Why floating rate loans should relish the new environment

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With US interest rates considered likely to resume their upward spiral as soon as next month and with little prospect of relief for investors who rely on an income, the whole world, it seems, is searching for an alternative to bonds in their portfolios. Here’s the case for floating-rate loans.

According to John Redding, who is in Australia to speak at two conferences on behalf of Eaton Vance, one of the largest and oldest managers who specialise in the alternative rates space, the environment is ideal for investors to consider loans which provide a form of guaranteed income without the duration risk of government bonds.

After speaking at the Investment Innovation Institute (i3) conference on fixed income, credit and currency, in Sydney last week, Redding said that floating-rate loans represented a “par asset class”, which means that the strategy is all about income.

We hear a lot about “equity income” – high dividend stocks and so forth – and other ways to generate income for retirees these days, but floating rate loans are “pure income”.

Redding, who has been at Eaton Vance in the rates area for almost 20 years, is due to speak at a Conexus general investment conference in Victoria on the subject this week as well. He speaks, with clients, to a recent white paper on how floating-rate loans and similar investments will benefit on a rising interest rate environment.

He said last week: “For the most part, over a long period, returns are dominated by income. For example, we lend a lot to private equity firms for transactions and they may take out a seven-year loan and often refinance it within two or three years. We earn a healthy spread above LIBOR [the main cash-equivalent index]. Today, it’s about 350-375bps above [LIBOR]. The portfolio has a very short duration, with loans being reset every 45-50 days on average.”

Unlike other interest rate investments, with LIBOR likely to rise thanks to the US Federal Reserve, all floating rate asset sub-classes, such as loans, should do well, getting back to their historical average of the mid-to-high single digit returns.

“And because of their short duration, they should rise fairly quickly,” Redding said.

He said that the two most important factors underpinning loans as an investment strategy were the fact that were “senior secured debt” and that they were floating rate. “The stats show that 98 per cent of the time you get repaid within two-four years,” he said. “The long-term default rate is only 2 per cent and, with those defaults, the recovery rate is about 75 per cent.”

Eaton Vance concentrates on debt in the “BB” and “B” categories, which have good liquidity. It also goes up the “safety” spectrum with a small portion of its portfolio when it considers appropriate for income-generation purposes.

The firm has had some Australian loans in the past, including one to Fortescue, and likes the opportunities here because of our strong legal protection system for senior lenders compared with the rest of the Asia Pacific region.

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