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Are Rising Rates Putting Bank Loans at Risk?

Hedge Against Rising Rates | June 03, 2022
STRATEGY Interest Rate Hedge
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Bank loan strategies place the burden of minimizing the impacts of rising rates on debt holders onto the bond issuers. Consider hedging the interest rate risk of fixed coupon bonds.

There Are Challenges with Bank Loan Strategies

Much has been written about the challenges facing investors in bank loan strategies, also known as leveraged loan or senior loan strategies.
 
  • Bank loans are not as liquid as regular high yield bonds.
  • They often have call provisions that can limit potential price appreciation.
  • They can have interest-rate floors, which might delay an increase in coupon payments as rates rise.
In a period when interest rates are rising quickly—and substantially—there is another key challenge.
 
  • Floating-rate debt can substantially burden companies, which may have to pay more and more money to service their debt.
A silver lining for many companies when interest rates and inflation are rising is that their fixed-rate debt burden is reduced. It’s a bit like one’s home mortgage becoming a smaller burden over time.
 
There is no such silver lining for companies’ floating-rate debt. As interest rates rise, they must pay more in debt service. It’s true that rising interest rates typically coincide with sufficient economic growth to support solid performance of corporate credit. However, the benefit may still tilt towards fixed-rate debt.
 

Why to Consider an Interest Rate Hedging Strategy

As an investor in corporate debt, instead of relying on a floating-rate structure that may place financial stress on the issuing company, you may want to consider hedging the interest rate risk of fixed coupon bonds.
 
To achieve that, you can purchase fixed-rate bonds, which benefit from the improving credit conditions more than floating-rate bonds (i.e., lower defaults, upgrades and tightening spreads). Then, you can pair those bonds with a short position in Treasurys to help offset the effects of rising rates.
 
History shows the potential benefit of this approach. The FTSE High Yield (Treasury Rate-Hedged) Index, which is composed of “regular” high-yield bonds combined with short positions in U.S. Treasurys, has delivered nearly double the return of the S&P/LSTA Leverage Loan 100 Index in periods of rising rates.
 

Interest Rate Hedging versus Bank Loan Strategies

Returns, on average, during periods of rising rates, 5/23/13‒3/31/22
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Source: Bloomberg. Starting date reflects available data since the launch of HYHG, which tracks the FTSE High Yield (Treasury Rate-Hedged) Index. Average returns are annualized, based on periods when changes in quarterly 10-Year Treasury yield are positive. Rising rate periods are any calendar quarter where the 10-Year Treasury yield increased, which are Q4 2013, Q3 2014, Q2 2015, Q4 2015, Q3 2016, Q4 2016, Q3 2017, Q4 2017, Q1 2018, Q2 2018, Q3 2018, Q4 2019, Q4 2020, Q1 2021, Q3 2021, Q4 2021 and Q1 2022. The S&P LSTA U.S. Leveraged Loan 100 Index is designed to reflect the performance of the largest facilities in the leveraged loan market and is a widely used benchmark for bank loan funds. Index returns are for illustrative purposes only and do not represent fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged, and one cannot invest in an index. Past performance does not guarantee future results.
 
Click here for fund performance.
 

The Takeaway

Bank loan ETFs may help you reduce interest rate risk, but they also face potentially significant challenges you need to understand. You may want to consider an interest rate hedged, high-yield bond ETF like ProShares High Yield—Interest Rate Hedged (HYHG) instead, if it meets your investment objectives.

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HYHG

High Yield—Interest Rate Hedged

Seeks investment results, before fees and expenses, that track the performance of the FTSE High Yield (Treasury Rate-Hedged) Index.

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This information is not meant to be investment advice. There is no guarantee that the strategies discussed will be effective. Investment comparisons are for illustrative purposes only and not meant to be all-inclusive. Index information does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged, and one cannot invest directly in an index.

Any forward-looking statements herein are based on expectations of ProShare Advisors LLC at this time. ProShare Advisors LLC undertakes no duty to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Investing is currently subject to additional risks and uncertainties related to COVID-19, including general economic, market and business conditions; changes in laws or regulations or other actions made by governmental authorities or regulatory bodies; and world economic and political developments.

Investing involves risk, including the possible loss of principal. HYHG entails certain risks, which include the use of derivatives (futures contracts), imperfect benchmark correlation, leverage and market price variance, all of which can increase volatility and decrease performance. Please see summary and full prospectuses for a more complete description of risks. There is no guarantee any ProShares ETF will achieve its investment objective.

HYHG seeks to hedge high yield bonds against the potential negative impact of rising Treasury interest rates by taking short positions in U.S. Treasury futures. The short positions are not intended to mitigate credit risk or other factors influencing the price of the bonds, which may have a greater impact than rising or falling interest rates. No hedge is perfect, and there is no guarantee the short positions will completely eliminate interest rate risk. Investors may be better off in a long-only high yield investment when interest rates fall than investing in HYHG, where hedging may limit potential gains or increase losses. Performance could be particularly poor during risk-averse, flight-to-quality environments when high yield bonds commonly decline in value. HYHG may be more volatile than long-only high yield bond investments. HYHG may contain a significant allocation to callable high yield bonds, which are subject to prepayment and other risks that could result in losses for the fund. There is no guarantee the fund will have positive returns.

Bonds will decrease in value as interest rates rise.

High yield bonds may involve greater levels of credit, prepayment, liquidity and valuation risk than higher-rated instruments. High yield bonds are more volatile than investment grade securities, and they involve a greater risks of loss (including loss of principal) from missed payments, defaults or downgrades because of their speculative nature.

Short positions in a security lose value as that security's price increases.

The fund concentrates its investments in certain sectors. Narrowly focused investments typically exhibit higher volatility.

Carefully consider the investment objectives, risks, charges and expenses of ProShares before investing. This and other information can be found in their summary and full prospectuses. Read them carefully before investing.

"FTSE®" and "FTSE High Yield (Treasury Rate Hedged)" have been licensed for use by ProShares. FTSE is a trademark of the London Stock Exchange Plc and The Financial Times Limited and is used by the FTSE International Limited ("FTSE") under license. ProShares have not been passed on by FTSE or its affiliates as to their legality or suitability. ProShares based on the FTSE High Yield (Treasury Rate Hedged) Index are not sponsored, endorsed, sold or promoted by FTSE or its affiliates, and they make no representation regarding the advisability of investing in ProShares. THIS ENTITY AND ITS AFFILIATES MAKE NO WARRANTIES AND BEAR NO LIABILITY WITH RESPECT TO PROSHARES.

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