How to Get a 6% Yield and Take Advantage of Rising Rates

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Amid a historic bond sell-off, the leveraged loan industry acts as a sanctuary. With the bond market down 11% overall this year, including interest payments, leveraged loans are doing well, with a loss of 1.3% including interest.

The sector could still be a winner versus traditional fixed income, given its average yield of 7.5% and its link to rising interest rates. But he will have to overcome increasingly strong headwinds.

The strength of the sector does not come from the quality of its credit. Leveraged loans are often given to highly indebted companies with “junk” credit ratings. Banks and other financial companies make the loans, which are then sold to investors in public markets.

The main reason they are doing well is their high floating rates. Interest on loans is usually reset every three months, based on benchmarks such as the London Interbank Offered Rate. The three-month Libor was recently at 3.2%. Yields on loans right now typically add another 3 to 5.5 points, as you’ll find in securities held by Paul Massaro, longtime manager of the $4.6 billion T. Rowe Price Floating Rate fund. (ticker: PRFRX).

Yields on loans are lower than junk bonds, averaging 8.4%, but well above the investment-grade average of 3.4%, according to the Bloomberg US Aggregate Bond Index .

As the federal funds rate gradually rises, benchmarks like the Libor will adjust upwards, rapidly increasing loan yields. “As the Fed has increased this year, our base rate has increased, giving us additional compensation,” Massaro said.

Another interesting feature: loans expire faster than long-term debts. They generally mature in six or seven years, although they can be acquired on the secondary market with even shorter effective maturities. This provides a cushion against the “duration” risk of traditional fixed income securities, where longer-dated bonds fall sharply in price as market yields rise.

“Loans occupy a unique place in the fixed income landscape, with a combination of competitive yields and short duration,” says Massaro.

So what’s not to like? On the one hand, the default values. If the economy falls into recession, the floating rate sector could be crushed. So far, the default rate seems quite low, although it is on the rise. The rate was 1.3% in August, compared to 1% in July and 0.6% at the end of 2021. The average since 2007 in a non-recessive period is 1.7%. If recessions are taken into account, the overall rate rises to 2.5%.

Defaults on loans are “still very benign overall,” says Eric Rosenthal, senior director of the leveraged finance group at Fitch Ratings.

Loan investors enjoy certain protections compared to bondholders. Bank loans, which are secured by the assets of the issuer, are usually at the top of a company’s capital structure, with first lien status. In the event of bankruptcy, loan holders would be paid before holders of high-yield bonds or stocks.

Still, a long or deep recession would be a killer, as would a massive sell-off of junky assets. During the 2008 financial crisis, the Morningstar LSTA US Leveraged Loan Index fell almost 30%, although it rebounded the following year, returning 52%. More recently, in March 2020, at the start of the pandemic, this index lost 12%.

The Loan Index has shown strength lately, recovering a bit over the summer and adding price gains to the sector on top of interest.

A low cost game is the 9.3 billion dollars


iShares Floating Rate Note

exchange-traded fund (FLOT). Its total return is roughly stable this year. The ETF has a 30-day SEC yield of 2.7% and an expense ratio of 0.15%.

Paul Olmsted, a research analyst at Morningstar who covers fixed income strategies, prefers actively managed funds to index funds. Thorough credit research can pay off in a climate of rising default rates, he says. “You can’t avoid flaws, but you can minimize them. That’s what you pay with active management.

Both T. Rowe Price and Eaton Vance have a lot of experience in the field, he observes. He recommends the T. Rowe Price Floating Rate, which is down 1.5% this year. It earns 5.8% and ranks in the top 10% of its Morningstar peer group year-to-date. And its 10-year annualized return of 3.25% puts it in the first quarter of this period.

Massaro says he’s not so worried about rising defaults, pointing out that many companies in the lending universe refinanced debt when rates were lower and pushed out debt maturities.

As of July 31, the fund was biased towards financial companies, airlines, healthcare and broadcasting companies.

One of its major holdings is HUB International, a private insurance brokerage firm. The loan held by the fund matures in 2025 and bears a coupon of 5.95%. Given the price of the loan, its yield to maturity is 7.4%. The insurance brokerage industry has “been very resilient through many different economic cycles,” says Massaro.

The fund chief also likes some loans in the software sector, including holdings like Epicor Software. Its loan, maturing in 2027, has a yield to maturity of 7.25%.

Another option is the $7.8 billion


Eaton Vance Advantage Variable Rate

fund (EIFAX), which recently had a payout ratio of 6.6%. It has underperformed this year, but its 10-year annualized return of 3.9% ranks in the top 2% of its peers.

The performance of these funds hinges on whether the US avoids a recession as the Fed raises rates to fight inflation. If defaults don’t increase much while rates continue to rise, bank loans should continue to be near the top of the class among bond categories.

Loan prices “could come down and be cheaper,” says Andrew Sveen, head of variable rate loans at Eaton Vance, but “their intrinsic value is significantly higher than they are now.”

Write to Lawrence C. Strauss at lawrence.strauss@barrons.com

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