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Considering High-Yield Bank Loans? Proceed With Caution

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When the market starts buzzing about rising rates, high-yield bank loans’ popularity grows. Although the bank loan bandwagon may look tempting, we’ve found reasons why high-yield bonds shouldn’t be so easily dismissed.

Investors are constantly on the hunt for higher yields, especially in the sustained low-yield environment of the past several years. When the US Federal Reserve announces a rate hike—or even hints at the possibility—many investors look to high-yield bank loans for extra income. But loans are not so cut and dried.

Don’t Judge a Book by Its Cover

Here are some oft-cited bank loan benefits and why we think high-yield bonds are a better alternative—even when rates rise.

Floating Rates. Bank loans’ floating-rate coupons are a big draw, and may even appear to give loans a leg up on traditional high-yield bonds. One often-overlooked point is how much the Fed would need to raise interest rates for investors to benefit when the rates adjust, or “float.”

Following the global financial crisis, when interest rates landed near zero, investors started demanding more compensation for the risk they took on with high-yield bank loans. As a result, most bank loans are now issued with a “floor,” or a minimum rate of return that investors receive above the benchmark rate.

Here’s the rub: investors only benefit when the loan’s floating rate rises above the floor.

Also, LIBOR doesn’t necessarily move in lockstep with the Fed. LIBOR trades with a spread to the federal funds rate, and if that spread compresses, it could keep LIBOR from rising significantly for some time—even if the Fed continues to raise rates.

Performance. Bonds have shown resiliency in the past several years, outperforming bank loans for the past eight years, with one exception—2015, when all high-yield sectors took a hit. Bonds stood their ground in some tough years, too: in 2008 during the credit crisis; in 2013 during the “taper tantrum,” when 10-year Treasuries skyrocketed by 160 basis points and spreads compressed; and in 2014 when oil fell, and bonds still beat loans despite having more exposure to the energy sector (Display).

So far this year, bonds have maintained the lead. And short-duration high-yield bonds, with their reduced risk and solid returns, have kept pace too, beating high-yield bank loans in most years.

Duration vs. Credit Conditions. Investors often tout bank loans’ lower duration as an advantage over high-yield bonds. While duration is used to gauge interest-rate sensitivity—the longer a bond’s duration (measured in years), the more its price will drop in a rising-rate environment—rising rates are not necessarily a negative for high-yield bonds.

In fact, high-yield bonds have historically had stronger absolute returns in rising-rate environments. The reason? Rising rates are offset by narrowing credit spreads, which tend to accompany improving credit conditions.

And, while investors may see a higher LIBOR rate as a reason to throw money at bank loans, a better credit scenario means the credit spreads on the loans—which are a far greater component of the overall yield than LIBOR is—are narrowing. Companies are often able to refinance their loans at lower rates—defeating the whole idea of coupons floating up with higher LIBOR. In fact, we’ve already seen a significant increase in high-yield bank loan refinancing in the past three months.

This means that issuing companies can and do call their loans at par at any time, at the expense of bank loan investors.

Staying on Course

Owning traditional high-yield bonds isn’t for everyone. Some investors may instead prefer the smoother path of short-duration high-yield bonds, which offer less risk and strong returns versus bank loans—and, as seen in 2008, often less downside than loans. It’s important to note that diligent credit selection is important—bonds rated CCC or below should generally be avoided.

Moderation is key, and investing in high-yield bank loans within a well-diversified fixed-income portfolio can make sense for some investors. But jumping into bank loans before taking the time to look at the bigger picture in high yield could have unwanted effects on a portfolio, no matter which direction rates are headed.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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