A 30-year secular move toward lower rates has left fixed income portfolios exposed to interest rate risk, and many investors now face the difficult task of anticipating when the market will start pricing in higher yields.
Compounding the dilemma are bloated government balance sheets in the developed world and the as-yet unknown effects austerity will have on growth in these economies. Furthermore, periods of rising commodities--coupled with currency volatility--further exasperates the outlook.
The experiments with quantitative easing by central banks, particularly the Federal Reserve, makes investors question the exit strategy around arguably loose monetary policy. Managing a portfolio of fixed income securities and using traditional floating rate strategies that focus only on bank loans to address these concerns might be less than optimal. We believe employing diversification across multiple asset classes to hedge the risk of rising rates may help investment professionals weather periods of interest rate volatility.
Traditionally, investors seeking to protect principal during periods of rising rates have looked at investments in the bank loan market due to their floating rate nature. The assets comprising this market are predominately rated below investment grade by the rating agencies. While these investments are secured by assets in most cases, they still come with substantially more credit risk than investment-grade companies. Depending on the clients' specific needs and risk tolerances, utilizing a strategy primarily limited to bank loans may not meet the clients' investment objectives.
Bank loans have gained in popularity over the past 10 years, and up until the Great Recession of 2008 were seen by many to have limited price volatility. During the depths of the recession, bank loans as an asset class typically reached prices in the low 60s. That time period was particularly difficult for loans due to several factors, including a significant use of leverage to finance the purchase of loans. When leverage was forced to come down and liquidity evaporated, investment managers were left scrambling for a buyer of their holdings. This significant selling drove down loan prices to what many consider below recovery values.
A repeat of that type of market volatility isn't anticipated today. However, we believe a push higher in yields by just two or three percent would result in price depreciation of multiple points. Furthermore, we believe the relatively low-yield environment of today often may not provide a sufficient income "cushion" to offset a material move lower in price.
Libor, a commonly used benchmark rate in which bank loan coupons reset, has averaged approximately 2.5% over the past 10 years, which is approximately 2.25% higher than Libor is today. According to Bloomberg, the average yield of Libor during the 1990s was nearly 5.5%. Investors should be asking themselves if they are being adequately compensated to own bank loans in today's period of uncertainty.
The bank loan asset class is generally callable at any time by the issuer, which can mean limited price appreciation when the market trades at or near par. There are circumstances where loans will trade above par for reasons that aren't specific to the fundamentals. Significant cash flows into the asset class--like we saw at the beginning of this year--can leave managers struggling to source investment options. This "technical" can arguably drive asset prices through fundamental valuations and, at times, above par.
As a result, portfolios may take a mark-to-market hit as loans are called by the issuer. Effectively, the price performance enjoyed above par is transferred back to the issuer rather than accruing to the portfolio. The worst-case scenario would be if the manager purchased the loan above par and it is called away shortly thereafter.
Also, there are instances whereby the loan is called and refinanced in other markets such as high yield, leaving the manager once again trying to source more liquidity rather than having the option to purchase the new loan. It should be noted that the option to call a loan should work in favor of the investor when companies announce the call of a loan that is trading at a discount to par.
Another consideration when evaluating a single asset class strategy, such as bank loans, includes additional enhancements such as Libor floors. A floor is a feature that prevents the instrument's coupon from falling below a specific level when the stated benchmark that the applicable margin resets off is receding, or is at a depressed level. Almost all of the new supply in the bank loan market this year has included a floor.
With three month Libor currently around 0.25%, many investors have been requesting floors to help offset the low level of rates. But it's important to understand that a portfolio comprised of a significant amount of investments with floors may not realize the benefit of rising income until the stated benchmark rises above the level of the floor. A portfolio of diversified securities by asset type and structure could enjoy the benefits of rising rates much sooner, since most investment grade bonds lack the floor feature.
We believe a diversified approach to the floating rate market could help minimize some of the risks outlined above. Investment options outside of bank loans can include moving up in credit quality to investment grade corporate bonds, structured products such as asset-backed and mortgage-backed securities, as well as municipals to name a few.
Investors may choose to source floating rate notes in the investment grade corporate market. Unlike bank loans, this market is typically unsecured. However, given the breadth and depth of these companies, we believe they generally expose investors to less credit risk. The investment grade corporate floating rate market is comprised of a significant amount of financial names. Attempting to construct a diversified portfolio of investment grade names can be challenging due to the lack of industrial floaters. We believe using interest rate swaps is an excellent risk management tool to swap the cash flows of a fixed rate bond to mirror those of a floating rate instrument.
Many companies that issue floaters may do so with a maturity of 3 years or less, which should further limit the investment options a portfolio manager may choose from. However, if you once again use an interest rate swap, the manager can buy a fixed rate bond with a longer maturity. This is an important tool to reflect the view of a research analyst that has a favorable outlook on a credit.
For example, Company A has a well developed credit curve that includes bonds with maturities in years one through ten. However, the company only has a two-year floating rate note. If a research analyst is very constructive on a credit, the manager will want to invest in the ten-year bond to reap the benefit of greater price appreciation as the risk premium of the issuer compresses. This is the direct function of the average maturity of the investment as seen below:
* A three-year bond priced at par, yielding 5%, experiences a 0.50% move lower in yield due to credit improvement. This yield change would equate to an increase in price of approximately 1.375 points.
* A ten-year bond priced at par, yielding 5%, experiences a 0.50% move lower in yield due to credit improvement. This yield change would equate to an increase in price of approximately 4.0 points.
As you can see from the previous example, the ten-year bond will outperform the three-year security by nearly 2.75%. Taking advantage of interest rate swaps as a risk management tool may give the portfolio manager greater flexibility to address changing markets and also own assets where the potential risk-reward is more favorable. Moreover, by employing interest rate swaps it allows investment managers to evaluate the entire fixed income market for opportunities rather than being limited to only natural floating rate securities.
Bank loans may play an essential role in a portfolio of floating rate notes. However, investing in a portfolio based solely on loans doesn't provide the diversification benefits, nor flexibility, of a multi-asset class strategy that encompasses investment grade corporate bonds, structured products or municipals to name a few. We believe using interest rate swaps as a risk management tool can provide additional diversification and investment options outside of the loan market, which is primarily rated below investment grade.
In our opinion, employing an array of investment opportunities may allow managers to adjust risk profiles to help meet today's challenging economic and credit environment.
[The views expressed represent the manager's assessment of the market environment as of July 15, 2011, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice.]?
David Hillmeyer, CFA, is Vice President, Portfolio Manager, Head of Investment Grade Corporate Trading - Delaware Investments, Inc.