Key Points

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.