Floating-Rate Loan

A Floating-Rate Loan (also known as a 'variable-rate loan' or 'adjustable-rate loan') is a type of debt where the interest rate is not fixed for the entire term of the loan. Instead, it periodically adjusts based on a pre-selected benchmark rate. Think of it as a financial chameleon, changing its color (its interest rate) to match its surroundings (the prevailing market rates). The total rate a borrower pays is typically a combination of this fluctuating benchmark plus a fixed spread or margin, which represents the lender's profit and the risk premium for that specific borrower. This contrasts sharply with a fixed-rate loan, where the interest rate is locked in for the life of the loan, offering predictability but no flexibility. For investors, floating-rate loans, particularly those made to corporations, can be an interesting asset class, especially in certain economic environments.

Understanding the mechanics of a floating-rate loan is all about grasping its two core components: the benchmark and the spread.

The interest rate on a floating-rate loan is a simple sum: Benchmark Rate + Spread = Total Interest Rate.

• The Benchmark Rate: This is the 'floating' or 'variable' part. It's an external, independent reference rate that reflects general borrowing costs in the financial system. Common benchmarks include the SOFR (Secured Overnight Financing Rate) in the U.S. and the EURIBOR (Euro Interbank Offered Rate) in Europe. As the central bank raises or lowers its key policy rates, these benchmarks tend to follow suit.
• The Spread: This is the 'fixed' part of the equation, at least for a specific loan. It's an extra percentage added on top of the benchmark. The spread does not change over the life of the loan and is determined at the outset based on the borrower's credit risk. A financially solid, blue-chip company might get a loan at SOFR + 1.5%, while a riskier, more indebted company might have to pay SOFR + 4.0%. The spread is the lender's compensation for taking the risk that the borrower might not pay them back.

For example: Imagine a company takes out a loan with a rate of SOFR + 3%. If SOFR is currently 2%, the company pays a total of 5% in interest. If, in six months, SOFR rises to 2.5%, the loan's interest rate automatically adjusts to 5.5%.

The interest rate doesn't change every second. It adjusts at predetermined intervals known as 'reset periods'. These are typically set for every one, three, or six months. On the 'reset date', the loan's interest rate is updated to reflect the current level of the benchmark rate. This structure provides a degree of short-term predictability for both the borrower's payments and the investor's income.

While most people encounter floating-rate loans as borrowers (like with some mortgages), value investors are often more interested in them as an investment. You aren't taking out the loan; you are acting as the lender, collecting the interest payments.

Individual investors rarely lend directly to large corporations. Instead, they typically invest in these loans through specialized funds, such as bank loan funds (a type of mutual fund or ETF) or, for more sophisticated investors, collateralized loan obligations (CLOs). These products buy and hold a diversified portfolio of corporate floating-rate loans, which are often called leveraged loans because they are made to companies that already have a significant amount of debt.

Investing in this asset class comes with a distinct set of pros and cons that are closely tied to the economic cycle.

• The Pro: A Hedge Against Rising Rates: This is the primary appeal. In an environment where central banks are raising rates to fight inflation, most fixed-income securities, like government and corporate bonds, fall in value. This is due to interest rate risk—why hold an old bond paying 3% when new ones pay 5%? Floating-rate loans, however, thrive. As the benchmark rate rises, the income they generate for the investor automatically increases. This gives them a very low duration, making them one of the few fixed-income-like assets that can perform well during rate-hiking cycles.
• The Con: Credit Risk is King: The main danger here isn't interest rates; it's the risk of default. The companies borrowing these funds are often rated below investment grade. If the economy slows down and enters a recession, these companies' profits can shrink, making it difficult for them to make their interest payments. If a company goes bankrupt, investors could lose a portion or all of their principal. The higher interest payments that come with rising rates can, ironically, be the very thing that pushes a fragile company over the edge.

For a value investor, a floating-rate loan is not just a bet on the direction of interest rates. It is, first and foremost, a loan to a business. The core task, as always, is to assess the underlying quality and durability of the companies in the portfolio. These loans are often senior secured, meaning that in a bankruptcy, the floating-rate lenders are at the front of the line to get paid back from the company's assets. This provides a crucial layer of protection. A true margin of safety comes from investing when the spreads are wide enough to compensate for the potential for defaults, and by focusing on funds that hold loans from businesses with resilient cash flows that can weather an economic storm. In short, they can be a smart tool to protect a portfolio from rising rates, but only if you don't forget the fundamental rule: you are a lender, so you must always worry about getting paid back.