The payout floats with SOFR, the defaults come out of the share price: a three-year worked case, with rates up, rates down and a recession.
A floating-rate loan fund pays out SOFR plus the loans' spread minus its expenses, and absorbs credit losses through its NAV, so its return is roughly the distribution yield minus the annual loss rate. On an illustrative fund paying 6.65 per cent (4.00 SOFR, 3.60 spread, 0.95 expenses) with 3 per cent defaults at a 35 per cent loss, NAV falls from $10.00 to $9.69 in three years and the investor earns 5.72 per cent a year. The distribution yield overstates the return by about the loss rate, every year.
Worked in full in The Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Bank loan funds are bought for their floating coupon: when rates rise, the payout rises. That part works. What the distribution rate leaves out is that defaults in a loan portfolio are not paid for out of income; they come out of the share price, quietly, a few cents a quarter.
| Input | Value |
|---|---|
| Amount invested | $75,000 |
| NAV per share at purchase | $10.00 |
| Shares | 7,500 |
| SOFR | 4.00% |
| Loan spread over SOFR | 3.60% |
| Fund expenses, of NAV | 0.95% |
| Annual default rate | 3% |
| Loss given default (recovery of 65 cents) | 35% |
| Holding period | 12 quarters |
Distribution per share, quarter q = NAVq−1 × (SOFR + spread − expenses) ÷ 4
NAVq = NAVq−1 × (1 − default rate × LGD ÷ 4)
Return = IRR of −cost, the twelve distributions, and the final NAV; annualised as (1 + quarterly IRR)4 − 1
Shortcut for a first read: distribution yield − default rate × LGD = 6.65 − 1.05 = 5.60 per cent.
Step 1, the payout. 4.00 plus 3.60 less 0.95 is a distribution yield of 6.65 per cent. The first quarter pays $0.1663 a share, $1,246.88 on the holding.
Step 2, the losses. 3 per cent of the loans default each year and lose 35 per cent: 1.05 per cent of NAV a year, about 0.26 per cent a quarter. NAV is $9.895 after a year, $9.792 after two and $9.690 after three, a fall of 3.10 per cent. The holding ends worth $72,671, a capital loss of $2,329.
Step 3, the shrinking base. Because the payout is a rate on a falling NAV, distributions decline too: the twelfth quarter pays $0.1615 a share. Three years of distributions total $14,748, $214 less than a flat 6.65 per cent would have paid.
Step 4, the return. The cash flows are −$75,000, twelve quarterly distributions, and $72,671 at the end. Their IRR is 5.72 per cent a year, a total gain of $12,420. The shortcut's 5.60 is close; the difference is quarterly compounding of the payout.
| Scenario | SOFR | Default rate | LGD | Distributions | NAV, q12 | IRR |
|---|---|---|---|---|---|---|
| Base | 4.00 flat | 3% | 35% | 14,748 | 9.69 | 5.72% |
| Rates up 2 points | 6.00 flat | 4% | 35% | 19,092 | 9.59 | 7.45% |
| Rates down 1.5 points | 2.50 flat | 3% | 35% | 11,422 | 9.69 | 4.16% |
| Recession | 4.00, then 2.50 from q5 | 9% in q5 to 8 | 45% in q5 to 8 | 12,388 | 9.40 | 3.68% |
| No defaults | 4.00 flat | 0% | n/a | 14,962 | 10.00 | 6.82% |
Rising rates help even with more defaults: two points of SOFR add 2.00 to the payout and the extra point of defaults costs only 0.35. The recession is where a loan fund is tested, and it is hit twice: SOFR falls as the central bank cuts, taking the payout to 5.15 per cent, while defaults of 9 per cent at 45 per cent loss take 4.05 per cent of NAV a year for four quarters. The floating coupon that protected against rate rises offers no protection here, because rates and credit move against the investor together.
The no-default row is the benchmark the distribution yield implicitly assumes: 6.82 per cent, the 6.65 restated as an effective annual rate. On the same SOFR path, the base case falls short of it by 1.10 points, roughly the 1.05 loss rate; only higher rates, as in the second row, can lift a fund with losses above it.
Start from the distribution yield, subtract default rate times loss given default, and check the result against an IRR built from the payouts and the ending NAV: 6.65 less 1.05 gives 5.60, and the IRR is 5.72 per cent. In a recession the same fund earns 3.68. The same method across a whole credit portfolio is in the weighted average yield of a bond portfolio, and the comparable fee stack for a private credit vehicle in what an interval fund earns after fees. Every path is modelled quarter by quarter in the free workbook for this case.
SOFR plus the average spread of the loans, minus the fund's expenses, applied to NAV. In the illustrative fund that is 4.00 plus 3.60 minus 0.95, a 6.65 per cent distribution yield, or $0.1663 a share in the first quarter on a $10.00 NAV. It is gross of credit losses, which come out of NAV instead.
No, the payout falls with SOFR. A 1.5 point cut takes the illustrative fund's distribution yield from 6.65 to 5.15 per cent and its three-year return from 5.72 to 4.16 per cent. Rate cuts often come with a recession and higher defaults, which in the stressed case take the return to 3.68 per cent.
Because defaulted loans recover less than par and the loss is written off against NAV. With 3 per cent of loans defaulting each year at a 35 per cent loss, NAV falls 1.05 per cent a year: from $10.00 to $9.69 over three years. Distributions also shrink slightly, because they are a rate on the lower NAV.
This article is one calculation from The Credit Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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