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Mispricing of Interest Rate Risk Adds to Bank Loan Sector’s Yield Appeal

01/04/2013

In our view, interest rate risk deserves as much attention as credit risk when investing in fixed income markets. Investor demand for yield and, in the case of investment grade corporate bonds and Treasuries, “safety” has driven bond prices to all-time highs and yields to corresponding lows.

At current levels, interest rate sensitivity is magnified, especially in higher quality bonds. This trend is of concern as investors may unwittingly be opening themselves up to significant future losses. When rates rise, bond prices fall, and when rates fall, prices rise. A bond’s interest rate sensitivity is measured by its duration, expressed as a number of years. The longer a bond’s duration, the greater the impact a rate change will have on the bond’s price.

As shown, a 1% interest rate increase would significantly diminish the returns of both investment grade and high yield corporate bonds. For example, a portfolio of investment grade bonds currently yielding 2.71% would lose 7.18%, giving up 2.65 years of return.

Average Price

Current Yield

Duration

Price Impact of 1% Rate Increase

Impact on Return in Years

Barclays Capital U.S. Corporate High Yield Index

$104.62

6.13%

4.12

-4.12%

0.67

Barclays Capital U.S. Corporate Investment Grade Index

$113.72

2.71%

7.18

-7.18%

2.65

Barclays Capital U.S. Aggregate Bond Index

$109.13

1.74%

5.06

-5.06%

2.91

Barclays Capital U.S. Treasury Index

$107.33

0.86%

 

5.43

 

 

-5.43%

 

6.31

Source: Barclays Live, as of 12/31/12.

Past performance is no guarantee of future results.

Floating rate bank loans are a way for investors to hedge against interest rate risk. Bank loans offer attractive yields, currently about 6.13% (Barclays Capital U.S. High Yield Loan Index, as of 12/31/12). They also carry minimal interest rate risk as their rates “float” up and down and are reset every 30-90 days tied to a base rate, such as the LIBOR rate. Finally, bank loans are senior and secured by all of the borrower’s assets, including receivables, inventory, tangible fixed assets such as property and equipment, intangible assets such as trademarks, and any interests in subsidiaries. This credit protection advantage is typically not found in the high yield sector, which makes bank loans an especially compelling fixed income portfolio diversifier at this time.

Barclays Capital U.S. Corporate High Yield Index is a market value-weighted index that tracks the daily price-only, coupon, and total return performance of non-investment grade, fixed-rate, publicly placed, dollar-denominated, and non-convertible debt. Barclays Capital U.S. Corporate Investment Grade Index represents investment grade within the Barclays Capital U.S. Aggregate Bond Index. Barclays Capital U.S. Aggregate Bond Index measures the U.S. investment grade fixed rate bond market. Barclays Capital U.S. Treasury Index includes public obligations of the U.S. Treasury that have remaining maturities of one year or more. Barclays Capital U.S. High Yield Loan Index provides broad and comprehensive total return metrics of the universe of U.S. dollar denominated syndicated term loans. The indexes are calculated on a total return basis, unmanaged , and not available for direct investment.

 

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.