Rising Interest Rates Can Wreak Havoc on Fixed Income Portfolios
We have been spoiled by the long bull market in U.S. Treasuries, which has driven interest rates lower and facilitated outsized gains in equities and other risk assets. At some point, the party will end and rates will move higher. Advisors must understand the inherent risks, and proactively evaluate alternatives for their fixed income portfolios to manage through successfully.
Rising interest rates can wreak havoc on a client’s fixed income portfolios. Do not be lulled into complacency as the wave of persistently declining rates has allowed any long-only fixed income fund – the blander the better – to generate enviable returns over the last several years.
In fact, the risk inherent in portfolios indexed to the Bloomberg Barclays Aggregate Fixed Income Index (the “AGG”) and the US Investment Grade Bond Index (“IG”) are at the highest level in recent memory. The duration of the AGG is 6, and the IG Index is 8.7. A simple mathematical example of a 1% rise in the 10-year Treasury would cause an approximately 6% decline in the AGG and an 8.7% decline in the IG Index, all things equal. This would be a shocking outcome for people who perceive these asset classes to be low-risk. Ordinarily, IG spreads would tighten to partially compensate for the move higher in rates, but spreads are so compressed already, it seems hard to imagine they can go much tighter from here.
Some investors have taken notice and begun to make changes. One of the popular trades has been selling fixed rate debt (IG or High Yield) and buying leveraged loans or funds that invest in such loans. The logic is that loans are floating rate products rather than fixed, and also that because loans were out-of-favor while rates were trending lower, that they are cheaper on a relative-value basis.
Inflows into bank loan funds so far in 2021 are $2.7 billion, or 3% of AUM in the asset class, which is on track for the highest amount since May 2018. New CLO formation in January, according to CSFB, has already been $5.3 billion from 11 deals, a sharp increase over 2020’s $1.95 billion across only 4 deals.
When the loan market sees large inflows, borrowers take advantage and re-price their loans lower, limiting future yields. Unlike loans which typically offer little or no call protection, fixed rate High Yield bonds would benefit from an anticipated rise in rates as companies would look to lock-in lower rates and would have to pay call premiums to refinance. Due to the increasing prevalence of loan-only capital structures, the amount of leverage through these loans is higher.