Investors searching for income often find it in the below-investment grade credit space. The challenge for advisers becomes, "Where do I put my clients' junk bond dollars to work?" When it comes to investing in below-investment grade credit, a bit of rivalry exists between high-yield bond and bank-loan investors.
Those backing the bank-loan horse will tell you that loans are senior in the capital structure, are secured by assets (much of the high-yield market is unsecured), and have almost no duration. They will tell you that their coupons increase with interest rates, allowing them to benefit from rising rates – which is counter to the conventional bond wisdom. They will most certainly show you that bank loans exhibit less volatility than high yield bonds. And, they would be correct.
Those who prefer high yield bonds will quickly point out that loans have negative convexity, are less liquid and generally offer less total-return potential than bonds. It would be difficult to poke holes in the high-yield bond argument. They, too, are correct.
(More: The history of bonds — at least since yields hit record lows last year.)
From a flow perspective, it appears that investors prefer bank loans when they believe interest rate hikes are likely. During the first half of the year, as rhetoric surrounding the Fed raising rates became more prevalent, investors flocked into bank-loan funds to take advantage of the floating-rate feature of the asset class. More recently, inflows into loans subsided and even turned negative, perhaps as there was a perception of a more measured pace of interest-rate hikes than originally anticipated.
PAIRING RATIONALE
For advisers looking to reduce investor exposure to loans, or for those simply trying to determine how to most efficiently play the below-investment-grade space, we have an idea for you: Pair short-duration high-yield with bank loans.
Short-duration high-yield is a subset of the overall high-yield market, and is characterized by shorter maturities and a bit higher credit quality (the index excludes CCC bonds). The appeal of short-duration high-yield is that it is a less risky, lower-volatility segment of the high-yield market that has historically underperformed the broader high-yield market during rallies, and outperformed during periods of spread widening.
Let's look at the rationale for the pairing.
First, by investing in both asset classes, an investor gets exposure to a diversified set of credits. The number of companies issuing both bonds and loans has decreased, leading to more unique constituents in each asset class.
Second, they tend to have different risk/return profiles. It is reasonable to expect traditional high yield to offer the greatest yield, as it carries the most risk. Similarly, an investor can expect bank loans to offer the least compensation due to the investment's relatively senior position in the capital structure. Short-duration high-yield falls somewhere in the middle, and while it outperformed bank loans in 11 of the last 15 calendar years, those excess returns were generated with 40% more volatility.
PORTFOLIO CONTEXT
Finally, when viewing the asset classes in a portfolio context, there is a case to be made for constructing a portfolio using both bank loans and short-duration high-yield. Over the last 15 years, a portfolio made up of 60% core bonds and 40% bank loans had a greater return with the same level of risk (measured by standard deviation) as a 100% core bond portfolio.
Taking it a step further, by adding short-duration high-yield to the portfolio (as represented by the Bank of America Merrill Lynch C Pay BB-B 1-5 Year index), for the same level of risk, the portfolio would have earned even greater returns.
(More: With yields low and interest rates headed up, what kind of bonds do advisers buy?)
For bank loan investors looking for the potential for diversification and enhanced total returns, but wary of putting money into high yield because of tight spreads, short-duration high-yield may be a suitable complement to a bank-loan allocation. While both asset classes invest in credits rated below investment grade, they may be more different than they are alike, and with investing, that is very often a good thing.
Adam Schrier is a portfolio strategist for MainStay Investments, a division of New York Life Investment Management.
