Expectations for rising rates are taking hold globally as policymakers react to a synchronized and sustained global expansion and abandon emergency levels of policy accommodation. Rising rates boost the appeal of floating rate assets, which have a built-in hedge against monetary tightening.
Our approach to floating rate assets is best captured by Muhammad Ali’s famous quote: “Float like a butterfly, sting like a bee.” In a floating rate context, this means staying nimble to avoid being stung, as we write in our Fixed income strategy piece Float like a Butterfly.
Floating rate securities pass on rate rises in the form of higher coupons, and alternatives for investors to manage rising rates have increased. It is critical to distinguish between different types of floating rate debt. The expanded menu of floating rate options today spans an array of income and risk, as the chart below shows.
The U.S. Treasury began issuing short-maturity floating rate notes in 2014 to diversify its cash funding needs. These bonds sport two-year fixed maturities and quarterly coupon resets. Short-term debt is not floating rate but can fit the bill by rolling over maturing debts at new yield levels. Indeed, short-duration bonds have posted positive returns even amid rising short-term U.S. rates.
Floating rate bank loans occupy the other end of the risk spectrum. They have the highest yields, as evident in the chart above, though their higher income potential comes with greater credit risk. Yields have narrowed across the risk continuum over the past year, a trend we see as unsustainable in the medium term. The narrowing, also evident in the chart, reflects increases in the Federal Reserve’s rate path and investors’ pursuit of higher yields.
Taking on bank loan risk has been rewarded, as seen in the recent spread compression illustrated in the chart. And just 1.6% of U.S. bank loan issuers defaulted in the 12 months through June, after a spike to 4% last year due to commodity- and energy-related defaults, Moody’s data as of July show. Low rates, refinancing and economic growth supporting company cash flows are helping issuers maintain solid interest coverage ratios—even as many have become more leveraged. Bank loans feature stronger recovery rates than high yield bonds in the event of default; recent experience bears this out. Past performance is no guarantee of future results.
We do, however, see some challenges, including tight valuations and declining investor protections. There’s an apparent structural shift away from the use of covenants that historically served to mitigate credit risk. A lack of covenant protections along with thinner subordinated debt cushions could mean significantly lower recovery values (and higher losses) in the next down cycle
The evolution of risks and rewards in the loan market means investors need to be even more selective in managing a bank loan portfolio, we believe. Given elevated valuations relative to the risks, we see this credit sector as fully valued. We see selected opportunities but our stance is defensive. Overall, we see better value in equity exposures and prefer an up-in-quality stance in corporate credit. In high yield we prefer bonds over loans. And we see selected opportunities in emerging market debt. Read more market insights in our latest Fixed income strategy.
Learn more about how consistent investment performance and low fees are critical to achieving your fixed income goals in today’s environment.
Listen to Richard Turnill and Jeff Rosenberg talk about BlackRock’s midyear investment outlook on the inaugural episode of our podcast, The Bid.