A long-term fixed income investor who wants to make a steady 6-8% return doesn’t have many choices right now. Bonds, unlike equities, are a “zero sum game” in the sense that the only long-term income generated is from the coupon on the instrument.
Of course an individual bondholder can generate a capital gain by selling a bond that they bought in the past that has a higher coupon than the current market yield, but then they are just monetizing (i.e. getting the present value of) the future “excess” yield that the bond’s higher coupon would yield them if they held it to maturity. Likewise, they can sell a bond at a loss that has a lower coupon than the current market yield, but here again they are merely up-fronting the loss (the negative differential in yield versus the current yield) that they would incur gradually if they held the bond to maturity. But the coupon on the bond – whether it is above or below the current market yield – is the only return there is on the instrument. Equities are different, of course, since there is – in theory – no limit to how much the dividends or the value per share of the company can grow to over time.
Bonds present unattractive outcomes in today’s environment
This idea – that bonds are a zero sum game – got somewhat clouded in the minds of many investors as we saw essentially a one way movement – down – in interest rates over the past 30 years. I bought my first Treasury bond – a 30-year variety – in the mid-1980s and the coupon was almost 10%. Anyone who bought and held that issue has had “equity” returns for the past 25 years.
But think how different – and unattractive – the choices available to today’s bond investors are. They can buy long-term Treasury bonds and receive – depending on maturity – between 2 and 3¼%. Not much of a return for 10 to 30 years, plus they carry a huge risk of principal loss if they decide to sell before maturity and rates have risen in the meantime. If they move further out the credit risk spectrum to corporate investment grade bonds, then they may make 3-4½% for long-term (i.e. 10-20 year) corporate risk. Still not much of a return for taking both credit and interest rate risk (mostly the latter), especially at a time when it is hard to imagine interest rates not moving against them. In fact, most fixed income investors I talk to think of buying long-term treasuries and/or investment grade corporates at these levels as essentially “locking in” a loss down the road (or a sub-standard return if held to maturity).
Obvious Choice is High Yield, but Loans or Bonds?
So that narrows the choice for fixed income investors to either corporate loans (floating rate, senior secured debt of non-investment grade corporates) or high yield bonds (fixed rate, unsecured or subordinated debt of the same cohort of non-investment grade corporates). Normally high yield bonds pay a higher yield than loans (depending on credit quality it might be 8-9% for high yield bonds vs. only 6-7% for loans), reflecting the fact that with HY bonds you have both greater credit risk (and higher credit losses because recoveries on unsecured/subordinated bonds that default are invariably higher than losses on secured loans) and the additional risk of loss if/when interest rates rise.
But currently the market is at one of those unusual points where loans have been caught in the recent downdraft that also pulled down equities and HY bonds, and as a result loans are yielding in the 8-9% range, about the same as HY bonds. This high return reflects the basic loan spread above LIBOR of about 700 basis points (i.e. about 7%) and the discount on the loan price (currently down in the mid-90s) which adds about another 150 basis points to the loan return over a typical 4 year life). So loan investors, who may have been looking at a return in the 6-7% range earlier this year (which still looked attractive for a solid, predictable cash-flow sort of investment in the “new normal” investing era), can now buy into the same asset class and look forward to an 8-9% return.
As I’ve explained in earlier articles, that looks like an “equity” return to me, but without the volatility of “real” equity, especially when you factor in the additional protection of the floating interest rates, which means income from loans will go up as rates increase in the future. Professional money managers are presenting this to clients as a way to “trade up” in credit quality and interest rate protection from high yield bonds, without sacrificing any yield.
My favorite vehicles for owning corporate loans are closed end funds. Here the picture is even brighter, since many closed end loan funds that had risen to premiums in recent months are now selling at discounts, so you get even more loan assets per dollar of investment. Here are some examples, all of which are now at discounts but which sold at premiums just a month or two ago:
- ING Prime Rate Trust (PPR), yielding 6.1%, discounted 8.89%
- BlackRock Floating Rate Strategy (FRA), yielding 7.11%, discounted 7.8%
- Eaton Vance Floating Rate Income (EFT), yielding 6.8%, discounted 4.29%
- Blackstone/GSO Senior Floating rate (BSL), yielding 7.41%, discounted at 4.3%
One nice thing about buying loans in discounted closed end funds, of course, is that you are acquiring earning assets at a compound discount: the underlying loans are bought by the funds at a discount from par, and then you’re buying the funds themselves at a discount.