Leveraged loans (secured bank loans to high-yield borrowers) and collateralized loan obligations (CLOs) are floating-rate assets whose coupons reset to a reference interest rate, most commonly 3-Month LIBOR. The quarterly coupon payments rise and fall with the level of LIBOR.
As the COVID-19 pandemic forced a global economic shutdown last March, the Federal Reserve (Fed) immediately cut short-term rates back to zero. Leveraged loan investors’ demand helped bring a return for LIBOR floors. Lenders negotiate with borrowers to have a LIBOR floor in order to mitigate the risk of falling interest rates. For example, if the floor is at 1%, even if the actual LIBOR number drops below the 1% threshold, the effective rate will be calculated on 1% LIBOR floor. LIBOR floors also impact CLO debt and equity investors who benefit from higher excess spread. The CLO liabilities are typically floored at 0%, while the portion of assets (leveraged loans) benefit from interest rates setting to higher rates at the floor.
LIBOR floors support the leveraged loan and U.S. CLO market in today’s zero-interest-rate environment. The Fed’s forward guidance is still indicating no interest rate hikes until 2023, which reinforces the importance of LIBOR floors in the short term. Investors’ lack of interest in floating-rate investments has been particularly notable in recent years. However, demand has picked up in recent months, as the fixed-income market has been focused on reflation and increasing odds for Fed liftoff from zero prior to 2023.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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