Bear Mountain Capital Inc.

The Fed, Rising Rates and Senior Bank Loans?

| September 18, 2013

Economy | Portfolio Management

In the media there is a lot of talk about the Federal Reserve Board (“the Fed”) and its chairman, Ben Bernanke. The Fed is often charged with managing the country’s monetary policy. Monetary policy helps manage the amount of actual money in the financial system and helps establish interest rates for US borrowers. Currently, the Fed is taking extraordinary steps to keep interest rates low in order to help facilitate a tepid economic recovery since the 2008 credit crisis.

However, the Fed is signaling it will begin to limit its activity, which would result in higher long-term rates. Currently, rates are at historical lows and have been for a number of years. This created a significant problem for bond investors who need or rely on interest income.

What can a bond investor do in this low-interest rate environment to boost income? Many investors over the last several years have done the following:
* Increased the average maturity (or duration) of their bond portfolio. Generally, the longer a bond has until maturity the higher its coupon payment (more income).
* Increased their exposure to high-yield bonds (also known as junk bonds). This increases the credit risk of a bond portfolio, but does provide higher income.

In both cases an investor receives more income. However, for that income they may pay a steep price: if interest rates rise, prices of these bonds, as described above, drop in value. Given where rates are today, this is the scenario most likely to play out over the years ahead. To be sure, most bond investors are not prepared for this level of volatility.

Income producing investment options for these investors are limited, but do exist. One option is the use of senior floating rate loans, also known as senior bank loans. Senior floating rate loans have the following unique characteristics:
* Near zero duration – meaning as interest rates rise, the price of the bonds remain stable. This result is very low interest rate sensitivity.
* Senior in the capital structure – issuers of these notes must pay off these loans prior to paying off more “junior” creditors. This helps ensure collateral is available to pay off the holders of senior bank loans prior to paying back other bond holders.
* Higher income than investment grade bonds – generally issuers of senior floating rate loans are non-investment grade companies who need access to the credit markets. The result is these issuers must pay a higher yield for investors to take on the additional credit risk.
* Historically low default rates – the non-investment grade status of these issuers results in a greater amount of default risk. However, the historical default rate over the last 20 years has been about 3%, a relatively low number.
* High recapture rate for defaulted bonds – for the 3% of senior bank loan issuers that have defaulted, the recapture of value of these loans is upwards of 70%. The net result is lower overall risk to diversified senior floating rate loan portfolio’s principal.

There are other advantages to senior floating-rate loans, such as a historically negative correlation with US treasuries and modest relative performance in decreasing rate environments. Exposure to this asset class should be taken into consideration as part of a larger bond portfolio and may not be appropriate for everyone. While economic fundamentals continue to improve, credit risk (read: default risk) is an issue when it comes to owning these types of bonds. In addition, during times of crisis and panic, bonds of this nature will tend to experience more volatility then higher-quality investment grade bonds.

Overall, an appropriate allocation of senior floating-rate loans can provide higher income, while simultaneously limiting exposure to interest-rate risk. In addition, the combination of these characteristics can provide additional diversification for a properly constructed portfolio.