Worried about a bond bubble? Try this hedge to take the edge off

Talk of a bond bubble has put skittish investors and financial advisers even more on edge over their large allocations to fixed income. And for good reason: Interest rates, currently at historic lows of near zero, will eventually start climbing, thus driving down the value of their fixed-income investments with low-yielding fixed rates.

To avoid such a scenario, advisers should consider ditching some of their fixed-rate bonds for senior floating-rate bank loans before rates start to rise. These types of bonds, which investors can gain exposure to through mutual funds, offer a smooth and profitable ride through a rising-rate environment because the adjustable yields generally move in sync with interest rates.

Senior floating-rate bank loans are short-term loans made to below-investment-grade companies — the same kind of firms that issue high-yield bonds because they don’t have the same access to capital as investment-grade companies.

The interest rates on these loans are pegged to the London Interbank Offered Rate, which is set by the market based on lending between banking institutions. The rates also include a risk premium, but it is the connection to Libor which makes these loans such an appealing investment strategy.

Here is why: Unlike the predetermined interest rate of a fixed-rate bond, the yield on a floating-rate bank loan resets every 30 to 180 days, with an average reset period of 45 days. That yield keeps pace with rising interest rates because of a strong correlation — 0.97, or almost full correlation — between Libor and the interest rate set by the Federal Reserve.

It is important, however, to get on board before interest rates begin to climb, because Libor will often move on the market’s expectations of action by the Fed. For example, in February, the three-month Libor was 0.25%, but it has since climbed to 0.54%, based on the market’s anticipation of a looming tightening of the money supply.

On rare occasions, the Libor will also move as the result of extreme macroeconomic situations, such as the bankruptcy declaration by Lehman Brothers Holdings Inc. in October 2008. At that time, the three-month Libor spiked to 4.8%, from 2.8% a month earlier; by December of that same year, the rate had settled back down to 1.4%.

For investors who are looking to gain exposure to these bonds, the best option is through a mutual fund that specializes in the asset class. Some examples are the ING Senior Income Fund Ticker:(XSIAX), MainStay Floating Rate Fund Ticker:(MXFAX) and Virtus Floating Rate Fund Ticker:(PSFRX).

“The strategy is a natural hedge against rising interest rates,” said Robert Dial, who manages the $900 million MainStay fund, part of the fixed-income group at New York Life Investments, which manages $263 billion.

A key component to the strategy is loan selection, according to Mr. Dial, who has started to overweight exposure to double-B-rated loans and underweight the lower-quality triple-C-rated loans. He has also added some high-yield-bond exposure to help boost portfolio performance.

“Within the asset class, we’ve placed greater importance on credit positioning,” Mr. Dial said. “We are first and foremost credit people.”

Balancing credit quality is part of the risk-reward dynamic that portfolio managers are navigating.

Most of the floating-rate loans used in this strategy are secured, making them senior to anything else on a company’s capital structure. But it is important to remember that the loans are still below investment-grade.

Some 39 mutual funds in the Morningstar Inc. database fit the general definition of floating-rate-bond funds. Of those, a third have been launched since the Fed’s last rate hike cycle, in 2006.

“We wanted to build a track record before the interest rate cycle turned,” said Kyle Jennings, co-manager of the $144 million Virtus Senior Floating Rate Fund.

Virtus Investment Partners, a $25 billion asset management company, launched the fund in February.

LACK OF CORRELATION

Although most market watchers don’t expect the Fed to raise rates until later this year, owning senior floating-rate bank loans has proven to be an effective means of capturing non-correlated performance.

Last year, for example, when the S&P 500 gained 26%, floating-rate loans as a broad category gained 44.9%.

This lack of correlation is further illustrated through a 10-year matrix comparing the performance of floating-rate loans with that of municipal bonds, corporate bonds, government bonds, high-yield bonds and large-cap stocks. For the 10-year period through 2009, the highest correlation was to high-yield bonds (0.78), followed by large-cap stocks (0.47), corporate bonds (0.29), municipal bonds (0.28) and government bonds (-0.36).

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].