Given today’s tumultuous investment landscape, one trend is certain: interest rates are on the rise. With the US Federal Reserve raising rates 3 times already in 2018 (with another one pending come December), most interest rate prognosticators are expecting another 3 hikes from the central bank over the course of 2019. Are there any type of investments available for individuals to take advantage of higher interest rates that are right around the corner?
In theory, rising interest rates can negatively impact 4 major components of a typical long-term investment portfolio. First, equity (stock) values should decline as discount rates are increased. Second, bond prices should fall as new bonds issued will offer higher rates to investors versus outstanding bonds. Third, real estate investment trusts should also decline when managers have to begin paying out more in interest to service short-term debt. Last, commodity prices also tend to decline in rising interest rate environments given the fact they do not pay a rate of interest or regular dividend and therefore may look unfavorable when compared to other investment options.
So what type of investment vehicle outside of the 4 mentioned above can investors consider as interest rates increase both domestically and across the globe? One idea is in the form of floating rate investments. Although floating rate investments can take a variety of forms, in the context of this article we will refer to what are called ‘bank loans’ to describe these products.
Bank loans are just what their name implies. They are loans made by banks to commercial and industrial borrowers who typically are saddled with significant debt. Bank loans are closely related to junk bonds and floating rate note funds but with a couple key differences. Similar to junk bonds, bank loans are made to companies who have below investment grade credit ratings. Like floating rate notes, bank loans also have interest rates that vary (or float). The key difference here is that bank loans trade on illiquid private markets, rather than on established securities exchanges.
In theory, bank loans do not pose a lot of risk. Despite being classified as ‘junk’ credit rating status, these type of loans are usually senior in the company’s capital structure. Being ‘senior’ means that in the event of a bankruptcy, the loans must be paid off first (or at least close to first). The loans are also typically secured by some of the company’s assets, meaning that if the company cannot make payments, then the bank can seize those assets and sell them to pay off the loan (in essence, investors are at the head of the line if the company should default on their promise).
From an investment standpoint, the main intrigue to investors with bank loans is that their yield (interest) will ‘float’ or fluctuate based on an index to which they are tied. When short-term (30, 60 or 90 day) interest rates rise, yields are reset and the investments pay more in the form of interest. Their rate is often pegged to LIBOR – the London Interbank Offer Rate (the interest rate that banks pay to borrow funds) or the Federal Funds Rate. For example, a rate could be quoted as “LIBOR + 0.50%”; if LIBOR stood at 1.00%, the rate offered would be 1.50%. While the yield changes throughout the life of the security as prevailing interest rates fluctuate, the spread (the “+0.50” in the example above) typically stays the same.
When compared to traditional bonds, interest rate risk is largely removed from the equation with bank loans. While an owner of a fixed-rate bond can suffer if prevailing interest rates rise, floating rate loans will pay higher yields if in fact interest rates go up. As a result, bank loans will tend to perform better than traditional bonds when interest rates are on the rise.
Of course, all investments come with risk and bank loan products are not immune. The main concern investors should have with bank loan is what is called ‘default risk’. Default risk is inherent in bank loans because the companies that take out floating-rate loans may have a more difficult time paying back their loans should their business prospects deteriorate. The typical firm offering bank loans carry sub-investment-grade credit ratings and therefore are more likely to default on their payments than less-indebted, higher quality firms.
Another risk with bank loans is the prospect of falling rates. When rates decline, investors lose out with a lower interest rate and lower payments. Furthermore, bank loan prices do not increase when rates drop, which occurs with a fixed rate bond.
Bank loan investments tend to perform best late in the credit cycle when interest rates are rising and economic growth is still strong. Many would argue that this is exactly where we are at the moment in today’s investment climate and bank loans are at the height of their risk. Due to concerns over bank loans’ lower credit ratings and the relatively illiquid market in which they trade in, returns can get hammered during recessions. For example, during the beginning of the Great Recession in 2008, bank loan mutual funds declined by 29.72%, while the Bloomberg Barclays US Aggregate Bond Index actually rose 5.24% (as measured by independent mutual fund rating service Morningstar).
For the majority of investors, the best way to invest in bank loans is through mutual funds. For example, the Eaton Vance Floating-Rate Advantage fund is one such product. Managers Scott Page and Craig Russ have been at the helm since 1997 and 2006, respectively. With over $10 billion invested in the fund and a reasonable expense fee of 1.28%, the fund has 92.7% of its portfolio invested in bank loans. Page and Russ start by weeding out the smallest borrowers as well as companies that have too much debt. The team favors loans issued to established companies with ample earnings and assets to cover their debts. To be considered for inclusion in the portfolio, a loan must be what is called ‘senior secured’, meaning that in the case of a default, holders of the loan have first dibs on the company’s assets – even before bondholders.
Almost the entire fund is invested in below-investment-grade ratings, but management skews towards better-quality junk loans. Currently, the fund has 86% of its assets in double-B and single-B rated loans (the highest below-investment grade loans), compared with 71% for the average bank-loan mutual fund. Over the past 15 years the fund has returned an average of 4.95% to investors, ranking it #1 in its category over that time period according to Morningstar. The fund carries higher risk than similar investments but has been awarding investors with a higher average return over time.
In the attached video from “The Street”, anchor Rhonda Shaffler interviews Craig Russ (mentioned above) who manages floating rate securities at mutual fund firm Eaton Vance. The asset class today is yielding between 4.5% and 5.5%, depending on the product, which is extremely attractive given today’s low interest rate environment. He goes on to explain that loan defaults do occur in the area of 2-3%, but loan recovery rates are very high, at 80 cents on the dollar of those defaults.
In conclusion, bank loan investments can play an important part of a well-diversified long-term portfolio, particularly at the later stages of the economic cycle when interest rates are on the upswing. With stock prices on a tear over the past 10 years and bond prices seeminly at their end of their 35-year run, I believe it is wise for investors to begin taking a look at bank loan funds to replace a portion of their stock and bond holdings. Furthermore, with cash paying such palty rates, investors could spread a portion of their cash holdings over to this area as well. For a typical long-term investor with a moderate-growth outlook, holding in the area of 5-7% of their portfolio in bank loan funds would be an appropriate allocation. As with any investment, please consult your financial advisor for suitability given your risk/return objectives.