Private Market Insights

How floating rate direct loans have thrived in past periods of rising interest rates and market volatility.

Led by the Federal Reserve’s campaign of increasingly large hikes, interest rates have risen meaningfully year-to-date. Conventional wisdom would guide investors to sell fixed income—a reflection of one of the most fundamental relationships in the investment world: as rates go up, investments go down. Add on top of this the potential risk of higher corporate default rates in a subsequent possible recession, and it’s easy to come to the conclusion of selling.

However, such sweeping generalizations can cause investors to miss opportunities with certain types of debt investments that, perhaps surprisingly, can provide compelling risk-adjusted returns through periods of rising rates, economic volatility and even subsequent recessionary periods.

Through our in-depth research on the topic, Ares has found that Floating Rate Direct Loans can help drive returns that are resilient and relatively protective of downside risk, resulting in a potentially attractive investment in a rising rate environment, both during and after potential market dislocations. We summarize what you need to know in our latest Private Markets Insights newsletter.

Floating Rate Direct Loans defined

The type of debt discussed here will be termed “Floating Rate Direct Loans,” meaning loans that have the following characteristics:

Let’s look at how each of these characteristics contributes to returns that have historically been both resilient and relatively protective of downside risk, resulting in a potentially attractive investment in a rising rate environment or even dislocated markets.

Resilient returns

Floating > fixed

The floating rate feature is the most critical in a rising rate environment because it mitigates the two largest reasons investors traditionally don’t like fixed income investments when rates are low and rising: 1) low, fixed coupon payments and 2) loss of principal.

Rate resets

By definition, floating coupon rates are reset to a reference interest rate every 30 to 90 days. So as rates increase, incrementally more income—the core component of return—is generated for the investor.

Diminishing duration

By pegging the coupon rate to the market, sensitivity of the price to changes in interest rates is nullified, holding all else equal. In addition, Floating Rate Direct Loans often have shorter contractual maturities of 5-7 years with a weighted average life of ~3-4 years compared to long-dated corporate bonds. Another way to say this is that the effective duration is low. This means these assets can deliver incrementally higher investment returns and current income as base rates increase without a corresponding reduction in the value of the debt (assuming credit spreads remain constant). An illustration of this can be seen in the figure to the right.

Price Sensitivity: Direct Lending vs. High Yield and Investment Grade Corporates

Volume and velocity

When it comes to loans of this kind, another core component of return is the “upfront economics” of the transaction. This is the structuring fee that the lender receives up front for structuring and completing the transaction. Therefore, higher transaction volume leads to more upfront fees passed on to the investor.

One might intuit that in a period of rising rates, fewer loans are issued because it costs more for companies to borrow. Lower volume would mean lower upfront fees and, therefore, lower expected return. However, research shows that Floating Rate Direct Loan volumes during past periods of rising interest rates have actually increased due to the combination of strong economic tailwinds and investment capital flowing to floating rate opportunities. This is illustrated in the figures below.

Annual volume 2003 – 2007

Annual volume 2015 – 2019

Private protection

Because Floating Rate Direct Loans require borrowers to pay higher interest as rates increase, credit risk is the most prevalent and important risk to manage. In our analysis of the last two of the Fed’s rate-tightening cycles, we observed very limited impact to direct loan default rates during these periods.

Fundamentals matter

These low default rate trends are due largely to relatively strong underlying economic and corporate fundamentals. Typically, the Fed tightens monetary policy when the economy is exhibiting stronger fundamental trends. During these two periods of rising interest rates, the average default rates of middle market companies have been lower than the long-term average annual default rate. This is largely attributable to improving economic fundamentals, which muted the impact of a gradual rise in interest expense on interest coverage ratios.

Careful covenants

In addition to strong fundamentals, private credit investors are protected by lending practices and documentation, which are arguably more stringent than those found in the syndicated loan or high yield markets. In the past, it has been difficult for the Fed to engineer a soft landing (i.e., no recession) after a rate-tightening cycle. While a recession is a possible scenario during the current tightening cycle, we believe middle market direct lending assets remain well positioned relative to other public market assets such as stocks and bonds. This is due to their seniority in the capital structure, covenant protections and long-term, flexible capital, which often enable the lender to mitigate defaults during periods of credit deterioration. We break this down even further below:

Position in capital structure. Last year, over 90% of private credit loans were structurally senior secured loans, meaning a company’s value would have to significantly deteriorate before resulting in compromised loan repayment.

Tighter terms. Private loans often have covenants, including a financial maintenance covenant that typically concerns leverage. These are considered important as they permit lenders to “get to the table” early and proactively address problems with the company before they become a crisis, ultimately protecting the investor.

More robust underwriting and monitoring. Private credit lenders invest in loans with the intention of holding them to maturity, not repackaging and selling them to others. Therefore, the lenders are more likely to conduct extensive business and legal diligence before investing in the company. Additionally, they may actively monitor the performance of the company.

Aligned motivations. Most private credit loans are made to nonpublic companies that are backed by private equity sponsors and have deep relationships with their lenders, which is important in a troubled loan situation. As private lenders likely represent a borrower’s most senior creditors, they are motivated to ensure the borrower’s business survives and the loan is repaid.³

While never fully mitigating credit risk, the combination of greater control over terms and access to non-public creditor information provides a sourcing and pricing advantage. This can add a measure of investor protection from default.⁴

Middle market default rates during rising interest rate periods

NOT paying the price

More price stability

Once the loans are made and the debt issued, the debt is largely owned by institutional investors. This type of investor base generally buys the debt as a longer-term investment and will hold it until maturity, not trading frequently. As a result, private credit typically exhibits greater price stability than public market equivalents, as demonstrated by the chart below (gold line vs. others). Due to the sharp rise in treasury rates, fixed rate, long-term assets such as high yield bonds and investment grade corporate bonds have experienced more significant price volatility, with year-to-date returns of -14.0% and -14.4%, respectively.⁵

Price point

In addition to greater price stability, Floating Rate Direct Loans have consistently generated higher coupon yields compared to high yield bonds, bank syndicated loans and investment grade corporate bonds, largely due to the illiquid nature and proprietary sourcing and structuring of the assets. By combining higher coupons, larger structuring and prepayment fees, low credit loss rates and relatively stable asset prices, Floating Rate Direct Loans have generated superior total returns over the past decade, as shown in the chart below.

U.S. Floating Rate Direct Loans exhibited greater stability vs. public market credits during recent market volatility

Ten-year total annualized returns on select credit assets

Conclusion

Putting this together, an analysis of Cliffwater’s Direct Lending Index returns highlights that Floating Rate Direct Loans outperformed other credit market alternatives such as syndicated bank loans, high yield bonds and investment grade corporate bonds during the last two of the Fed’s rate-tightening cycles (2005-06 and 2017-18). Direct lending returns also held up relatively well when the economy subsequently slipped into a recession following these cycles. When reviewing the full business cycle, including the period of rising rates and the subsequent recession and declining rate period followed by the recovery, the Floating Rate Direct Loans outperformed by a significant margin in both the 2005-2009 cycle and again in the 2017-2021 cycle.

Based on their attractive characteristics—floating rate coupons, strong structural protections and price stability—we believe Floating Rate Direct Loans have the ability to outperform in the current interest rate hiking cycle and related market volatility.

Total returns of selected credit investments during rate hiking cycles and subsequent recessions