Income investors are finding themselves in a bit of an odd situation right now.

Here’s what I mean…

According to Bankrate, the national average for a one-year CD is still a meager 0.28%. You can lock up your principal for five years at a slightly better rate of 0.48%. But I wouldn’t recommend it – not with several additional rate hikes likely by the end of the year. Before long, every bank in town might be paying considerably more.

The same logic applies to corporate and government bonds.

After being anchored near zero for much of the pandemic, the Fed Funds rate is finally back to 1.75% and will likely top 2% in July. Policymakers expect baseline rates to approach 3.5% by the end of the year.

_{Source: New York Fed}

Bond yields will inevitably follow suit as borrowing costs up and down the line are forced higher.

Translation: The era of cheap money is over for now.

But what about all of the outstanding debt issued in prior years with yesterday’s lower coupons? Back in 2020, retailer Target sold a $1 billion block of bonds paying 2.65% with a maturity of 2030. At the time, that was an enticing payout. But not anymore.

Would you be content getting 2.65% for the next eight years if the going rate for newly-issued bonds of similar quality and maturity suddenly rises to 4%? Or 5%? You could always sell the bond in the secondary market and reinvest elsewhere. But buyers wouldn’t pay full price. They would insist on a discount that would effectively offset the anticipated interest differential between now and maturity.

I’ll spare you the math. But that’s why bond prices weaken in a rising rate environment. Of course, the reverse is also true. If you have a bond paying 5% and rates drop to 4%, then buyers would be willing to pay a premium. But the odds of a rate decrease anytime soon are slim to none.

Not all bonds react the same. All things equal, longer maturities are more sensitive to rate fluctuations than shorter maturities. Likewise, high-grade instruments with low coupons tend to be more vulnerable than low-grade bonds with high coupons (aka “junk bonds”).

So this isn’t the best time to be holding long-dated government bonds. While Treasuries are said to be among the safest investments on the planet, all bets are off when rates are rising. The iShares 20-Yr Treasury Bond ETF (NYSE: TLT) has tumbled 26% this year — a steeper decline than the S&P 500.

And rates are still quite low by historical standards. With more hikes on the horizon, it’s probably wise to focus on shorter-term instruments with lower durations and less interest rate sensitivity. The iShares Core 1-5 Year Bond Fund (NYSE: ISTB), for example, has held its ground much better, slipping just 6%.

A Compelling Alternative

Once the dust settles, the billions in assets inside these and other bond portfolios will tilt towards higher-paying securities, and their monthly distributions will rise accordingly. As it stands, investment-grade bond yields have already eclipsed levels seen in the 2008 financial crisis.

I think they’re approaching a buying point – but not just yet.

In the meantime, there is one special group that is virtually immune to what the central bank is doing. In fact, it will feast during this time of famine. I’m talking about bank loan funds.

I brought this up a couple of times in recent days (here and here). But I only scratched the surface in terms of discussing what makes them so appealing in this environment. So today, I’d like to dive a little bit deeper…

Banks and other financial institutions profit by borrowing money at low rates (say 1%) and then loaning it out at higher rates (maybe 5%). If you don’t like the idea of settling for what the bank gives, then invest in what it receives.

Bank loan funds, which invest in syndicated, packaged pools of this debt, give ordinary investors a way to do just that. They provide access to an asset class that once belonged almost exclusively to hedge funds and other institutional investors.

Essentially, these loans are made to sub-investment-grade companies with less than stellar credit. The proceeds are typically used in conjunction with merger and acquisition activity. Because the borrowers don’t have the strongest balance sheets, there is a fair amount of credit risk involved. But those risks are mitigated by two factors.

First, the loans are protected by restrictive covenants and backed by tangible collateral such as property and equipment. Second, the senior status of these loans allows investors to get their money back ahead of other creditors in the event of non-payment.

Defaults have been rare, running just under 2% annually under normal conditions. And even then, recovery rates average 80%, meaning investors received 80 cents back on the dollar. That compares with 50% for senior unsecured bonds and less than 30% for subordinated bonds.

Inoculating Against Rate Hikes

What really makes this group shine in the current environment is that rates tied to these loans are variable. Many are linked to a short-term benchmark such as the London inter-bank offered rate (LIBOR) plus a spread of 2% to 3%. So whenever interest rates creep higher, the rates on these loans float right along — most reset every 30, 60, or 90 days.

Again, the reverse is also true in a falling rate environment. But that’s not much of a threat right now. I find that asymmetrical risk/reward proposition highly attractive.

So while traditional bond investors can only watch helplessly as interest rates rise, bank loan yields will ratchet higher with every uptick. Not surprisingly, cash has been pouring into this asset class, much of it redirected from traditional bond funds — which just saw net outflows for 19 consecutive weeks.

The Fidelity Floating Rate High Income Fund (FFRHX) welcomed $3+ billion in fresh new assets last year. T. Rowe Price Floating Rate (PRFRX) took in $2 billion. With low default rates and a fresh supply of new loan issuance (fueled by private equity takeovers), active managers have been able to avoid trouble spots and seek out value.

Those two funds are perfectly viable options if you’re interested.

In my previous article, I also mentioned these names: Nuveen Floating Rate (NYSE: JRO), First Trust Senior Loan ETF (NYSE: FTSL), and SPDR Blackstone Senior Loan ETF (NYSE: SRLN).

But my personal favorite is a closed-end fund (CEF) we recently added to our portfolio over at High-Yield Investing. With the flexibility to utilize tactics a lot of other funds can’t, it already offers a 7% yield – and I fully expect that payout to rise along with rates in the coming months.

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