Fear of inflation and rising interest rates have prompted tremendous interest in mutual funds and closed end funds that invest in high yield bank loans. Bank loans have the magical quality of not losing value when interest rates rise because they pay a floating interest rate which moves with short-term rates.
There are two major benefits provided by high-yield bank loans:
- They don't lose value when interest rates rise.
- In the case of a default, they get back their money before bondholders and most other creditors.
In theory, high-yield bank loans should do much better than other bonds with fixed coupon rates when rate rise. In general, bonds with fixed coupon rates decline in value when interest rates rise. However, Alliance Bernstein has conducted research which indicates that this generalization does not apply to the riskiest part of fixed income market. They studied the performance of high yield bank loans in months where market interest rates (basically treasury rates) rise. From January 2006 thru September 2012, high yield bank loan prices were up 1.3% in months when rates rose and 10-year Treasury bonds had negative returns. However, the surprise was the price performance of high yield bonds in these months which were up 1.4%.
Are the prices of high yield bonds insulated from rising interest rates?
Ivan Rudolph-Shabinsky, a portfolio manager for Alliance Bernstein, gave the following answer:
Our research indicates that when the spread between Treasuries and high yield is over 500 bps (5%), the impact on treasury rate moves on high yield bonds is minimal. In general, as the spread drops below 500 bps there is a straight line increase in the sensitivity of high yield prices to rate moves. If the spread was 250 bps, we would expect the price move of a high yield bond to be half the price move of a similar Treasury.
Price moves in high yield space are highly influenced by the perception of credit risk. When most of the bond's yield is coming from credit risk, small changes in market rates don't have much impact. In fact, increasing interest rates in the context of an improving economy is a positive from a credit perspective.
During my conversation with Rudolph-Shabinsky, he shared some other interesting facts about high yield bank loans and bonds. One fact that surprised me was the percentage of companies that issued both high-yield bank loans and took out bank loans directly. He estimated that only 40% of high yield bond issuers also had large outstanding bank loans. In effect, the type of company that participated in each market was different. He pointed out that 8 of the 10 biggest high-yield bank loan borrowers were from companies that had a leverage buyout (LBOs), while only 1 out of the 10 high yield biggest issuers of high-yield bonds were LBOs. In his opinion, the companies that were in the high-yield market were generally riskier than those issuing high yield bonds.
Ivan Rudolph-Shabinsky contrasted the relative safety of high yield bank loans and bonds in the following way:
High yield bank loans are considered to be safer than high yield bonds because they a more senior in the capital structure. Historically, I believe the recovery rate for defaulted bank loans is around 70 cents on the dollar versus 40 cents for the bonds. However, the recovery rates says nothing about the probability of default which I believe is greater for bank loans.
Does Ivan Rudolph-Shabinsky have a suggestion for investors that want to protect themselves from rising interest rates while receiving a yield above 3.0%?
Yes. He suggests that investors consider a short-term high yield fund. Alliance Bernstein's research indicates that short-term high yield bonds deliver more return than high-yield bank loans with less volatility. From January 2006 through September 2012, Ba and B-rated short-term high yield bonds outperformed loans by 2.6% per year.
In December 2011, Alliance Bernstein launched the Limited Duration High Income Funds (ALHAX). Although the fund does hold some investment grade bonds, it's essentially a short-term high yield bond fund. Since inception, the fund has returned 11.4%.