Someday, eventually, maybe later this year even, the Federal Reserve is going to raise interest rates.
Now, for those of you that have been searching for yield during this five-year income drought, rising interest rates may seem like a great thing…
And it can be. That is, unless your portfolio is stocked with the types of income producing investments that are interest rate sensitive.
What do I mean by that, exactly?
Well, many income-producing securities like bonds, bond funds and bond ETFs will fluctuate in value as market rates rise or fall.
The relationship is an inverse one. So when the Fed raises rates, the value of most bonds and bond funds will decline.
On the other hand, not all income producing securities are interest rate sensitive.
As a matter of fact, one type of investment safe from interest rate fluctuations, called senior loan funds, are seeing record inflows as savvy investors prepare for inevitable rate hikes…
A Growing Playing Field with Billions Pouring In
So far this year, senior loan funds have pulled in billions of new dollars.
The biggest of them, PowerShares Senior Loan Portfolio (BKLN), has a veritable line of Brinks Trucks outside its offices every day.
Year to date, BKLN’s assets under management have grown from $2.7 billion to $4.2 billion. That an increase of more than 55% in only five months.
But it’s not just BLKN, because the playing field is widening. New funds focusing on this still relatively new category are popping up, despite the fact that senior loans have been around forever.
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Reducing Interest Rate Risk
It’s true. These funds have great dividend yields. BKLN has a yield of 4.68%, SNLN has a yield of 5.8% and FTSL has a yield of 4.15%.
But that’s hardly the biggest selling point. In the end, it’s all about keeping your investments safe from the deteriorating effects of rising interest rates.
You see, funds like BKLN are composed of floating-rate, senior secured debt obligations issued by companies that are rated “speculative.” In that way, they’re kind of like junk bonds.
This means that they are, in fact, risky and subject to the possibility of default. That’s precisely why buying them through an ETF is the way to go about it.
On the other hand, bank loans are considered to be a bit safer than junk bonds for two reasons.
One, they are backed by collateral. And two, senior loans have less interest-rate risk.
Because their interest rates are pegged to a floating rate benchmark like LIBOR (London Interbank Offered Rate), their yields will rise (or fall) in direct proportion to the benchmark yield.
Most other types of bonds pay a fixed rate predetermined before being issued. And fixed-rate securities (unlike floating rate securities) move in the opposite direction of interest rate changes.
So when rates rise, fixed rate securities fall. Likewise, when rates fall, fixed-rate securities rise.
Since interest rates are super low today and are expected to rise, fixed-rate bond funds are at risk of loss – potentially very big ones.
That’s precisely the kind of risk that senior loan funds like BLKN avoid and why investors would do well to take them into consideration.
Bottom line: When the Fed will actually begin to raise rates is anybody’s guess, but it’s going to happen sooner or later. And when it does, you don’t want to be stuck holding on to securities that are going to tank because of it.