The prospect of multiple rate hikes has roiled the stock and bond markets, making the first quarter of 2022 one of the worst quarters for fixed income in decades. Retirement savers and retirees alike have had a difficult time looking for low-risk investments that still offer decent returns.
Experts believe that inflation will remain high throughout the year, and rising Treasury yields have devastated bond prices. As a result, investment research firm Morningstar says that investors should focus on protecting their portfolios from the pressure of rising rates. And one of the sure-fire solutions for reducing that risk is to capitalize on bank-loan funds. Here’s why.
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Morningstar Recommends Bank-Loan Funds for Reducing Interest-Rate Risk
The biggest concerns for fixed-income investors are inflation and rising interest rates. Just like it reduces the power of your dollar at the grocery store, inflation can eat away at the value of a fixed-income asset. Interest rates, too, have an inverse relationship with the price of assets such as bonds. Together, they can sweep value straight from a fixed-income portfolio.
Given that the Federal Reserve has indicated that it will aggressively raise interest rates throughout the year to combat high inflation, Morningstar recommends that fixed-income investors position themselves more defensively for the time being. Specifically, the investment firm says to focus on reducing interest-rate risk by buying into bank loans.
Bank loans offer attractive value for fixed-income investors, since the coupons usually have floating interest rates, resetting regularly in response to market rate fluctuations every one to three months. This feature substantially reduces their sensitivity to interest-rate risk, unlike bonds, which suffer in value as interest rates rise.
Many investors have already flocked to bank-loan funds since the year began. Morningstar notes that bank-loan mutual fund and exchange-traded fund inflows have jumped 8.2% over the first quarter of 2022, pulling in nearly $9.6 billion in only four months.
What Investors Need to Know
Although bank-loan funds do slash exposure risk to rising interest rates, the unique characteristics of bank loans carry other risks. As bank loans are essentially private loans taken out by companies from banks and other lenders, the loans often carry credit ratings below investment grade. The extra yield offered for bank loans compensates investors for their credit risk.
Many bank loans enjoy a senior status in their issuers’ capital structure, improving the loans’ recovery rate in event of a default, but the creditworthiness of these loans is highly variable. Furthermore, many newer bank loans are issued with few protections to protect lenders, since loose lending in recent years have made the supply side of the market quite competitive. Again, these loans may offer temptingly high yields as compensation for greater credit risk.
Lastly, investors need to be aware of liquidity risk in the bank-loan market. These loans trade over the counter–that is, outside of any securities exchange–and tend to be traded far less frequently than stocks. The settlement process can also be manual, typically taking between a week and half a month on average.
All that said, Morningstar Associate Manager Research Analyst Lan Anh Tran argues that bank-loan funds run by active managers “can leverage sound credit research to…pounce on opportunities or flee from problematic loans.”
Morningstar data from the past ten years indicates that active funds such as the T. Rowe Floating Rate Fund and Eaton Vance Floating Rate Fund have performed up to eight times better than the U.S. Bank Loan category average, but default rates range widely depending on the experience level of the team. For example, the T. Rowe Price Floating Rate Fund has a trailing-12-month yield of 3.88% and enjoyed a mere 0.1% default rate, whereas the S&P/LSTA Leveraged Loan Index returned 3.25% with a 2% default rate.
Expense ratios for these actively-managed funds also run from 0.7-1%, so fixed-income investors should make sure to research well or consult an expert before jumping in.
Bottom Line
Investment research firm Morningstar recommends that fixed-income investors focus on reducing interest-rate risk as the Fed kicks off a series of aggressive rate hikes. Bank-loan funds may offer comparatively high yields for interested investors. However, given the unique risks of bank loans, it may be best to focus on actively-managed funds since these may offer a better default profile relative to their yields.
Retirement Planning Tips
- Not sure if investing in bank-loan funds will help you create a low-risk portfolio for retirement? For a solid, long-term financial plan, consider speaking with a qualified financial advisor. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Use SmartAsset’s free retirement calculator to get a good first estimate of how much money you’ll need to retire.
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