This article was written by Invesco PowerShares Director of Fixed Income Product Strategy Scott Eldridge.
The outlook for both interest rates and energy prices is far from certain. For investors who are looking for less exposure to these risks in their fixed income portfolios, bank loans, also known as senior loans, may present an attractive opportunity that’s more defensively positioned (from a rate and energy risk perspective) than the overall high yield market.
This year has seen considerable flows into high yield exchange-traded funds. However, high yield valuations have tightened over the past two months, and investors are eyeing the potential for interest rate risks to emerge and energy risks to persist.
Fed’s patience has run out
At the most recent Federal Open Markets Committee meeting on March 18, the word “patient” was removed from the Federal Reserve’s official statement about rate hikes. Fed Chair Janet Yellen has indicated in the past that removal of the word “patient” may predate a rate move by two meetings, which could narrow the date range for a rate hike to this summer.
In a rising rate environment, bank loans have a key advantage over traditional high yield bonds — they are structured with floating rates. This allows their coupons to adjust upward as rates rise, and makes them a potentially attractive source of yield to consider in a rising rate environment. As investors focus on the interest rate exposure of their fixed income investments, bank loans may offer a lower sensitivity to interest rate risk thanks to their lower duration, while providing the potential for attractive income.
Energy prices may present default risk
Plunging oil prices may spell trouble for highly leveraged energy companies — financial strain and default risk could be on the horizon for these companies. Bank loans tend to offer far lower exposure to the sector than high yield bonds:
Yield spreads have compressed for high yield corporates and bank loans
For the past three years, a fairly tight pattern has persisted between bank loan yields and high yield corporate yields. The spread between the two has fluctuated between 1% and 2%. In mid-December, just before the recent high yield flows accelerated, the spread reached the high end of the range near 1.85%. By late February, the spread had tightened to around 1.2%, eroding much of the relative value that high yield held over bank loans. (Figure 3)
Consider diversifying high yield exposure with bank loans
Investors’ preference for high yield at the beginning of the year was beneficial as spreads tightened. But today, I believe bank loans may present a tactical and strategic opportunity for fixed income investors: They may present a more attractive risk profile in a rising interest rate market ahead, and they may have lower exposure to default risk in the energy sector. For investors still unsure if now is the time to get defensive on rates, even a partial rotation out of high yield and into bank loans could capture some of high yield’s gains in recent months while preparing for potential risks ahead.
Learn more about PowerShares Senior Loan Portfolio.
Important information
The S&P/LSTA U.S. Leveraged Loan 100 Index is representative of the performance of the largest facilities in the leveraged loan market.
The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar-denominated, below-investment-grade corporate debt publicly issued in the US domestic market.