Higher Income Ahead as Fed Raises Rates?

by:
Managing Director and Portfolio Manager, Fixed Income Investors

“The Fed appears poised to raise interest rates in June and gradually thereafter,” according to Art Torrey, Portfolio Manager of MainStay Floating Rate Fund. “And that strengthens the prospects for higher income ahead from floating rate loans,” he added.

Fed to Raise Rates  

Wages are advancing, job formation is occurring at a healthy clip, and the unemployment rate matched its low point of the last business cycle when it fell to 4.4% in April. As a result, the market is discounting 83% odds that the Fed will raise rates when it meets in June, according to the CME FedWatch tool.

Looking ahead, future rate increases should be accretive to the income investors receive from floating rate loans. That’s because three-month LIBOR – the interest rate most minimum coupons or “floors” are tied to – is above 1%, the level of many loan floors. As rates go up from here, so too should coupon income.

Performance in a Rising Rate Environment   

Should 10-year Treasury yields also rise, that should bode well for floating rate loans (Figure 1). Historically, they have outperformed investment grade bonds during periods of rising rates, as have high-yield bonds and short-duration high-yield bonds.

Performance during previous rising rate periods

Source: Morningstar, 12/31/16. Floating rate loans are represented by the S&P/LSTA Leveraged Loan Index. High-yield bonds are represented by the Bloomberg Barclays U.S. Corporate High-Yield Index. Investment-grade bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index. Short-duration high-yield bonds are represented by the BoA/ML U.S. Cash Pay High Yield BB-B Rated 1-5 Year Index. An investment cannot be made directly into an index. Past performance is no guarantee of future results. Index definitions can be found at the end of this report.

Defaults Expected to Remain Low

A combination of subdued defaults, near average option-adjusted spreads, and net inflows makes for a compelling risk-return trade-off. Defaults are currently running at about half their historical average. Given a growing economy, Torrey expects defaults to remain low into year end.

The asset class has received $15.4 billion in year-to-date retail fund flows through April 28.

Picks and Pans         

Where are Art and the team finding value? Although they focus on specific credits, patterns do emerge from the team’s work. They generally see opportunities in residential building products, business services, chemical companies, industrial equipment, select specialty retail, and gaming. By contrast, the team has its share of concerns about the prospects of select retailers, telecom equipment, and some electronics firms.

Conclusion

Floating rate loans have characteristics that are relatively well-suited for a rising rate environment.

LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world.

LIBOR floors – The London Interbank Offered Rate (LIBOR) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. LIBOR floors provide a guaranteed minimum yield on loans no matter how low the benchmark three-month London interbank offered rate fell. Today, most loans offer a 1% LIBOR floor, and the three-month LIBOR rate stands at 0.25%, meaning a loan with a LIBOR floor gives investors a yield base that’s three-quarters of a percentage point higher than a floorless loan (loans vary in terms of how much additional yield, or spread, they offer above either LIBOR or the floor rate).

Treasury securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity. Interest income on these securities is exempt from state and local taxes.

All mutual funds are subject to market risk and will fluctuate in value. Before considering an investment in a floating rate fund, you should understand that you could lose money.

Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, borrower industry concentration, and limited liquidity.

Securities purchased by the Fund that are liquid at the time of purchase may subsequently become illiquid due to events relating to the issuer of the securities, market events, economic conditions, or investor perceptions. As a result, an investor could pay more than the market value when buying Fund shares or receive less than the market value when selling Fund shares.

The Fund may not be able to pay redemption proceeds within the allowable time period because of unusual market conditions, unusually high volume of redemptions, or other reasons. To meet redemption requests, the Fund may be forced to sell securities at an unfavorable time and/or under unfavorable conditions.

Liquidity risk may also refer to the risk that the Fund may not be able to pay redemption proceeds within the allowable time period because of unusual market conditions, unusually high volume of redemptions, or other reasons. To meet redemption requests, the Fund may be forced to sell securities at an unfavorable time and/or under unfavorable conditions.

Past performance is no guarantee for future results, which will vary.

The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only, and is not intended to constitute the giving of advice or the making of a recommendation. The investments or strategies presented are not appropriate for every investor and do not take into account the investment objectives or financial needs of particular investors. An investor should review with its financial advisors the terms and conditions and risks involved with specific products or services and consider this information in the context of its personal risk tolerance and investment goals.

For more information about MainStay Funds®, call 800-MAINSTAY (624-6782) for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus or summary prospectus carefully before investing.

Fixed Income Investors is a multi-product fixed-income investment manager and a division of New York Life Investments. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, New Jersey 07302.

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Arthur Torrey

Managing Director and Portfolio Manager, Fixed Income Investors

Mr. Torrey is a Portfolio Manager in the High-Yield Credit Group. He joined New York Life Investments in 2006 and is responsible for the management of non-investment grade assets including floating rate loans and high-yield bonds

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