Income Alternatives for Rising Rates

Jenna Dagenhart: The yield curve has inverted for the first time since 2019. And fixed income investors are facing rising rates now that the Fed has started its first hiking cycle since 2018. Joining us now, to talk about looking for value in this environment, is Fran Rodilosso, VanEck, head of fixed income ETF portfolio management. Fran, you've been on the virtual road, speaking with clients. What are you hearing from them? What's the problem that fixed income investors are facing right now?

Francis Rodilosso: Hi Jenna. Thanks for having me on. Well, yeah, we've done a lot of virtual road shows the last couple of months. And during that period, investors, the list of things to worry about, has only grown. But when we started and what still remains, I guess a primary concern, is the Fed has begun what could be or should be a prolonged hiking cycle. So interest rates are rising. And so, the big question is, where can I earn income, but also at the same time, protect against capital loss from rising rates? Of course, the problem goes a little deeper than that. Rates are rising for a variety of reasons, but CPI, the reading through [FEP 00:01:18] of 2022, now through the end of February, is 7.9% year over year. So real rates, particularly at the front end of the yield curve, which sort of are measured against current inflation rates, are highly negative.

Francis Rodilosso: So even if you can protect against capital loss and even bigger challenges, finding a way to earn income that doesn't cause you to lose money in real terms... And then, also finally, there were some traditional solutions for investors. Corporate credit's often a good place to be earned spread while rates are rising. The good news in the corporate credit space is that balance sheets are quite healthy. We've gone through a period of great growth. Corporations have refinanced at very low rates. Many are carrying a lot of cash on their balance sheets. So generally, a very benign credit environment. The problem coming into 2022 that investors were facing was, that was mostly priced in. So, we think the corporate credit space, at some point during the cycle, in terms of fixed rate investments in both investment grade and high yield bonds, could become quite attractive. But right now, or where we came into the year, spreads were tight enough that the sensitivity to interest rate moves made those asset classes less attractive. So, I think investors have been asking, "Where else can we go?"

Jenna Dagenhart: Yeah, what's the solution Fran? Where can investors look for income, given this growing list of challenges?

Francis Rodilosso: Yeah, well, one we like, which is kind of boring, to be honest, is in the investment grade corporate space, but it's investment grade floating rate notes. These are instruments with virtually zero interest rate duration. In floating rate notes, they're coupons reset quarterly, and they pay a spread above a reference rate. Traditionally LIBOR. Now as the whole world is transitioning away from LIBOR over SOFR or one form of SOFR or another. So there's been a lot of talk about levered loans and bank loan funds, a way to access floating rate exposure. Well, investment grade floating rate notes have similar mechanic. Two main differences. One, much higher credit quality by investing in corporate credit that's rated investment grade. It's largely financials by the way. Also, no LIBOR floors. So investment grade floating rate notes have already begun adjusting higher, in yield.

Francis Rodilosso: That's not necessarily happening in a lot of the levered loan market where there are LIBOR floors that haven't yet been reached. So this is a safer alternative with less carry than, say, levered loans. But with much higher yield, at least in the context of extremely low yields versus, say, other cash, T-bills or money market alternatives. As I mentioned before, and right now, corporate balance sheets are healthy. So we still think this is a good place to be, but we are later in the credit cycle or the business cycle overall. So we don't think, particularly as there's been spread compression, so spreads are tight on, say, triple C high yield corporates. They're tight on levered loans. This isn't a bad time to move up in credit quality, at the same time, that you're also looking for ways to shorten duration.

Francis Rodilosso: There is a give up in that sense. And that's why I said this is boring. This is a lower yielding asset class. VanEck, we have an ETF FLTR, that invests only in corporate and financial floating rate notes, because it's only corporates and financials. And because we invest in some longer dated floating rate notes, it's a higher yielding alternative to some other floating rate funds that are in the market. And so, I think that's a really, really interesting solution right now. Again, not so exciting, but that might not be a bad place to be in the near term, with the various risks out there.

Jenna Dagenhart: Finally, Fran, what about investors who have a higher risk tolerance and/or greater absolute yield needs?

Francis Rodilosso:Yeah, that's the other end of the risk spectrum. We believe that there is an exciting alternative to bank loans, sort of on the other side of the risk spectrum. And that's in the private credit space. Certainly, many institutional investors have moved in that direction over the last couple of years. And business development companies represent a way for all investors to access this space via investment companies structured as business development companies. And they are making loans to the middle market companies and lower middle market companies. The types of borrowers who don't have access to the large cap bank loan market. For several reasons, business development companies earn higher yields than one would achieve by investing in bank loans. One, again, they're to smaller companies. They're smaller loans, in general, they're less liquid. So there's a premium to be paid there.

Francis Rodilosso: Number two, the income that business development companies earn flows through on a tax advantage basis to investors. And number three, business development companies do employ leverage on a limited basis. We have a ETF at VanEck called BIZD, that invests only in the most liquid part of the publicly traded business development company market. And why I think investors might want to consider BIZD now, at least ones who do have that risk tolerance and have maybe still a benign view on where we are on a credit cycle, is talking about distribution yield, that has recently exceeded 8%. Over 80% of the underlying portfolios for each of these business development companies is comprised of floating rate instruments. So again, very low interest rate duration in the underlying portfolios. These are professionally managed and highly diversified. And so, we think it's a really interesting way to access the private loan market.

Jenna Dagenhart: Well, Fran, thank you very much for joining us.

Francis Rodilosso: Again, my pleasure, Jenna. Thank you.

Jenna Dagenhart: And thank you for watching. Once again, that was Fran Rodilosso of VanEck, head of fixed income ETF portfolio management. And I'm Jenna Dagenhart with Asset TV. To receive regular updates from VanEck's experts, please visit vaneck.com/subscribe.

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