A Suitable Solution in a Rising Rate Environment?
During the last several years, investors and advisors have faced challenges in their attempts to design suitable portfolios. If you are reading headlines and listening to financial news programs, you may be confused by the prior statement. We are consistently reminded by the media that major stock indices are reaching record highs nearly every month. Domestic stocks have thrived since the financial crisis, leaving most investors thrilled with the portion of their portfolio designed for growth. Unfortunately, income seeking investors have experienced a very different reality. Over the last five years, municipal bonds, corporate bonds, CDs, and savings accounts have delivered returns well below historical averages. Most investors do not have the luxury of allocating 100 percent of their portfolios to equities. Very few high net worth investors have the stomach to accept the volatility associated with a portfolio consisting exclusively of individual stocks. Investors approaching retirement, and certainly those who have started taking distributions from their investments, must shift focus from maximizing return to limiting downside risk.
Moderate and conservative investors benefitted from a 30-year bull market for bonds; however, more recent history has delivered a trend reversal. Traditional vehicles designed for income and/or risk management have delivered less than desirable recent returns. Core bonds have provided an annual average return between 1-2 percent over the last five years[1]. Why have bonds struggled to deliver results during this period? The combination of a low yielding environment and the inverse relationship bond prices and interest rates have negatively impacted returns. If interest rates rise, bond prices decline. A loss of principal will offset the interest payments from bonds, creating a scenario where it is possible to experience a negative annual return from your fixed income investments. The consensus among analysts and economists suggests interest rates are likely to continue rising. If forecasts are accurate, the next several years of returns from traditional fixed income investments may resemble the last five.
What options does an investor have to protect their bond holdings in a rising rate environment?
Prior to answering the question, we must disclose there is no perfect solution for every potential economic environment. A suitable investment depends on your (or your advisor’s) viewpoint, and there is a trade-off with every decision. Professional advisors operate in the world of probabilities, not in a world of certainties. A unique tactical strategy should be used in moderation, not to make large speculative bets.
Let’s review a strategy many professionals have recently utilized with a reasonable amount of success in a low yielding, rising rate environment: increasing their exposure to high yield bonds, also known as junk bonds. High yield bonds have allowed investors to replace the income they were receiving from investment grade corporate bonds or treasury bonds a decade ago. The risk associated with this strategy: high yield bonds tend to be low quality debt. Investors have been willing to accept additional risk as the competition to acquire income yielding investments has intensified. Consequently, many high yield bond funds are lowering their credit standards, exacerbating the risk of these investments. The spread between the yield offered by junk bonds and treasuries, is approaching historical lows. Many analysts would make a compelling case that the narrow spread suggests the high yield market (or at minimum the lowest quality components of the index) is overbought. Junk bonds have outperformed traditional core bonds in the last several years, however the next phase of a rising rate environment may not be quite as favorable for high yield.
If you believe interest rates will rise gradually, the economy will remain reasonably healthy, and financial markets will remain stable, floating rate funds may be an appropriate solution for your portfolio.
What are floating rate funds? Funds investing in debt paying a variable rate of interest are called floating rate funds. The rate is typically tied to a reference rate such as LIBOR[2]. For example: Investors receive the current 90-day LIBOR rate plus a spread (additional yield beyond LIBOR) influenced by the risk associated with the loan. Three-month LIBOR rates tend to correlate closely to the federal funds rate.
Why would an investor allocate to floating rate funds?
- The coupon rate is tied to current market interest rates. If the Fed elects to raise rates, it is likely the coupon on the note will increase, and ultimately your cash flow from the investment will increase. The result is your fund is not impacted by rising rates the way a traditional bond would be impacted.
- Yields typically exceed the yield of treasuries or traditional corporate bonds
- They are typically senior notes, meaning they have priority in the debt structure. Owners of floating rate notes are one of the first in line to get paid if the borrower experiences financial difficulty.
What is the downside?
- Interest rates are higher for a reason, the debt is lower quality in most cases and floating rate funds tend to allocate a portion of assets into non-investment grade debt
- Funds may use leverage to increase returns, therefore increasing risk
- Floating rate notes will not generally provide downside protection in a risk-off environment. High quality bonds perform well when fear is prevalent in the financial markets. Floating rate funds experience a higher correlation with stocks over short periods with elevated volatility.
Do floating rate funds differ from bank loans?
- Yes, although they have many of the same characteristics and are typically grouped in the same category. Floating rate funds can own investment grade debt. Bank loans are private investments held by funds or large institutions. Typically bank loans are of lower quality and fall into the “junk” category. Bank loans have less liquidity and therefore carry additional risk. If you are evaluating floating rate funds, you may see the fund benchmarked against a bank loan index.
Floating rate funds should not be used as a substitute for your entire bond portfolio. When paired with traditional bonds in a rising rate environment, floating rate funds can serve as a complimentary asset to potentially enhance risk-adjusted returns. An investor would not allocate to floating rate loans if he or she anticipates a credit crisis. An extreme example occurred in 2008 when the S&P 500 declined 37 percent, the bank loan index declined 29 percent. While bank loans outperformed stocks, commodities and real estate in 2008, investors were obviously not exempt from severe short-term losses. The index quickly recovered, as investors who managed to stay the course benefited from a 45 percent return in 2009[3].
Why would OJM be comfortable with floating rate loans for the appropriate client?
While we would advise against making a decision based on the potential worst-case scenarios, it is important to understand the potential downside of any investment. A financial crisis is not the norm and does not occur with great frequency. The floating rate index has experienced a negative return twice in the last fifteen years. Default rates on senior floating rate loans have averaged less than 4% and, through the end of 2017, the default rate for leveraged loans was 2.0 percent.[4] When assessing risk, one must look beyond default rates and evaluate the recovery rate of those defaulted bonds. A default does not equate to a complete loss; in many cases lenders recover 100 percent of principal. Twenty years of Moody’s research tells us first lien loans have a 70.3 percent recovery rate and a 65 percent recovery rate in a recession.
At OJM Group, we have been assessing floating rate funds for some time. Further due diligence allowed us to eliminate strategies allocating to low quality companies in the space. Focus on quality, accept a moderate degree of volatility, and identify the appropriate economic environment for an allocation to floating rate funds. Follow these steps and you may improve your odds of success when investing in the bond market throughout a period of rising interest rates.
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Andrew Taylor, CFP® is a Wealth Advisor and at the wealth management firm, OJM Group (www.ojmgroup.com). He can be reached at 877-656-4362 or ataylor@ojmgroup.com.
[1] As measured by the Barclays U.S. Aggregate Bond Index and Barclays US Govt/Credit Intermediate Bond Index as of 5/31/2018.
[2] London Interbank Offered Rate
[3] Credit Suisse First Boston (CSFB) Leveraged Loan Index. https://www.pimco.com/en-us/resources/education/the-benefits-of-a-diversified-bond-portfolio/
[4] https://www.valuewalk.com/2018/04/guggenheim-defaults-recovery-rates/