While the actual yield bank loans may offer in the future is not certain, this analysis does show that bank loans provide an attractive income option relative to other fixed income alternatives for investors looking to limit interest rate risk at the beginning of a possible rising rate cycle.
It’s important to understand the trade-off between interest risk and credit risk. We know there is no such thing as a free lunch. That additional income compensation comes with assuming credit risk (the risk of a default or credit downgrade) and the risk that prices drop sharply in a risk-off environment if demand suddenly dries up.
Conclusion
Yields across much of the fixed income market are low, which leads us to increasingly look to the equity market for additional income. Our preference for stocks over bonds—supported by low interest rates—is one of our highest conviction recommendations for 2021. Several segments of the equity market—particularly the energy sector and banks—offer higher yields than traditional high-quality bonds and offer attractive capital appreciation potential as interest rates rise. For suitable fixed income investors looking for yield and concerned about rising rates, we believe now is a good time to give bank loans a look.
Jeffrey Buchbinder, CFA, is an equity strategist at LPL Financial.