Following months of uncertainty, the U.S. Federal Reserve has indicated that there could soon be a hike in the Federal Funds Target Rate. Interest rates have been kept in a range between zero and one-quarter of a percent since December 2008 and have not risen since June 2006.
As interest rates have been at historically low levels for nearly the last seven years, some fixed income investors have shifted their focus to senior loan securities with floating-rate characteristics, such as interest rate floors, to protect themselves in the event of falling rates. Interest rate floors protect the loan interest rate by increasing the loan interest rate to the spread plus the floor if the reference rate ever falls below the floor. Simply put, the formula for loan rates in these structures can be stated as follows.
Loan Interest Rate = Maximum of (Reference Rate or Floor) + Spread