Beyond Bonds: Buyer Beware

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David Evanson and Oliver Pursche

TheStreet.com, Fall, 2013

As we exit the low interest rate era and return to rising rates, bonds and other fixed income instruments will come under selling pressure. This means in 2014 investors will be hunting for bond replacements in order to help safeguard their portfolio without having to account for falling bond prices and volatility.

Some investors will migrate to one or more of the hybrids — floating rate securities, step-up bonds and Treasury inflation protected securities. However, Izzm seeing sophisticated investor moving into some questionable alternatives (in my mind) and I just want to highlight the downside and risks associated with those instruments.

In particular, Izzm seeing investors discussing master limited partnerships, interest rate linked structured notes and bank loan products as if they were interchangeable with bonds. Theyzzre not and herezzs why.

Master Limited Partnerships
Master limited partnerships have become increasingly popular with investors seeking high yield investments in a low-interest rate environment. Generally, most, although not all MLP earn the majority of their “income” from energy related activities — think oil or natural gas pipelines and youzzve pretty much got it.

To date, these have been investor “darlings.” Two of the largest, the Kayne Anderson MLP (KYN) and JPMorgan Alerian MLP ETN (AMJ) are up significantly this year. Each is trading at a premium to its net asset value.

MLP investors, like any other partnership, are considered unit holders. MLP investments receive different tax treatment than ordinary income producing investment. As such, MLP investors receive a K1 instead of a 1099, potentially negating certain tax deductions. Most significantly, MLP “income” is typically a combination of actual income and return of the investorszz own principal. As such, the “true” MLP yield can be significantly lower than their cash-flow implies.

The takeaway: Given the lower “real” yield that is produced, as interest rates rise, the attractiveness of the MLP income potential is likely to decline.

Interest Rate Linked Structured Notes
Interest rate linked structured notes provide investors and speculators the ability to “bet” on the direction of a specific benchmark interest rate, for instance LIBOR or the ten-year Treasury. In November, Goldman Sachs (GS) alone sold $1 billion of these floating rate instruments.

If the investorzzs thesis proves correct, then the IRL will rise in value, potentially generating above market rates of return. Conversely, if the thesis is incorrect, as a result of the aggressive nature of IRLs, investors could lose the entirety of their investment.

The takeaway: Interest rate linked structured notes should not be compared to bonds, as they are mostly used as speculative instruments and in seldom cases as part of a complex hedging strategy.

Bank Loan Products
Typically reserved for institutions and ultra-high-net-worth individuals, bank loan products are just as the name implies — the investor is the lender.

The investment into bank loan products, typically structured in a fund format, is capital used to offer loans and other lending structures to third-parties. Moreover, most of bank loan products are structured as leveraged loans, thereby greatly increasing the risk associated with these instruments. Popular funds in this space include PowerShares Senior Loan Portfolio (BKLN) and the SPDR Blackstone/GSO Senior Loan (SRLN).

The takeaway: While these instruments can have significant returns, the risk is highly dependent on the skill and due diligence capabilities of the manager. In other words, with interest rate risk you lose the opportunity cost of yield but with credit rate risk, you can lose everything.