No Need to Flee Fixed Income as Interest Rates Rise

Research from Highland Capital Management indicates retirement plan sponsors may consider more shifts within their fixed-income portfolio, from fixed-rate to floating-rate assets.

Bank loans are a part of the capital markets most people refer to as leveraged finance, which includes both high-yield bonds and bank loans. Mark Okada, chief investment officer at Highland Capital Management in Dallas, Texas, told PLANSPONSOR pension plans have been involved in the leveraged loan space for a long time, but we are hearing about them more now because of what is happening with interest rates. “For the last 20 years, interest rates have almost only come down, but now that is changing,” he said.

Bank loans do not have any interest rate risk, since they are floating-rate assets, Okada added. “The study shows bank loans did not hurt fixed-income portfolios in periods of falling interest rates, but in periods where rates actually rose, it was dramatic how bank loans actually helped,” he said.

Highland Capital conducted an in-depth study of bank loans in a broadly diversified portfolio by testing two specific asset allocation models—a 100% fixed-income portfolio and a 60/40 equity/fixed-income portfolio. According to the study, over the past 20 years, 10-year Treasuries have gradually declined by approximately 400 basis points (6.69%, January 1992 to 2.58%, July 2013) to hit the recent all-time lows. “With fixed income asset classes, one would have expected declining interest rates to favor high-yield and investment-grade bonds. Instead, bank loans did not meaningfully impact from the risk and return of the 60/40 equity/fixed-income portfolio; it also added meaningful value to the 100% fixed-income portfolio,” the study said.

The study explained that bank loans that have a high historical correlation with high-yield bonds; however, bank loans are significantly less correlated with equity and investment-grade bonds. Lower correlations typically mean that a portfolio with bank loans will experience greater diversification benefit (e.g., reduced volatility) than a similar portfolio without bank loans.

Bank loans are also less volatile than high-yield bonds for several reasons. Relative to high-yield bonds, they are more senior in the capital structure, experience lower defaults and have higher recoveries. Also, 58% of outstanding institutional bank loans are currently owned by Collateralized Loan Obligations (CLOs).

Highland Capital performed the same optimal allocation testing on both portfolios for rising rate periods to understand their performance and gain some insights into how the portfolios would hold over the next 20 years. It found the optimal portfolio allocated nearly 100% of the fixed income to bank loans. Generally, the more bank loans investors had in their portfolios during the rising rate periods, the better the performance of their portfolios.

“Over the next 20 years, rates are going back up. Pension plan sponsors are long-term investors, so analyzing the horizon, this will hurt them a lot going forward,” Okada said. “In periods of rising interest rates, bank loans are positive to both types of portfolios, and that is the environment we are entering now, so the investments should be considered.”

Okada added, “Bank loans are gaining a lot of tractions with investors. We are having increasing dialogues in the space, and we expect more activity as interest rates rise.”

The study report, “Bank Loans: A 20 Year Retrospective,” can be found at  https://www.hcmlp.com/News-and-Views/Whitepapers.