As Interest Rates Rise, Beware of the Default Risk Trap

 | Jun 13, 2017 | 8:00 AM EDT
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Investors worried about rising interest rates should not drastically reduce their interest-rate-sensitive assets such as Treasuries or high-yield bonds, a fixed income specialist has warned.

As the Federal Reserve tightens monetary conditions, many investors believe they need to hold more floating-rate instruments. Bank loans -- also known as leveraged loans or senior secured loans -- are one such instrument.

These have grown rapidly in popularity: in the U.S., they totaled around $73 billion in 1998 and had swelled to more than $600 billion by 2013. In 2016, there were about $1.2 trillion leveraged loans outstanding in the U.S. In Europe, the market for bank loans was smaller, but it is rising rapidly as well.

These loans are generally rated below investment grade. Investors use them to diversify away from fixed-rate debt instruments, but a lot of people are probably not aware of the amount of risk they actually are taking, Gershon Distenfeld, director of cat AllianceBernstein, told Real Money in an interview.

"By worrying too much about interest-rate risk you can end up taking on a lot more credit risk, which is much more damaging," he said. "If rates move a little bit, as long as you don't sell the security you're going to get your money back at the end of the day."

"I'm not sure investors realize that two out of three issuers of these loans don't have any debt underneath them. You can call it senior, but in many cases, it's not senior to anything. So in the event of a problem, that debt is going to be on the hook as well."

Distenfeld said because investors "throw so much money at that market," companies that normally should issue debt in the high-yield bond market have opted for bank loans instead. "It's a classic case of demand creating poor supply. We saw that in the housing market a decade ago, and I think we have to be very cautious here."

Investors should look to balance credit risk and interest-rate risk by holding both high-yield debt and Treasuries, in Distenfeld's view.

"Both are still likely to have positive returns, but they will be lower than they have been over the past few years. But certainly, the cost of keeping your money in cash is still going to be too great," he said. "I think high yield is still a very good place to be relative to equity markets."

Valuations are rich in the developed world, and they are telling investors to brace for lower returns in the medium to longer term, Distenfeld said.

"Starting with 2.25% yield on the 10-year Treasury, starting with P/Es close to 20 on the U.S. equity market, starting with sub-6% yields in the high-yield market, to get 7-8-9-10% returns is pretty unlikely."

Investors might be tempted to borrow in order to try to enhance their returns or to invest in products that have leverage in them, but they should resist that temptation, Distenfeld cautioned.

"I think individual investors have to be careful that they don't stretch too much for returns when they aren't there," he warned.

With valuations in the developed world at nosebleed levels, Distenfeld likes emerging markets, where he believes both sovereign and corporate debt "can be a good idea".

"We like Brazil a lot; inflation has been coming down dramatically, real rates are still high. In local currency, Mexico debt is quite attractive," he said, adding that the Mexican peso had overreacted to the risks posed by the Trump presidency.

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