In 2013, we created a suite of strategies that we believed could improve on traditional approaches for managing interest rate risk in bond portfolios. In our view, a potentially more intuitive alternative to senior loan strategies was to own a broad-based portfolio of high-yield bonds but then hedge out nominal interest rate risk. The resulting portfolio would have similar income, risk and total return characteristics but would still be invested in cash bonds. Since that time, the exchange-traded fund industry has seen cumulative inflows of nearly $11 billion into senior loan strategies compared to $350 million into rate-hedged, high-yield bonds.1 Despite this massive flow discrepancy, performance for loans has generally lagged. Below, we highlight the performance characteristics of the two approaches and discuss possible trade-offs going forward.
High-Income, Low-Rate Risk
For both strategies, the combination of low interest rate risk and high-income potential has seen heightened interest in the current environment. Concerns about a normalization in Federal Reserve (Fed) policy combined with an uptick in global economic momentum has seen nominal rates rise while credit spreads have tightened. Although rates have spent much of 2017 lower at tenors of greater than five years, we believe that rates could rise through the end of the year. Similarly, we do not currently forecast a meaningful uptick in the default rate. The result has credit spreads near some of their tightest levels of the cycle.
As we highlighted in a previous post, while many investors are focused on the impact that tax reform may have on U.S. corporate earnings, there may also be an equally strong positive impact on credit. If riskier borrowers pose less risk to lenders, than we believe credit spreads could continue to tighten over the next 12 to 24 months. Although a common argument by investors is that they prefer their senior position in the capital structure relative to other creditors, the fact remains that most firms that finance themselves in the loan market tend to have fairly low levels of term debt. Therefore, loan investors are often only senior to equity holders, not bondholders.
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