Schwab Bond Insights: Bank-Loan Funds, Green Bonds
- As we get closer to the first rake hike, we expect the yield curve to flatten, as short- and intermediate-term yields move higher than long-term bond yields.
- While bank-loan funds have made headlines due to their positive total returns, secured status and floating coupon rates, they are vulnerable to defaults and a lack of liquidity.
- Green bonds offer investors the ability to receive tax-advantaged income while also investing in a socially conscious way.
The timing of the Federal Reserve’s first interest rate hike since 2006 continues to dominate market headlines. While we believe the second half of the year is the most likely timing, recent economic data, specifically the strong employment report, has brought market expectations forward a bit. The U.S. economy added 257,000 jobs in January, bringing the three-month total of new jobs to more than 1 million.
Although we are getting closer to the Fed’s liftoff date, that doesn’t mean we suddenly expect all bond yields to move higher in unison.
We do think short- and intermediate-term bond yields will rise as we get closer to the first rate hike. However, we continue to see plenty of factors that can prevent long-term Treasury yields from moving much higher—including the higher yields that they offer relative to other international developed market government bonds. The roughly 2% yield of the 10-year Treasury bond may not appear attractive on an absolute basis, but it’s well above the 0.35% yield that a 10-year German government bond offers. We think that should keep foreign investor demand high.
As we get closer to the first rake hike, we expect the yield curve to flatten, as short- and intermediate-term yields move higher than long-term bond yields. However, we think that when the Fed does begin to raise rates, the pace and magnitude of the hikes will likely be below that of previous cycles, so investors expecting much higher bond yields may need to temper expectations.
Bank loans are a type of corporate debt that, like traditional corporate bonds, have a set maturity date and pay interest. Unlike traditional corporate bonds, they can generally be prepaid at the issuer's discretion. They are generally issued to large institutional investors, so for individual investors, the preferred way to invest is usually through a mutual fund or an exchange-traded fund (ETF).
Total returns on bank-loan funds have been positive since 2009, making them a popular investment option in the current low yield environment. However, in 2014, bank loans—as measured by the Barclays U.S. High Yield Loans Index—only generated a total return of 1.5%, underperforming more conservative investments like U.S. Treasuries and investment-grade corporate bonds.1
Bank loans' secured nature and floating coupon rates also generally catch investors' attention. While those may be positive attributes for investors, we think the details made available to investors are often limited, and the risks underestimated. Below, we discuss how bank loans work and take a deeper look at some of their risks.
"Secured" doesn't always mean safe
Bank loans are backed ("secured") by a pledge of the issuer's assets, such as inventories or receivables. They are senior to most other corporate debt, meaning that in a default, they would get paid before the issuer's other corporate bonds. Their senior status generally leads to a higher recovery rate, which is the amount a bondholder ultimately receives when an issuer defaults on its debt.
However, we think the "secured" nature of bank loans can give investors a false sense of security. If a bank loan has a sub-investment grade rating, that's typically because the issuing company has a poor credit profile, meaning the investment still has a heightened risk of default. Despite the collateral backing them, bank loans can—and often do—default. The default rate of bank loans tends to follow the trend of sub-investment grade bonds, although it's usually a bit lower.
Despite their secured status, bank loans can still default
Source: Moody's Monthly Default Report December 2014. Trailing 12-month speculative-grade default rate. The cumulative default rate calculation methodology used by Moody's is a discrete-time approximation of the nonparametric continuous-time hazard rate approach. A pool of issuers, called a cohort, is formed on the basis of the rating held on a given calendar date (or set of dates), and the default/survival status of the members of the cohort is tracked over some stated time horizon, which in this instance is 12 months. Default rates include only bonds rated by Moody's.
Coupons are tied to short-term interest rates
Bank loans have floating coupon rates, meaning their coupons consist of a fluctuating reference rate, plus a spread, which is usually set at a fixed amount. The reference rate is usually a short-term benchmark interest rate like the three-month London Interbank Offered Rate (LIBOR). Three-month LIBOR is highly correlated to the fed funds rate.
