“If you fall, I’ll be there” — a floor
Like a lot of jokes, good or bad, truth is at the core of the statement above, whether with respect to gravity or the protective financial mechanism launched in the loan market following the financial crisis of 2008 — the LIBOR floor (herein referenced simply as the “floor”). Instead of relating to a falling object, however, we apply the quote to short-term interest rates (e.g., LIBOR) and a derivative instrument (the floor) that is conditionally declaring its presence should rates drop.
The advent of the use of LIBOR floors with institutionally-traded bank loans2 occurred for two main reasons: 1) the floating-rate nature of interest payments made on loans, and 2) the unprecedented drop in LIBOR to near zero (more on these topics later). The combination of these two factors helped drive loan prices violently lower during the 2008 crisis and nearly shut down the rapidly-growing market.
Today, however, with short-term rates expected to rise, loans face an unprecedented interest rate backdrop. Because most loans now include a floor, the anticipated near-term performance of the asset class is in question. LIBOR floors take center stage in this analysis, with the primary concern being whether they will help or hurt loan performance going forward.
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