When interest rates rise, the effects tend to show up pretty quickly – on mortgage rates, on savings accounts, and across parts of an investment portfolio. Not everything responds in the same direction, though.
Floating-rate loans are a case in point. Unlike conventional bonds, whose coupons are fixed on day one and don't move whatever happens to interest rates, the interest on a floating-rate loan can rise along with market rates. That can make them a bright spot when higher rates are causing headaches elsewhere. There is, of course, a trade-off. Here's how it all works.
What happens when rates rise or fall
For most households, rising interest rates are felt as a cost. Mortgage and other loan payments climb, and the cost of borrowing for big purchases goes up. But for investors, the picture is more mixed. While bond prices tend to fall when rates rise – because new bonds pay more, making older ones less attractive – floating-rate loans behave differently.
Floating-rate loans, also known as floating-rate notes or bank loans, have interest payments that reset periodically, often every few months, based on a benchmark rate such as SOFR or EURIBOR. When that benchmark rises, the interest paid to the lender rises too. So instead of watching income stay flat while rates climb, investors in these instruments can see their income increase.
This makes floating-rate loans a popular tool in portfolios that want to hedge against rising rates. They are often used by institutional investors and are also available through mutual funds and exchange-traded funds (ETFs) that focus on this asset class.
The risks to keep in mind
The added income potential doesn't come without strings. Floating-rate loans are typically made to companies with below-investment-grade credit ratings – often referred to as leveraged loans. That means the borrowers are riskier than those who issue investment-grade bonds, and the risk of default is higher.
If the economy slows or a borrower runs into trouble, the loan may not be repaid in full. In a downturn, defaults can rise, and the value of these loans can fall. Also, while the interest rate on a floating-rate loan adjusts upward when rates rise, it also adjusts downward when rates fall. So the income boost can quickly reverse if the central bank starts cutting rates.
Another point to consider is liquidity. Some floating-rate loans are not traded on public exchanges, making them harder to sell quickly. That can add to volatility in times of market stress.
What it means for investors
For everyday investors, the key takeaway is that floating-rate loans can be a useful diversifier, especially in a period of rising rates. They offer a way to potentially earn more income when rates are climbing, which can offset losses in other parts of a bond portfolio.
But they are not a risk-free alternative to cash or government bonds. The higher yield comes with credit risk and the possibility that income will fall if rates drop. As with any investment, it's important to understand what you own and how it fits into your overall strategy.
Investors who are considering floating-rate exposure might look at funds that specialize in this area, but they should read the prospectus carefully and be aware of the fees and risks involved. It's also wise to remember that past performance is not a guarantee of future results.
For more on how rising rates can affect different parts of the market, see our coverage of the RBA's recent rate decision and its implications. Also, check out how banks like SBI benefit from loan growth in a higher-rate environment.
Ultimately, floating-rate loans are a tool, not a magic bullet. They can help you adapt to a changing rate environment, but they require a clear-eyed view of the risks. As always, consider your own financial situation and risk tolerance before making any investment decisions.
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