You cannot fall below the floor. If you were an equity investor during the Great Recession, you witnessed a historic freefall with no certainty of its bottom. And if income was your preferred investment outcome, the bond market wasn’t the best fallback option. Interest rates were already in the middle of a long-term decline before dropping 200 basis points in late 2008 and falling even further in a post-Recession effort to stimulate economic growth.1
While the market conditions are different today, one of the questions they pose is similar: Where are you turning for risk-adjusted income? If you’re not sure, consider corporate credit, more specifically senior secured loans, which have returned an average income of 5.39 percent annually since 2002.2 How did these loans offer such consistent income during the extended credit crisis? LIBOR’s protective floor.
LIBOR, or the London Interbank Offered Rate, is one of the most common short-term interest rate benchmarks used to help calculate a senior secured loan’s floating-rate coupon. When a senior secured loan’s coupon took a hit post-Recession, investors like you demanded a higher interest payment to offset higher credit risk.3 In response, most floating-rate loans instituted a LIBOR floor. This structure provides a minimum rate of yield if LIBOR is at or below its floor for such investments, yet still delivers the upside if LIBOR exceeds its floor as rates increase.
For example, a hypothetical loan with a LIBOR floor of 1 percent priced at LIBOR plus 4 percent would provide you with a coupon of 5 percent, even if LIBOR dropped to .5 percent. If LIBOR rose above its floor to 1.5 percent, the coupon of this hypothetical loan would typically reset after 90 days to 5.5 percent.
Read this additional article for further insights on how senior secured loans react to our current rising interest rate environment.