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What is a Floating Rate Loan?

Floating-rate loans are a type of variable-rate loan that is given out by banks or other financial institutions to companies that are struggling with low credit. These types of loans are sometimes referred to as senior bank loans or syndicated loans. Borrowers will take out this kind of loan to increase their capital for such things as debt refinancing and recapitalizations. Once the bank originates these loans they will turn around and sell them as hedge funds, mutual fund, or collateralized loan obligation. Floating rate loans are a mainstay of the United States debt market, and have increased from $126 billion of floating rate loans to over $607 billion. If you are considering investing in or taking out this sort of loan, then it is crucial that you learn all about them before proceeding.

Why The Loans are Called "Floating-Rate"

These types of loans are termed "floating-rate" because the interest that is paid on the loans adjusts periodically, typically every 30 to 90 days. The amount that these loans changes depends on a reference rate such as the LIBOR, as well as a credit spread on top of the reference standard that has already been determined. The amount of this credit spread is decided by the credit of the borrower, as well as the value of any collateral that is used to back the loan. On top of this, the covenants that are tied to the loan are also used to determine the rate. Floating-rate loans are classified as a type of senior debt, as certain assets, such as the borrower's inventory, property, or receivables, typically collateralize them.

The Future of Floating-Rate Loans For Investors

While floating-rate loans have been present for over 30 years, it was only in the past decade that the market has changed from a more traditional lending market to a fully developed asset class. Due to this market evolution, many financial experts believe that floating-rate loans should become a more prevalent part of peoples' asset allocations in the future. This is especially the case since these types of loans have incredible diversification potential and also come with a certain level of protection that can help in times of higher inflation environments and an increase in interest rates.

The Advantages of Floating Rate Loans

Overall, the special characteristics of a floating rate loans compared to more traditional ones allow this kind of bank loan to have quite a few benefits. For one, this type of loan comes with a defense against an increase in interest rates. This is because yields are reset depending on a prevailing benchmark rate, which means that floating rate loans have a natural defense against increasing market interest rates. On the other hand, fixed rate loans can come with price volatility. Another major benefit is that they usually have a senior position in a borrower's capital structure.

The Disadvantages of Floating Rate Loans

No loans are without risk, and these loans do come with inherent risk. The majority of this risk is caused by the fact that these types of loans are given out to companies that have low credit ratings, which means that there is a much higher likelihood that they will default. Another risk of floating rate loans is that most people consider them to have a speculative characteristic, which indicates that they come with an inherent default risk of both interest and principal. Additionally, these loans can be risky depending on the borrower's industry concentration, limited liquidity, collateral impairment, etc. due to these risks, you must weigh the pros and cons carefully before proceeding.