Posted inAsset Class in Focus

One way to play rising rates

A high yield product that links to the LIBOR rate could be a suitable way to play the next act of the interest rate saga, according to M&G Investments.

Gordon Harding, investment specialist, fixed interest, at M&G, explained that his firm’s high yield floating rate notes (FRN) instrument, which invests in leveraged companies mainly in Europe and the US, provides returns something like a leveraged loan, and moves in tandem with interest rates. 

“When the LIBOR moves up, the [FRN] coupon does as well. Conversely, if LIBOR goes down, the coupon does as well. The instrument moves in line with short term interest rates.”

FRN vs traditional high yield

The strategy differs from that of traditional high yield products, which will have a limited amount of interest rate duration.

On average, the global high yield index has four years of interest rate duration, Harding said. 

“That means if the US Federal Reserve raises rates by 1%, you’d lose 4% of capital in a traditional high yield bond fund.”

The FRN coupon instrument has virtually zero interest rate duration, he said.

The coupon is linked to the LIBOR rate, plus it has a fixed spread to compensate the holder for the credit risk of the coupon-issuing company. 

Currency hedging can also provide some insulation from fluctuations, such as the recent rise in the dollar and fall in the euro.

Harding said the strategy is to hedge the currency of the product from, for example, euros to dollars. “By doing so, you swap out your local currency LIBOR rate for the dollar LIBOR rate.”

Risk underneath

FRN coupons are debt instruments, and the underlying entities issuing them are mainly rated BB, slightly higher than assets in the traditional high yield universe, which would be rated B, Harding said.

The major risk is a credit event in the underlying assets.

“The [coupon-issuing companies] are not immune to the credit cycle. If credit spreads or corporate performance are poor, that will be reflected in the value of these instruments.”

However, M&G has a benign view on default rates, “even in the high yield space”, he said.

“The trailing 12-month default rate is 1.5%, which means that only 1.5% of high yield companies globally have defaulted in last twelve months.”

“We expect that to continue for foreseeable future.”

A relative risk is if government bond yields and interest rates fall, as the product is linked to interest rate fluctuation. However, he said further downside in the LIBOR rate is limited, and the expected trend for interest rates is up.

Early movers

UK investors, anticipating a rate hike at home, have been early movers in high yield FRNs, Harding said.

The asset class has been around since the 1990s, but the reference index for FRNs products began in December 2012.

He said few of the products in market are pure-play, like the M&G vehicle.

 “A number of funds will buy this type of asset. Leveraged loans will buy it to get liquidity, normal high yield products will have some exposure to it, but not many are invested purely in FRNs. “

Part of the Mark Allen Group.