We are in the early phases of a rising interest rate environment. Investors need to be mindful about how that potentially impacts their portfolio. So, investors invest in fixed income for two very simple reasons. One, current income, of course, but also preservation of principal.
This dynamic about the preservation of principal becomes significantly more challenging in a rising interest rate environment. So, if you invest in a bond, whether it’s a municipal bond or a corporate bond or a treasury bond, you are paid a fixed rate year-in and year-out. The problem is, if interest rates go up, the value of your principal has to decline to account for the new rate.
So, just to give a quick example. So, let’s say you buy a bond at three percent, and next year, because rates have gone up, that same company issues a bond at four percent. Well, everyone who owns that three percent bond is going to sell their bond because they want the four percent bond. That underscores the challenge of fixed-income investing in fixed-coupon investments in a rising rate environment.
Investors should look to potentially senior secured loan assets as a way to hedge interest rate risk in their portfolio. So, unlike bonds that pay a fixed coupon, loans pay a floating-rate coupon. So, when interest rates go up, you can potentially generate incremental interest income, which protects the value of your principal. Historically, data has shown that floating-rate assets outperform other fixed-income asset classes during a rising interest rate environment.
Now, another dynamic that we love about senior secured loans, in general, and we’re going love this regardless of the market backdrop, is that loans are at the top of the capital structure. So, they’re senior to bonds, they’re senior to preferred and they’re certainly senior to equity, and they’re also often times collateralized. This dynamic of being at the top of the capital structure and collateralized helps mute market volatility and is actually a very good way to potentially preserve principal.
So, at its core, investors need to understand where we are in the current rate cycle and think about the amount of interest rate risk that is embedded in their portfolios. Investors could potentially sidestep some of this risk and better guard their portfolios by looking for alternative fixed-income products that, at their core, are overweight floating-rate assets.