Many investors have the misconception that investments with floating coupon rates, like bank loans, perform well when all interest rates rise, but that’s not the case. The only rate that matters for bank loans is the benchmark rate. While most U.S. Treasury yields have fluctuated over the past few years, the three-month LIBOR has barely budged. In fact, it’s held in a tight range between 0.22% and 0.31% since the beginning of 2013.
Also, most bank loans have what’s known as a LIBOR "floor," meaning the reference rate will never be set below that floor, regardless of what yield LIBOR offers. For example, let’s assume that the coupon on a bank loan is made up of a three-month LIBOR plus a spread of 4%, with a LIBOR floor of 1%. Even if LIBOR was as low as 0.25%, the coupon would still be 5%—the sum of the 1% floor and the 4% spread.
So if you're looking to invest in bank loans based on the hope that the coupon rises, what matters is your outlook for short-term interest rates. We still think the Federal Reserve will implement its first rate hike sometime in the second half of 2015. With the coupons on many bank loans having floors, we think that not only is it unlikely the coupons will rise until the Fed begins raising rates, but short-term rates would also need to climb to a level above many of the floors.
Bank loans are illiquid
Liquidity risk can be a problem for many bonds, especially those rated sub-investment grade, but it's even more pronounced with bank loans and the funds that hold them. Liquidity risk is the relative ability of a security to be sold without substantial transaction costs or reduction of value. The harder it is to sell a security, or the greater the loss in value resulting from a sale, the greater the liquidity risk.
Part of bank loans' liquidity risk stems from their structure. Unlike traditional bonds, bank loans trade as private transactions. Rather than trading electronically on the over-the-counter market, bank loans often need to be physically delivered (by faxing the paperwork, for example) between the buyer and seller. On top of that, settlement times for bank loans typically range between 15 and 25 days due to their physical and private nature, according to Moody's.2
So selling a loan can take a lot longer than selling a bond. Rather than waiting a few days to get cash proceeds from a sale, you may have to wait weeks with a bank-loan fund. This is true in most market environments—not just during negative market conditions.
If many investors decide to sell at the same time, the fund may not actually have the cash to pay for those redemptions. This could cause the price of bank-loan funds to decline even further. Below we list some examples of popular bank loan mutual funds and ETFs, along with their cash positions, so you can get an idea of how well (or poorly) they may be able to address large investor redemptions.
Bank Loan ETFs
PowerShares Senior Loan Portfolio
SPDR Blackstone/GSO Senior Loan ETF
Bank Loan Mutual Funds
Lord Abbett Floating Rate Fund
Ridge Worth Seix Floating Rate High Income Fund
Source: Schwab Center for Financial Research and individual fund fact sheets and sponsor webpages. ETF data as of January 20, 2015; mutual fund data as of December 31, 2014. The ETFs shown are the two largest bank loan ETFs, according to ETF database (www.etfdb.com). The mutual funds shown were selected because they are on the Schwab Mutual Fund OneSource Select List®.
What should you watch out for?
The risks mentioned above are always prevalent with bank loans, but we're beginning to see even more risks in the current environment. We think liquidity risk will be heightened in 2015, which could pose problems for bank loans due to their relatively illiquid nature. The prices of bank loans and bank-loan funds were very volatile in the second half of 2014, and we think that could continue.
Even though the Barclays U.S. High Yield Loans Index posted a positive total return in 2014, it had a negative total return for the second half of the year: it lost 1%. Although prices have fallen a bit since the post-crisis highs reached in June 2014, we think they have room to fall further and have limited upside potential.
We’re not the only ones who are highlighting the risks with bank loans. The Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporations have all been warning about deteriorating underwriting standards in the bank loan market. Bank loans are sub-investment grade investments, and should always be considered aggressive investments. Don't let the secured nature and floating coupon rates give you a false sense of security.
Are you interested in adding socially responsible investments to your portfolio while also receiving tax-advantaged income? If so, one option to consider is "green" bonds. Municipal issuance of green bonds increased nearly 250 times last year compared to the volume sold in 2013.3
Although issuance and popularity has spiked, muni bonds carrying the green label represent a small part of the municipal bond market and are relatively difficult to identify. There may be alternatives, depending on your objective.
