(MoneyWatch) Whenever interest rates fall to low levels, investors who are normally risk averse when it comes to their bond purchases begin trading safety for yield. Among the popular choices are junk bonds, preferred stocks, high-dividend stocks, REITs and MLPs. Now, we're even seeing resurgence in what are called leveraged loans. Apparently, investors haven't learned their lessons from the financial crisis.
These loans are floating rate notes, which provide higher yields (currently about 5.2 percent) and don't have the same term risk that junk bonds have because their yields move together with interest rates. However, they entail significant price risk because they're backed by bank loans of lower quality. Banks make these loans, which are often used to finance leveraged buyouts, anticipating that they can get them off their balance sheets by selling them to investors.
Last year, investors poured $62 billion into loan funds and collateralized loan obligations, with almost half of the inflows occurring in the fourth quarter alone. That's more than double the $28 billion invested in 2011 and trails only 2006 and 2007 for highest single year ever. This sector of the bond market has become so popular that Invesco's PowerShares Senior Loan Portfolio ETF (BKLN), which went public in the first quarter of 2011, has seen its assets grow to almost $3 billion, despite an expense ratio of 0.66 percent.
Before you wade into the leveraged loan pool, remember that there's a reason these loans carry much higher yields. They're risky, and the risks tend to show up at exactly the wrong time -- when your stocks are getting hit. Standard & Poor's has created an index for leveraged loan investments called the S&P/LSTA U.S. Leveraged Loan 100 Index. In 2008, the overall index fell 29.1 percent. Just when you needed the bond portion of your portfolio to provide a safety net, the risks of these loans became apparent.
This type of performance creates a problem beyond the losses themselves. When stocks perform poorly, you need to buy more of them to rebalance your portfolio. If you owned safe Treasury bonds, their values rose when stocks were getting hammered. For example, in 2008 five-year Treasury notes returned 13.1 percent (outperforming the leveraged loan index by 42.2 percent). To rebalance the portfolio you would be selling the Treasuries after that large gain (at high prices) to buy stocks (at their lower prices). Instead, if you owned leveraged loans you would have to be selling them (at low prices) to buy the even poorer performing stocks. You can't recover from losses on the assets you sell.
This example demonstrates that it's not only the level of correlation of returns that matters, but because correlations are not static, it also matters when the correlations tend to rise and when they tend to fall. And during crises, the correlation of all risky assets tends to move towards one. That's one reason why I recommend that you limit the bond portion of your portfolio to only the safest assets.
Don't be tempted by the high yields carried by leveraged loans. They don't necessarily translate into higher returns. This is especially true for leveraged loans -- they may not contain even the types of loan covenants that protect investors that even high-yield bonds may have.
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