Mitigating Interest Rate Risks with ETPs

At Cranberger I have started to also segment ETPs according to Strategy Solutions like "Exposure with Interest Rate Hedge" or "Duration Management".

Below dynamic list provide a Cross-Segment overview of just what ETPs are currently avalible that somehow seek to neutralize the effect of a Interest Rate increase. These Solution currently spans Floating Rate, Senior Loans and Interest Rate hedged Corporate Bond ETPs.

Floating Rate Explained

When interest rates rise, prices of existing bonds fall, and vice versa. That’s because when rates rise, the lower rates paid by older bonds become less attractive, so their prices fall. On the other hand, when rates fall, prices for older bonds tend to rise because those bonds pay a higher rate than newly issued ones.

In contrast, the interest rate on floating rate securities adjusts to reflect increases and declines in market interest rates. As a result, floating rate securities tend to attract investors during periods when interest rates are rising, but may be less attractive when interest rates are falling.

Given this important difference, floating rate securities can help investor diversify the fixed income part of the portfolio. If fixed rate investments decline in value, floating rate investments could potentially increase in value and help compensate for some of the loss. Bear in mind that diversification does not provide a guarantee against loss.

Floating rate securities do tend to have higher credit risk (the risk that the borrower will not be able to pay back the principal and interest) than comparable fixed rate securities. But to help compensate for that added risk, they may offer higher yields. And because their interest rates adjust, floating rate securities may produce yields that are more likely to keep pace with current market rates. In addition, floating rate securities are often secured by collateral pledged by borrowers. In the event of a default on the loan, the collateral may be liquidated to reimburse investors.

Finally, floating rate securities involve other risks, including liquidity. Liquidity risk refers to the limited trading of these securities, which may affect the ability of investors to buy and sell them at the desired time or price.

Senior Loans Explained

Credit risk has declined dramatically, as evidenced by defaults that are running below long-term averages, robust new issuance and demand for bonds, and healthy corporate balance sheets and earnings. Today, interest rate risk is a greater threat to Fixed-income portfolios. With that in mind, a unique asset class to consider is the Floating rate or bank loan market.

Leveraged loans (also known as Floating rate loans, bank loans or high-yield loans) are loans extended to companies with higher levels of debt relative to their cash cows.

Companies typically borrow in the loan market to re-finance existing debt, recapitalize their balance sheet or finance leveraged buy outs. Banks and other financial institutions are the primary arrangers of these loans, which are then syndicated (i.e. sold) to investors. The loans are below-investment-grade credit quality and are secured by assets of the borrower.As the most senior source of capital in a company’s capital structure, these secured, leveraged loans are paid down first in the event of a bankruptcy.

The interest rate paid on the loan is based on an index, typically LIBOR, plus a predetermined spread. The coupon on bank loans resets regularly to mirror a market interest rate (typically LIBOR, which resets every 30–90 days). As a result, bank loans generate income that reflects the overall rate environment plus a premium that is set at origination. The premium or spread reflects the underlying credit quality of the issuer as well as technical factors in the market at the time of issuance: the market’s appetite for risk, liquidity, the default environment, etc.

Because the interest income generated by Floating rate loans is tied to a market rate of interest, such as London-Interbank Offered Rate (LIBOR), income generally keeps pace with changes in market interest rates.

For example, if LIBOR is 5% and the premium on a particular loan is 3%, the company taking out the loan would pay investors an interest rate of 8%. The benchmark rate may l fluctuate, while the premium remains fixed for the life of the loan. Therefore, if LIBOR were to rise to 6%, the loan would reset, and the company would pay an interest rate of 9% (6% for LIBOR, plus the 3% premium).

Bank loans are generally the most senior source of capital in a company’s capital structure and are paid down first in the event of a bankruptcy or liquidation. They offer collateral protection with a first lien on most, if not all, assets of the issuer, have more robust documentation and have financial covenants that are regularly monitored by the lenders. As a result, bank loans have experienced a much higher recovery rate in default situations

Because Floating rate loans reset frequently, they essentially have no duration risk (The measure of the sensitivity of the price of an investment to a change in interest rates). Floating rate loans have near-zero duration, such that their principal value remains largely unaffected by interest rate changes.

Typically, an investor has to give up yield in exchange for low interest rate risk. Floating rate loans offer a higher yield with lower duration because the underlying issuers are below investment-grade credit quality. If investors are comfortable with the underlying credit risk, which can be mitigated by the aforementioned structural features of the asset class — they can achieve a yield that keeps pace with the overall trajectory of interest rates and are less likely to not suffer the price declines typically associated with other fixed-rate investments. 

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