A prescription for rising rates?

In contrast, clients holding longer-term fixed-income investments, including corporate or government bonds, would be locked into an inferior rate of return for the specified term of the bond.

But keep in mind that the floating-rate feature is a double-edged sword. Floating rates are attractive in times of rising rates; but if rates take a dip, the return on these products also will decline.

“We are coming off a 30-year rally in bonds, and there is concern about rising interest rates,” says Andrew Barfoot, product manager with Manulife Mutual Funds, a division of Toronto-based Manulife Financial Corp. “There’s more nervousness now than there has been for a number of years. The floating-rate feature on senior loans can provide protection in a rising interest rate environment.”

Floating-rate senior bank loans represent a form of corporate debt that often is syndicated to institutions for investment purposes but is not easily accessible to retail investors.

The market is located primarily in the U.S., where it is more common for banks to syndicate large corporate loans among various institutions and where these investments are traded in a large, liquid market worth an estimated US$1.3 trillion.

In Canada, on the other hand, the major banks may participate in such loans together, but retail investors usually are not included.

“In the past year or so, we’ve seen more products focusing on this area, but it’s still a small universe,” says Dan Hallett, vice president and director of asset management with HighView Financial Group in Oakville, Ont. “The challenge today is that investors seeking yield are reaching further along the risk spectrum to get higher yields – and any tilting toward higher-yielding corporate securities requires caution. The attraction of floating-rate vehicles is that they offer protection from interest rate hikes. But it’s important to know what the risks are and how they might materialize.”

One of those risks is creditor risk. There is a higher likelihood that these loans will suffer defaults if the economy heads into a downturn. These loans generally are non-investment grade, but the risk can be reduced by selecting a fund portfolio manager with expertise in analyzing corporate credit and in putting together an appropriately diversified portfolio.

There also is some liquidity risk because the loan market is not as large as the stock market, and temporary imbalances between supply and demand could affect pricing. During the 2008-09 global financial crisis, for example, many investment funds investing in floating-rate loans suffered steep losses as investors around the globe fled to government paper. Although floating-rate loans bounced back quickly, that behaviour demonstrated the capacity for volatility.

To reduce risk, Jeff Sujitno, managing director, high-yield debt, and portfolio manager with Calgary-based Hesperian Capital Management Ltd. in Toronto, prefers to hold a mix of loans and high-yield bonds. He likes the floating-rate features of senior loans, but those loans can be repaid easily by borrowers and this, he says, creates a reinvestment challenge for portfolio managers.

On the positive side, loans rank higher than high-yield bonds in a company’s capital structure, and loan investors have priority of payment before other creditors.

Therefore, if the borrower should go bankrupt, the assets used to secure the senior bank loan would be sold to repay the loan before bondholders or preferred or common shareholders receive any payment. Senior loans typically are well secured by tangible company assets, while high-yield corporate bonds generally are unsecured.

“Senior loans sit at the top of the balance sheet,” says Neil Murdoch, chief investment officer with Connor Clark & Lunn Capital Markets Inc. of Toronto. “They are well secured, and usually have more collateral to service the loan than the value of the loan. You are taking some credit risk, but it’s lessened by the fact that senior loans are secured and protected by various covenants. There’s a benefit in having property, plant and equipment put up for security. From a risk/reward perspective, the loans are a good option for a piece of a portfolio.”

Floating-rate senior bank loans offer a yield comparable to corporate bonds, but have a lower default rate and higher recovery rate if they do default.

PowerShares Senior Loan (CAD Hedged) Index ETF, sponsored by Invesco Canada Ltd. of Toronto, for example, recently had a weighted average yield to maturity of 5.5%. This ETF seeks to replicate the performance of the S&P LSTA (Loan Syndications and Trading Association) leveraged loan 100 index, hedged to Canadian dollars.

The starting point for setting rates on floating loans is usually a recognized benchmark, such as the London interbank offered rate (LIBOR), plus a spread. Every 30 to 90 days, the coupon rate is reset to adjust for movements in the benchmark.

Floating-rate bank loan funds

Among the mutual funds specializing in floating-rate bank loans and other floating rate debt are:

– BMO Floating Rate Income Fund, sponsored by Toronto-based Bank of Montreal;

– Trimark Floating Rate Income Fund, sponsored by Invesco Canada Ltd. of Toronto;

– Manulife Floating Rate Income Fund, sponsored by Toronto-based Manulife Financial Corp.;

– AGF Floating Rate Income Fund, sponsored by AGF Investments Inc. of Toronto.

Other mutual funds, such as CI Signature High Income Fund, sponsored by CI Investments Inc. of Toronto, and Norrep High Yield Class, sponsored by Hesperian Capital Management Ltd. of Calgary, include floating-rate loans and notes in their portfolios.

Closed-end fund alternatives in the category include Manulife Floating Rate Senior Loan Fund, sponsored by Manulife Financial, and ING Floating Rate Senior Loan Fund, sponsored by Connor Clark & Lunn Capital Markets Inc. of Toronto.

On the exchange-trade fund (ETF) side, there is Horizons AlphaPro Floating Rate ETF, sponsored by Horizons Exchange Traded Funds Inc. of Toronto, and PowerShares Senior Loan (CAD Hedged) Index ETF, sponsored by Invesco. In addition, FT Portfolios Canada Co. of Toronto recently launched First Trust Senior Loan ETF (CAD Hedged), an actively managed ETF.

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