Floating-rate securities gain more attention

Institutional investors' appetite for floating-rate securities is growing, and they are eagerly anticipating the U.S. Treasury Department's January auction of floating-rate notes.

This is the first new product the department has brought to market in 17 years, since introducing Treasury inflation-protected securities in 1997.

The Treasury Department's move to sell floating-rate notes, contemplated for some time, demonstrates the U.S. government's interest in expanding the potential buyer base for its debt. The FRNs enable Treasury to sell to buyers seeking protection from the anticipated rising interest rate environment.

“Several years ago (floating-rate securities) may have been more of a niche asset class. Now it's seen as more of a strategic allocation,” Stephen Hillebrecht, fixed-income product strategist at Lord, Abbett & Co. LLC, Jersey City, N.J., said in a telephone interview. “It will diversity your overall portfolio.” Lord Abbett currently manages $8.8 billion in bank loans, all floating-rate securities.

The Treasury's first floating-rate note auction — of probably between $10 billion and $15 billion —is set for Jan. 29.

More institutional investors are turning to floating-rate securities — which include bank loans and collateralized loan obligations — as a way to earn yield and protect their fixed-income portfolios from rising interest rates. Investors look to floating-rate strategies as a means to get attractive income with low or no duration. The total size of the institutional bank loan market, using the Credit Suisse Institutional Leveraged Loan index, was approximately $733 billion, as of Oct. 31.

In late October, the $41 billion Teachers Retirement System of the State of Illinois, Springfield, made its second floating-rate investment, part of a revamp of its fixed-income portfolio. Trustees approved a $34 million floating-rate fixed-income allocation to Houston-based manager Garcia Hamilton & Associates LP.

Earlier last month, the Oklahoma State Regents for Higher Education, Oklahoma City, approved a $13 million investment in Oaktree Capital Management's U.S. senior loan fund as part of the $645.3 million endowment's decision to shift to floating-rate debt and equities from bonds.

“Floating-rate securities are critically important at this time. Bank loans and CLOs are perfect alternatives to fixed income. You're not sacrificing yield,” Mark Okada, co-founder and chief investment officer of Highland Capital Management, LP, Dallas, said in a telephone interview. Mr. Okada's firm last month won a $250 million non-core fixed-income mandate from the $21.2 billion Austin-based Texas Municipal Retirement System for a custom credit strategy using senior secured bank loans and CLO debt.

An October research paper by Highland Capital advocates for increased allocations to bank loans to both boost risk-adjusted returns and provide downside protection, regardless of what interest rates are doing.

“While much of the "great rotation' discussion has focused on a move away from fixed income into equity as a response to rising interest rates, investors may consider more shifts within their fixed-income portfolio from fixed-rate to floating-rate assets,” the paper said. “By doing so, investors could achieve many of the benefits of diversification by combining fixed income and equity, even as they prepare for a rise in interest rates.”

Keith Brakebill, portfolio manager in the global fixed income investment division at Russell Investments, Seattle, said: “We're going to see more people enter this segment of the market.

“The credit angle is driving inflows toward the market. It will open the banking market to more and more issuers,” Mr. Brakebill said. Russell doubled its allocation to bank loans between the first and second quarters of 2013. As of Sept. 30, Russell managed approximately $2 billion in floating-rate bonds in the U.S.

Investor appetite for such floating-rate strategies has grown more because of potential damage from rising interest rates than any fears of inflation, said Highland Capital's Mr. Okada. With the Federal Reserve looking to eventually taper quantitative easing and drop its near-zero interest-rate policy, institutional investors are anticipating that rates will be volatile in their fixed-income portfolios. So, floating-rate securities capture positive returns, according to Mr. Okada, based on the ideas that interest rates will rise and that the economy is improving.

This trend isn't exclusive to the U.S. Michael Rummel, a spokesman at the London-based hedge fund manager CQS (U.K.) LLP, said his firm has seen a lot of interest from pension funds in both the U.K. and the U.S. in such floating-rate strategies as European senior-secured loans and asset-backed securities.

“Within ABS, we find European CMBS very attractive in particular,” Mr. Rummel added.

“In general within fixed income, you have a choice of duration risk or credit risk, and we feel taking interest rate risk is not a good idea,” said Lord Abbett's Mr. Hillebrecht. “This is an attractive asset class that is less volatile” than fixed rate.

Still, this is not an asset class without risk. Floating rate is seen as a good way to mitigate interest-rate sensitivity, though at the cost of incurring significant credit risk.

“Floating-rate funds aren't necessarily bad, they're just not necessarily for everyone,” cautioned Donald G. Bennyhoff, said senior investment analyst at Malvern, Pa.-based Vanguard Group Inc. and co-author of a research report on the subject. “They're not always a low-risk investment. But because they have a low duration, we worry that investors think there's no risk.”

“This is a credit product, so you always have credit risk,” pointed out Jonathan Sharkey, portfolio manager of the Pioneer Floating Rate fund at Pioneer Investments, Boston. The mutual fund has about $840 million in assets; Pioneer manages a total of $1.4 billion in floating-rate strategies.

Some money managers believe the risks can be mitigated through savvy active management and a good understanding of the asset class.

“You always have to be careful about how you execute a great idea,” said Highland Capital's Mr. Okada. “There are always going to be times when excess liquidity creates irrational exuberance and you see that in all markets. If you're smart about how you allocate and about with whom you partner, you can have a fantastic exposure and experience in the asset class.”

Mr. Hillebrecht noted something similar. “A lot of money has gone to the asset class, so active management and credit research is very important,” he said. n