Why buy boat insurance, if you don't have a boat?

The idea of insurance is to protect the holder against an adverse event, such as sickness, accident or death. However, having insurance is only important, if there is a risk of that adverse event. Does it make sense to have insurance for a risk that doesn’t exist?

Over the last few couple of years, we have been in a rising interest rate environment, which has been negative for traditional fixed income. Because of this, investors embraced floating rate bonds, also known as bank loans, which provide a measure of protection or insurance against rising rates, since the coupon on the bonds increases as rates move higher. The demand for floating rate loans has been quite strong over the past couple of years with the par amount of bank loans outstanding doubling since 2012. 

This sizeable increase in demand and issuance has created a few risks for investors in the asset class. First, the loan covenants, provisions that are supposed to protect investors, increasingly have been weakened. And although loans are senior to bonds in a company’s capital structure, the weaker the covenants, the less protection for investors should there be a default. And second, the increased issuance has exacerbated the liquidity risk. The key to understanding this risk is understanding the differences in how loans are traded and how that differs from bonds. Settlement terms refer to how long before buyers must pay for their purchased investments and when sellers are entitled to proceeds from the investments they’re selling. Stocks and bonds settle on T+3 settlement terms or 3 business days following the investor’s request to sell. Bank loans can settle as quickly as T+5 or as long as T+40. During periods of large redemptions, liquidity can be an issue, and it can also create a drawdown in price similar to what we saw in 2015.

Besides, the short-term risks that may exist with Floating Rate Loans, we no longer believe that investors require insurance against rising interest rates. We believe that we have seen the end of this yield tightening cycle and rising interest rates should no longer be a concern for investors. The Federal Open Market Committee announced on March 20, that it would hold the Federal Funds Rate to a target of 2.25%-2.50%. The “dot plots” suggests that the median expectation is that the rate will remain at its current level for the remainder of 2019, with only one hike expected in 2020. The futures market is now pricing a sixty-five percent probability of a rate cut by the end of this this year. 

This is further evidence that we have probably seen the peak in US Treasury Yields. 

Our inflation model which incorporates owner’s equivalent rent, oil price and wage growth had already signaled an upcoming moderation in inflation. This same model anticipated an increase in inflation ahead of the FOMC hiking rates back in 2016. Looking ahead, the model suggests that inflation will trend below 2.0% for the first three quarters before rallying into the end of year on higher oil prices.

This muted level of inflation and change in the Fed’s interest rate posture has changed the narrative for fixed income investors. There is no longer a need for investors to protect against the risk of inflation and rising rates. 

For those clients that still need yield in their fixed income portfolios, we would suggest shifting from floating rate loans to other fixed income vehicles, such as higher yielding foreign sovereign bonds or high yield corporate debt. According to Bank of America Merrill Lynch, high yield bonds are currently yielding more than floating rate loans at 6.5% vs 5.4%, respectively.

Investors would be better served concentrating on their current needs then buying boat insurance, when they don’t own a boat.