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Michael Terwilliger Portfolio Manager Resource Credit Income Fund
“Investors need to think about the amount of interest rate risk that is embedded in their portfolios.” – Michael Terwilliger
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Date: September 5, 2017
Category: Credit

Can Loans Serve as a Fixed-income Income Investment Alternative?

Senior secured loans fixed incomeAs a fixed-income investor, you are looking at headwinds in the search for risk-free income. Where can you turn? The search could lead you to senior secured loans.

Having a diversified portfolio of stocks and bonds has always been Investing 101. Generally, they have reacted differently to different economic conditions and their low correlation helped manage portfolio risk, while driving income and total returns.1

However, lately stocks and bonds have become more correlated, removing some of the safety that made bonds so attractive. And, after three decades of historically low interest rates, bonds are also delivering less income as interest rates rise.

So, what does this mean if you are a fixed-income investor who thrived in the bond market over the last three decades? The search for risk-adjusted income could lead you to senior secured loans.

The interest rate bet

You’re rolling the dice on interest rates if you’re hoping that the traditional bond market will deliver the income you want. And in our current environment, that gamble is coming up snake eyes.

A promising employment picture, relatively stable inflation, and a broadly-improving economic backdrop have given the Federal Reserve the green light to continue normalizing interest rates. And no matter what “normalization” means to rates long term, here’s what it means to you right now: they are going up … and that’s bad news for bonds.

You’re rolling the dice on interest rates if you’re hoping that the traditional bond market will deliver the income you want.

Bonds pay interest income at a fixed rate until maturity, which works well when rates are steady or declining, as they at least hold their value. However, if rates continue to climb, you’ll face the unenviable choice of either watching your bonds’ values erode or selling them at a loss.

For example, the high-yield bond market has built-in significant interest rate risk at this point in the cycle. Today, its yield sits at 5.67 percent.2  By comparison, just under 15 months ago, its yield sat at 10.10 percent.3 The lower the yield, the greater the risk bonds face as rates rise.

Avoid the bet altogether

Senior secured loans pay interest at a floating rate that typically resets every 90 days, potentially helping you earn incremental income as rates rise. And while you participate in the income upside, in many cases, you will also be protected from the downside risk. Roughly 90 percent of loans have a LIBOR floor, which helps insulates them from a freefall should rates start to drop. It sounds too good to be true, but a loan’s floor provides a minimum level of income no matter where rates stand.

This structure allows senior secured loans to pursue consistent income in any interest rate environment, far different than bond funds that are left exposed to interest rate movements.

Loan market investment income return

 

Income with lower risk is possible

Despite rising rates, you may still need income without greater risk. Senior secured loans are secured, typically by a company’s assets like property and equipment. They are first in line in case the underlying company defaults on its loans. Senior secured loans will get repaid in full before unsecured debt like high-yield and subordinated bonds and equities receive a cent. Like anything else, being first reduces your risk of missing out. If you are at the front of the line when concert tickets go on sale, your chances of securing seats are far greater than if you are near the back.

Play the odds

So, don’t make the same fixed-income bet despite worsening odds of achieving your investment outcomes. Bonds are quickly becoming a dicey gamble in today’s environment if income is your investment goal. Turning to senior secured loans may help generate potential risk-adjusted income for your portfolio as interest rates rise.

1 Correlation is a measure of the degree to which the value of different investment types move in the same direction; if they perform independently of one another, they are non-correlated.

2 Bank of America Merrill Lynch U.S. High Yield Index. 5/11/17.

3 Bank of America Merrill Lynch U.S. High Yield Index. 2/1/17.

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