The current interest rate situation makes purchasing bonds tricky at best. However, every complete and comprehensive financial plan will include an allocation to investments that provide a fixed-income stream.
So if bonds are not the greatest investment right now, but investors should still allocate to fixed-income investments, what's the answer?
Consider senior secure loans—loans secured by assets and senior in the capital structure of a firm—as a potential alternative.
First, investors must understand that there is a difference between a bond and a loan. A bond is essentially an IOU. An investor lends a company money in exchange for interest payments over the course of the loan and a promise to repay the loan at the end of some specified time period.
A loan is a contract with covenants designed to protect the lender (or investor). These covenants are essentially conditions that a borrower must conform to in order to stay in compliance with the terms of the loan. Basically, they are rules. Break the rules, and you default on the loan, and the lender can demand immediate repayment.
These covenants can be administrative in nature, such as the promise to be in compliance with the law, or financial, such as maintaining a specific financial metric like an interest-coverage ratio. They can also be restrictive in nature such as prohibiting the borrower from paying a dividend over a certain amount to equity holders.
That brings us back to senior secured loans. These loans represent the most senior obligations of a company. They're the ones paid off first in the event of a bankruptcy. They are senior to senior unsecured loans, high-yield bonds, mezzanine loans, and equity holders.
Additionally these loans have the first claim on all of a company's assets such as accounts receivable, inventory, cash flows, and "PP&E" (plant, property, and equipment). This makes them less risky than bonds—and especially stocks.
A real world example is General Motors. When GM declared bankruptcy, equity holders lost all of their money. Bond holders got back about $0.20 of each dollar they lent, but the senior secured lenders got $1.00 of each dollar back—all of their money back.
Many of these loans are tied to a floating interest rate like LIBOR, or the "London Interbank Offered Rate." This should be helpful to investors in a rising interest rate environment.
Investors should look for portfolio managers who specialize in these types of loans for any allocation they make to fixed income going forward. Like any investment, moderation is the key, and there are various liquidity issues surrounding certain portfolios of senior secured loans.
However, a complete and comprehensive financial plan should outline the process for generating liquidity in any investor's portfolio. Therefore, with a proper plan in place, having less liquid portions of a portfolio is not such a bad thing, especially over the long term.
David B. Armstrong, CFA, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service wealth management firm. Monument Wealth Management is backed by LPL Financial, the independent broker-dealer and Registered Investment Advisor. David has been named one of America's Top 100 Financial Advisors for two straight years by Registered Rep Magazine (2009 and 2010 based on assets under management) and has been interviewed by several national media sources over the past several years. David and Monument Wealth Management can be followed on their blog Off The Wall, their Twitter accounts @MonumentWealth and @DavidBArmstrong, and on their Facebook page. Securities and financial planning offered through LPL Financial, Member FINRA/SIPC.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results. Asset allocation does not ensure a profit or protect against a loss.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rate rise and bond are subject to availability and change in price.