for similar coupon schedules), leveraged loans are higher-risk and command higher spreads due to their poorer credit quality.

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Note that the higher risk of leveraged loans results in a much higher return for investors. Over the past two years, leveraged loans have had returns just below the returns of high yield bonds. However it wasn’t until recently that retail investors had access to such a market via leverage loan ETFs like SNLN and BKLN. HJ Heinz, which was recently taken over by Berkshire Hathaway (BRK-B), is the largest issuer in the index, yielding 3.25%.

In the case of FRNs, the returns are commensurate with those of a money market investment. While both instruments are structurally similar, FRNs carry no risk and have much shorter maturity, so their return is lower. Both instruments should be part of a diversified investment portfolio, so investors need to understand the different roles each plays rather than choosing one for the other.

For those investors with a lower risk profile and preferring credit quality over higher yield, move on to Part 7 in this series.

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