Helping the environment
A municipal green bond is a bond issued by a state or local government that allocates its proceeds to fund environmentally friendly projects. Currently, no formal criteria or definition as to what constitutes an environmentally friendly project has been accepted. However, in 2014 a group of banks released voluntary guidelines to help provide guidance to issuers.
According to the guidelines, projects that promote renewable energy, sustainable waste management, or clean transportation, for example, would all be considered green projects.4 The bonds are then described as meeting the “green” criteria in their offering prospectuses. Investors who buy green bonds get paid interest and principal from the same sources as other municipal bonds, which may be backed by the general obligation (GO) pledge of the state or local government, or by a revenue pledge of the specific project or entity.
For example, in 2013, Massachusetts issued $669 million in munis backed by the commonwealth's GO pledge. This included $100 million in green bonds—the first green bonds to be issued by a state. The only difference between these and other GO bonds was the use of proceeds—the money was used specifically to finance environmentally friendly projects.
In 2014, states and local governments issued $2.5 billion in green bonds, up from $100 million in 2013.5 With the huge jump in issuance has come media attention and increased popularity for green bonds. Despite the boom in issuance, however, green municipal bonds still make up a very small fraction of the market—just 1.7% of total muni issuance in 2014.
Only 11 states have brought green bonds to the market, according to the Climate Bonds Initiative. Investors interested in adding green muni bonds to their portfolio may have a hard time getting access to them because they represent such a small share of the market.
Green bonds are difficult to identify
Identifying green bonds takes additional work because it requires reviewing a bond’s offering documents to see if it has been designated as a green bond, based on established criteria. Also, we found that green bonds may, on average, offer lower yields than bonds with similar characteristics that don’t carry the green label.
Yields for select green bonds may be lower than their similar counterparts
Yield to maturity
Yield to worst
Next call date
State of CA GO 13063CNP1
State of CA GO 13063CNR7
State of CA GO 13063CEV8
State of CA GO 13063CNQ9
State of CA GO 13063CNS5
State of CA GO 13063B3W0
State of CA GO 13063BD90B
Source: Schwab Bond Source, as of 2/3/2015.
Note: Prices based on 25 bonds which includes a $25 total commission. Yields may be different due to a number of different factors, such as maturity, coupon, call date and investor demand. For illustrative purposes only.
Still, we think green municipal bonds can make sense for two primary reasons. One, they offer a way to invest in a socially conscious manner, if that’s part of your investment objective. Two, they offer investors an opportunity to receive tax-advantaged income. However, investing in green muni bonds will likely be difficult due to their small share of the market and the cumbersome work required to identify them.
Socially responsible investing: Beyond green bonds
An alternative would be to consider municipal bonds that don't carry the green label. Municipal bonds by definition are sold to serve a public purpose. They allow investors the opportunity to lend money in support of a host of municipal projects that, many would argue, could be have a local, social benefit. For example, construction of a university or school, increased public transportation aimed at helping to reduce carbon emissions, or improvements to public parks and open spaces could all be seen as projects that have a social benefit.
Though they may not carry the green label, those projects may still suit your investment objective. The purpose of an individual bond, and the use of the proceeds from the borrowing, can be found on Schwab.com as part of the security’s description or in the offering prospectus.
What to do now?
Investors can search for municipal bonds with a specific purpose by selecting different “purpose classes” in the “Find Bonds” section of Schwab.com or reviewing the official statements of bonds through MuniDOCS® on Schwab.com.
I hope this enhanced your understanding of bond markets and Federal Reserve policy. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)
1 Source: Barclays. Barclays U.S. High Yield Loans Index 2014 total return of 1.5%. Barclays U.S. Treasury Bond Index 2014 total return of 5.1% and Barclays U.S. Corporate Bond Index 2014 total return of 7.5%.
2Source: Moody's, "Mind the Gap: Retail Bank Loan Funds Pose Liquidity, Reputational Risks for Managers," July 7, 2014.
3 Source: Bloomberg.
4 Source: Green Bond Principals, 2014, as of 1/13/2014. http://www.ceres.org/resources/reports/green-bond-principles-2014-voluntary-process-guidelines-for-issuing-green-bonds.
5 Source: Bloomberg.
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