Senior floating-rate bank loans have helped investors generate income under the threat of rising rates, but with the Fed holding off on tapering, high-yield, junk bond exchange traded funds could be a better play.
"Our latest High Yield and Bank Loan Outlook report reveals that high yield bond fund flows have been volatile, and performance has been uneven," Scott Minerd, Global Chief Investment Officer at Guggenheim Partners, said in a note. "Now that the risk of a near-term increase in interest rates has faded, we expect to see more stability in high-yield flows and more volatility in bank loans as mutual fund investors reposition to search for yield rather than protecting themselves from rising rates."
The PowerShares Senior Loan Portfolio (BKLN) has attracted $4.4 billion in inflows so far this year, making it the most prolific PowerShares ETF by that metric. Senior bank loan funds are typically rated speculative grade, or considered "junk." The securities also employ a floating rate component that helps investors hedge against rising interest rates. BKLN has a 4.14% 30-day SEC yield.
The iShares iBoxx High Yield Corporate Bond (HYG) and SPDR Barclays High Yield Bond (JNK) do not have a built-in interest rate hedge. The HYG ETF has a 4.19 year effective duration and a 5.25% 30-day SEC yield. JNK has a 4.42 year duration and a 5.55% 30-day SEC yield.
With rate concerns on the back burner, junk bond investors' focus is back on credit risk, but speculative grade debt default rates are still relatively low.
"Despite the volatility experienced in the third quarter, our research shows that default rates for below-investment-grade bonds typically remain low for some time following periods of monetary accommodation," Minerd added. "The Fed has indicated interest rates will remain near zero at least until mid-2015, and we expect rates to stay low even longer. The take-away for investors in the below-investment grade market is that the fourth quarter outlook appears positive, and more positive for high yield bonds than bank loans."
Nevertheless, investors should still be aware that quantitative easing speculation is still rampant, which could fuel short-term volatility.
Source: Credit Suisse. Data as of September 30, 2013.
Max Chen contributed to this article.
Full disclosure: Tom Lydon's clients own HYG and JNK.