Investors looking for income frequently find it in the bond market. Bonds represent a debt obligation that the issuer promises to repay. Amateur investors commonly underestimate the risk of fixed income investments and, therefore, may not fully appreciate the benefits of certain bond instruments, such as senior secured floating rate loans.
The most significant bond investment risks include interest rate risk and credit risk. Interest rate risk exists because investors can buy bonds from other investors, on what is called the secondary market, rather than buying bonds directly from the issuer and holding them until maturity. The current value, also known as the present value, of a bond is determined by summing the net present value (NPV) of all coupon payments and the NPV of the bond’s face value, which is the value at maturity. If the coupon payments and face value of a bond are fixed then the present value of the bond decreases as interest rates rise. This is known as interest rate risk. Bonds also carry the risk of default. In addition to default, bonds carry the risk of being downgraded by rating agencies, which could have implications on price. The risk of default and the risk of downgrade are collectively known as credit risk. Certain fixed income products attempt to mitigate interest rate risk and credit risk by establishing terms that favor the investor.
Present market conditions have seen interest rates at or near historic lows and should therefore alarm investors susceptible to interest rate risk. The savvy investor may choose to invest in floating rate bond products as a means of seeking to hedge against an increase in interest rates. Floating rate bonds typically have a coupon that adjusts with (floats on top of) the risk-free rate of return, Rf. One common reference for Rf is the London Inter-Bank Offered Rate (LIBOR), which is the interest rate at which large banks lend each other money. The interest rate of any bond can be represented as the spread over Rf, which refers to the additional interest earned above Rf. A bond with a fixed rate of return will have a spread that decreases when LIBOR increases and vice versa. In contrast, a floating rate bond will have a fixed spread above LIBOR and will therefore have a variable rate of return that adjusts when LIBOR changes. Floating rate bonds are therefore a wise choice for the investor seeking to satiate income demands in an unsustainably low interest rate environment.
When a borrower issues floating rate debt, the obligations of the borrower can change significantly as interest rates rise. While an investor in a floating rate bond may not be concerned about interest rate risk, the investor is justifiably concerned about credit risk. Two types of bond products exist which abate credit risk. The first is senior debt. Senior debt obligations are those debt obligations that are to be repaid before any other debt obligations are repaid or shareholders’ equity is distributed. Investors in senior debt are assured that, in the event of a bankruptcy or default, they receive payment first. The second bond product that carries a low credit risk is secured debt. Secured debt obligations represent loans to a borrower that are supported by the borrower’s assets. For example, a mortgage is a loan secured by real estate. In the event of a default, the asset that is backing the bond can be liquidated to satisfy the debt obligation to the investor.
It is worthwhile to consider other fixed income products that minimize interest rate risk and/or credit risk. For example, high-yield bonds, which provide a higher coupon payment compared to otherwise equal investment grade bonds, are one alternative that may remain competitive if interest rates rise. However, these bonds generally have a lower credit quality and therefore carry a higher credit risk. U.S. treasuries arguably carry the lowest credit risk, but typically have a fixed rate of return and are therefore very susceptible to interest rate risk. Some bonds offer a floating rate of return, a senior repayment, and secure the debt obligation with assets. Such bond products, which combine these attractive features, bring the highest premium to a portfolio in comparison to other fixed income alternatives in the present fixed income environment.