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Bank loans instead of high-yield bonds as rates rise?

By Xavier Brenner

bank-loans-yield

After rising sharply in 2013, yields on the 10-year Treasury note have paused at 3% following a weak December jobs report, but the long-term trend for interest rates still looks to be higher.

Rising interest rates are a potential problem for fixed-income investors, since bond prices and yields move in opposite directions.

That's one reason why some investors trying to earn extra income have recently been favoring bank loans instead of high-yield corporate bonds. Bank loans have decent yields but are structured as floating-rate securities with durations near zero, so they provide some protection against rising rates. Like high-yield bonds, bank loans are issued by companies with credit ratings below investment grade.

There are also concerns that high-yield corporate bonds may be overvalued with so many investors stretching for income in a low-rate environment. For example, Bespoke Investment Group recently took at look at the high-yield credit markets. The demand for high-yield bonds has pushed the yield spread between junk bonds and Treasuries of similar maturity to a six-year low.

The narrow spread means investors aren't getting paid much for taking on the higher credit risk of high-yield bonds relative to Treasuries.

high-yield-bonds-2

Chart source: Bespoke Investment Group

Fear of rising interest rates and a high-yield bond market that could be overvalued are a couple reasons why some investors are looking at bank loan funds and ETFs.

These funds typically buy speculative-grade loans used to finance buyouts. Again, since their rates are usually variable and the underlying debt is sometimes short in duration, the loans are less vulnerable to increases in interest rates. And they usually offer better yields than high-quality bonds.

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