When interest rates are low, some investors stretch for yield by taking on credit risk. At the same time, many investors are also seeking alternative ways to protect themselves against a potential rise in interest rates, without sacrificing that hard-earned yield.
These dual concerns have led many to consider bank loan funds, which recently have had more inflows than any other domestic fixed-income asset class.
Other Than Recent Returns, What Makes Bank Loan Funds So Popular?
Bank loans, a type of corporate debt, have a maturity date and pay interest. Their interest payments, however, are determined based on a floating reference rate (typically Libor) plus a fixed spread. Depending on the loan agreement, the rate is adjusted periodically, typically at intervals of 30, 60 or 90 days.
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There have been a number of articles over the past few years claiming to refute the existence of a small-cap (or size) premium, which is the historical difference in returns between small-cap stocks and large-cap stocks. While the critiques have been somewhat varied, two common claims are that the risk-adjusted returns of small-cap stocks have been similar to large-cap stocks and that the performance of small-cap stocks has been weak in international stock markets.
The Size Premium in Growth and Value Stocks
While it’s true in aggregate that small-cap stocks have had similar risk-adjusted returns (or Sharpe Ratios) compared with large-cap stocks, a more nuanced picture emerges when we separately look at the performance of small-cap versus large-cap in growth stocks and then in value stocks. The figure below displays the difference in Sharpe Ratios comparing small-cap growth stocks with large-cap growth stocks and then comparing small-cap value stocks with large-cap value stocks.
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Until the recent sell-off toward the end of July, yields on high-yield bonds had been hitting record lows. At the end of June 2014, the yield on five-year bonds rated BB—the credit rating just below investment grade—was only 4.3 percent, or about 2.7 percentage points higher than the yield on five-year Treasurys. That puts the yield spread at levels not seen since before the 2008 financial crisis began.
This all matters because with the yields on safe bond investments at low levels, investors are chasing yield wherever they can find it—not just in high-yield bonds, but in other risky investments, such as dividend-paying stocks and REITs.
My colleague and co-author Kevin Grogan takes a look at whether it makes sense to add high-yield bonds to a portfolio. From its inception in January 1979 through June 2014, Vanguard’s High Yield Corporate Fund (VWEHX) returned 8.8 percent per year. By comparison, the Barclays Credit Bond Index Intermediate returned 8.3 percent per year over the same period.
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