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This episode aired on Bloomberg TV on Jul 9, 2013

Leveraged Loans, Part 2

Q. With the turmoil in bonds lately, we’re seeing a flight into leveraged loans and leveraged loan ETFs. We’ve talked about these before but you say there are some key points investors should be aware of right now?

A. There are. To review the basics, these loans are usually made to companies that already have a fair amount of debt on them– hence the name– and are normally secured by assets of the borrower. But what makes them attractive to a lot of folks right now is that they typically have floating rates, usually paying a base rate of LIBOR plus a spread — let’s use 3% in this example. So investors naturally expect more income as rates rise– The flows into BKLN, the big leveraged loan ETF, have been huge as a result.

Q. But you’re saying there are two big catches here?

A. Yes. First off, 3 month LIBOR has really been darn close to zero for a long time and is around .27% right now. Over the past few years, to induce investors, the deals have had a “LIBOR Floor” of, say, 1%-2%, let’s say 1.5% for our example. That is, you get paid a base rate of the greater of 1.5%, or actual LIBOR, plus the spread of 3%. But with LIBOR so low, that base rate isn’t going to change anytime soon. People who are buying these now in the expectation that they’re immediately going to start paying more will be disappointed.

Q. But, still, unlike typical bonds, their value shouldn’t fall merely because overall interest rates go up, correct?

A. That’s right… they don’t really have any duration risk. The point about the LIBOR Floor is just that the payments they generate won’t actually be going up anytime soon.

Q. OK, got the LIBOR Floor. But you mentioned two catches… what’s the other one?

A. Leveraged loans are callable. That is, if rates really take off, the issuer can simply prepay them with new debt and they go away. So they may not provide the kind of long term income that you might expect.

Q. I see. But at least you’ll be able to take the money and reinvest it at the then-higher rates…

A. Exactly so. So maybe you can say they’re a kind of income instrument that will at least tread water, instead of going underneath it, as rates rise.