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Pay enough attention to the calamity in the fixed market this year and advisors will eventually find silver linings and pockets of opportunity.
Indeed, history confirms there are some corners of the fixed income market that aren't vulnerable to rising Treasury yields. Actually, some bonds excel when yields rise, which of course sounds counterintuitve, but it's true.
Many of the best-performing fixed income assets against the backdrop of rising interest rates hail from the corporate bond market, including bank loans. Bank loans, also known as leveraged or senior loans, often prove enticing when rates rise because they provide high levels of credit exposure with floating rate components tied to short-term interest rates.
Those are favorable characteristics, but none guarantee upside. Year-to-date, the S&P/LSTA U.S. Leveraged Loan 100 Index is off 0.67%, but that's far better than the Bloomberg Barclays U.S. Aggregate Bond Index. That's less bad, but clients may be able to do better with rate-hedged strategies.
Friending Rate-Hedged Funds Over Bank Loans
I recently extolled the virtues of rate-hedge funds, noting the asset class is a viable alternative to floating rate notes (FRNs), making the conversation about hedging rates vs. senior loans all the more compelling and relevant.
An important element of this discussion is that leveraged loans are junk bonds callable at par and they're usually less liquid than traditional high-yield corporate debt. Fortunately, there are rate-hedged high-yield funds advisors can access, including the ProShares High Yield—Interest Rate Hedged ETF (HYHG).
An advantage of HYHG relative to a bank loan fund is that the ProShares ETF doesn't feature callable bonds – an important point for advisors to consider because callable bonds can have limited upside potential.
“High yield interest rate hedged bond ETFs provide a unique solution for investors. They offer diversified portfolios of high yield bonds, with full exposure to credit risk as a primary source of return, and built-in hedges designed to alleviate the impact of rising rates. In addition, unlike many bank loan strategies, the FTSE High Yield (Treasury Rate-Hedged) Index (HYHG's benchmark) excludes callable bonds,” according to ProShares.
In addition to exclusion of callable bonds, which amounts to addition by subtraction, hedged high yields do shine when rates rise. During the rising rates periods spanning June 2013 through December 2020, HYHG's underlying index returned 9% while the aforementioned leveraged loan index gained just 4.73%.
More Rate-Hedged Perks
In addition to offering still tempting yields without the rate risk of traditional junk bond funds, high-yield rate-hedged ETFs can lob off enough income to guard against inflation – something that's sure to be to the liking of clients.
Of course, rate-hedged funds aren't perfect for the obvious reason that when Treasury yields decline, these products' performance will languish.
However, in the current environment with 2% 10-year yields in play, rising inflation and clients starved for income, advisors can do well by clients by reducing rate risk while upping credit exposure. Rate-hedged strategies accomplish those objectives.
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