Despite the Federal Reserve’s recent rate hike, fixed income yields are still low by historical standards—a reality that has prompted many investors to turn to ever more esoteric investment vehicles in hopes of higher returns. One example: bank loans—a type of corporate debt issued by companies with poor credit ratings. They’re private transactions, so you don’t purchase bank loans directly but rather through a mutual fund or an exchange-traded fund.
The underlying loans have coupons that include a floating reference rate—often based on the three-month London Interbank Offered Rate (LIBOR)—plus a fixed spread to compensate for the risk. The floating rate means the overall yield rises along with short-term interest rates, while the spread typically boosts the yield above that of more traditional fixed income investments.
Most bank loans have a LIBOR “floor,” meaning the reference rate will never be set below that threshold. (Nearly all bank loans have a floor or 1% of less.) Once LIBOR exceeds that floor, the reference rate is free to float upward.
LIBOR is closely tied to the federal funds rate, so it tends to rise as the Fed raises rates. That was the case after the Fed’s rate hike late last year, when the three-month LIBOR finally surpassed the 1% mark—resulting in higher coupons for nearly all bank loans.
The bottom line: Bank loan funds are not suitable for everyone. But if you’re interested in an investment with a high relative yield that could benefit from future rate hikes, they might be worth considering.