In LPL Research’s Weekly Market Commentary this week, we looked at some stock and bond options that may be attractive income-producing ideas for suitable income-oriented investors. On the bond side, many income-oriented investors are growing increasingly concerned about taking on additional interest rate risk at the beginning of a potential rising rate environment. (Bond prices fall when interest rates rise.) For those investors, bank loans, which carry minimal interest rate risk, may be an option. LPL Research recently upgraded bank loans to “neutral” given the favorable economic outlook, and loans may be especially attractive for investors focusing on income.
Bank loans are a type of security issued by companies that don’t have investment-grade credit ratings. These companies have a greater risk of experiencing credit downgrades, or even defaults, especially in challenging economic environments. Similar to high-yield bonds, these securities come with higher yields to compensate for that additional risk. And while bank loans and high-yield bonds are generally both issued by the same companies, loans are senior to other forms of debt, which means they have priority of assets in the event of default.
“In this yield starved world, we believe investors can increase portfolio yields by prudently adding risk without taking on additional interest rate risk” said LPL Financial Chief Market Strategist Ryan Detrick.
We think bank loans may make sense for several reasons. First, we are expecting strong economic growth for 2021 and into 2022, which would, in our view, put upward pressure on U.S. Treasury yields. Bank loans exhibit very little interest rate sensitivity because the interest they pay goes up when short-term yields increase. More importantly in the near term, investor demand may improve given positive economic conditions, which should help buoy prices. Finally, underlying fundamental conditions have improved for noninvestment grade companies and we do not believe increased default risk poses an imminent concern.
Looking more closely at interest rate sensitivity, in today’s LPL Chart of the Day, we rank the major fixed income sectors by income per unit of interest rate risk. Since fixed income indexes have different degrees of interest rate sensitivity, this exercise allows us to determine compensation for taking on interest rate risk on a more uniform basis. The obvious stand-out is the bank loan sector. Now, it is not realistic to assume that bank loans will provide the level of compensation outlined in the chart (the actual expected yield is 3.7%). But it does show that, relative to other fixed income alternatives, bank loans provide an attractive income option for investors looking to limit interest rate risk at the beginning of a possible rising rate cycle.
But we know there is no such thing as a free lunch. That additional income bank loans provide is compensation for assuming credit risk and illiquidity risk. In economic downturns and turbulent markets, loan defaults rise and sellers of loans may not find buyers quickly, which can lead to significant price dislocations in volatile market conditions, even in highly liquid investment vehicles like ETFs. So, before investing in any fixed income instrument, it’s important to understand the trade-off between interest rate risk and other forms of risk.
Other alternatives that may be appropriate for income-oriented investors include preferred securities and emerging market debt. Both of these options are also rated “neutral” by the LPL Research team and provide attractive yields relative to the amount of interest rate risk of the underlying investments. Please see the recently updated Global Portfolio Strategy report for our views on these markets.
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