Quick Thoughts: Defensive on the Curve
To gain insights on investing in fixed income in a rising-rate environment, I sat down with Walter Kilcullen, Head of US High Yield for Western Asset Management, and Reema Agarwal, Head of Floating Rate Debt for Franklin Templeton Fixed Income. Here are some highlights of our conversation.
With the characteristics of low duration, lower volatility, and higher income versus other fixed income asset classes, we believe a mix of short-term high yield and floating rate debt may provide investors some level of defense in a rising interest-rate environment.
- The short-term high yield and floating rate loan markets may provide opportunities as interest rates rise. These asset classes are buoyed by relatively low default rates, mid- to late-cycle economic growth and strong inflows.
- The composition of the high yield market has moved toward higher credit quality with opportunities for ratings upgrades. Higher-rated BB debt was 36% of the total US market in 2007 and has increased to 53% today.1 This is partially due to the “fallen angels” effect where higher-quality companies saw their ratings decline after various crises and become “rising stars” during recoveries. Lower default rates have also been a factor, currently at about 1% versus a historical average of 4.5%. An additional indication of improving credit quality is that approximately 70% of new issuance is being used to retire existing debt.2
- Floating rate loans (bank loans) provide investors higher income as interest rates rise. The yields on these instruments are pegged to short-term rates, creating a very low duration. This had led to strong inflows, coupled with default rates near 0.3% versus 3.5% on average and bank loans being secured at the top of the capital structure.3
- Beware of individual company default risk to maximize returns and minimize risk. The dynamics of the floating rate market create opportunities to participate in the positive aspects of the asset class through careful security selection. For the high-yield market, we believe volatility like we’ve seen in the early part of 2022 provides opportunity, as the attractive fundamental aspects of the underlying securities don’t generally fluctuate so quickly.
What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Floating-rate loans and debt securities tend to be rated below investment grade. Investing in higher-yielding, lower-rated, floating-rate loans and debt securities involves greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy. Interest earned on floating-rate loans varies with changes in prevailing interest rates. Therefore, while floating-rate loans offer higher interest income when interest rates rise, they will also generate less income when interest rates decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value.