A New Institutional Fixed-Income Security

Abstract

Fixed–income investors have enjoyed above–average returns for nearly two decades, due to the continual decline in interest rates from the record levels of the early 1980s. Although interest rates could decline further, the potential for significant capital gains, without taking extreme duration risk, is limited. At the same time, disruptions in the bond market over the past twelve to eighteen months have caused a widening of spreads and improved the compensation for investors willing to take credit risk. As a result, investors in spread products appear to have a more favorable balance between return and risk than that available by taking interest rate risk only. Bank loan offers one of the best trades available to investors who believe the long secular decline in rates is nearing an end, and who believe the market has overreacted in pricing other types of risk. Bank loans offer a floating rate alternative for investors willing to assume credit risk and an excellent hedge against rising rates. In addition, loans have minimal correlation with other asset classes and are a superior tool for reducing overall portfolio volatility. Over the past ten years, the market for bank loans has matured. Most major commercial and investment banks make a market in these securities, a derivatives market has evolved to facilitate hedging and risk management, a variety of indexes are available to measure performance, and the uniformity of terms and conditions has markedly improved. Given the current market conditions and the maturation of this sector, we anticipate a growing emphasis on bank loans in institutional and portfolios.