Since the Federal Reserve has raised short-term rates three times in the past six months and has clearly conveyed its intentions to "normalize" rates in a deliberate and methodical fashion, many investors are concerned about how their portfolios may be affected by a tightening cycle.
Rising rates are usually accompanied by robust business conditions during which economically sensitive investments and exposure to credit risk are well rewarded. Given that backdrop, floating-rate instruments — notably, senior bank loans — are a compelling way to reduce rate exposure.
Experience shows that during rising rate periods, senior bank loans can play a very helpful role in a portfolio, providing both relatively high income and the benefits of economic expansion in a double-barreled defense against interest-rate risk. As shown in Figure 1, senior loans deliver materially lower interest-rate risk (effective duration) than conventional fixed income securities — and higher yields than most. This makes senior loans a potentially effective diversifier against the primary risk faced by all fixed-rate securities when interest rates rise.