When rates are rising, depository institutions often look to floating-rate loans to manage interest rate risk. Before going all-in, establish criteria for comparing floaters with the fixed-rate loans most lenders originate. That starts with the difference between weighted-average life and duration.
Floating-rate basics
A floating-rate loan pays a benchmark rate plus a spread. Benchmarks are short-term rates (SOFR has replaced the now-defunct 1-month LIBOR) and reset anywhere from monthly to annually. Resets of three or five years are generally considered adjustable-rate rather than true floating-rate loans.
WAL vs. duration
- Weighted-average life (WAL) is the principal-weighted average time until repayment. Fixed-rate auto loans often have a WAL of 2 to 2.5 years, even with 5-year-plus contract terms, because of amortization and prepayments.
- Duration measures how much an asset’s price changes for a small change in yield.
For fixed-rate loans in a low-rate environment, duration and WAL are close. For floaters they diverge sharply: a floater’s duration is roughly the time to its next reset. Each reset is like receiving a new asset at the then-current rate. A floater resetting annually has about a 1-year duration; one resetting monthly, about a 1-month duration.
Benchmark by duration
The simpler of two evaluation approaches is to compare the floater to a fixed-rate asset of similar duration, not similar WAL. For a loan resetting annually, the 1-year Treasury bill is an easy comparison, even if the loan’s WAL is 5 years.
Two drawbacks to adjust for:
- Liquidity: unlike a true short-term loan, a floater returns little principal at reset, so the lender can’t redeploy that cash. Some adjustment is needed; how much is up to the lender.
- Caps and floors: periodic and lifetime limits extend duration and are complex to value. If they’re far from being hit, they have little impact.
Bottom line
Comparing floaters to fixed-rate loans with similar WAL, coupon and price is unfair, because it ignores their short duration and rate resets. Comparing to a duration-matched alternative gives a much better read on the opportunity.