Other key differences
One of the most important distinctions between investment-grade loans and Treasuries is that the former are issued by private firms, whereas the latter are issued by the U.S. Treasury Department. Investment-grade loans are syndicated loans that are bought or traded by a group of banks or institutional investors. The loans are structured, arranged, and administered by investment and commercial banks (the arrangers) and then syndicated to other banks or institutional investors. Treasuries, on the other hand, are issued by the U.S. Treasury Department at periodic public auctions.
Interest rates and risks
Most Treasuries, with the exception of Treasury inflation-protected securities (or TIPS) and, more recently, floating rate notes (or FRNs) have fixed yields determined at the time of issue. This feature makes the prices of Treasuries vulnerable to changing interest rates. The price of Treasuries decreases as interest rates increase and increases as interest rates decrease. The quantum of increase or decrease varies depending upon their maturity. The longer the maturity, the more responsive the price to interest rate movements.
In contrast, investment-grade loans pay a floating rate based on a reference rate like the London Interbank Offer Rate (or LIBOR). Generally, the interest rate is less than or equal to LIBOR plus 150 basis points (bps), or LIBOR plus 1.5%. The spread will vary depending on the credit rating of the issuer and the term-to-maturity. Other things remaining constant, the higher the borrower’s risk profile and term-to-maturity, the higher the spread.
The high duration risk reflects in the higher price volatility compared to the steady price of investment-grade loans. Note that the shorter Treasuries, as represented by the iShares 1-3 Year Treasury Bond (SHY) ETF, show less volatility than the long Treasuries, as represented by the iShares 20+ Year Treasury Bond (TLT), given their lower duration.
Due to interest rates being set at periodic reset dates, investment-grade loans have a duration of close to zero and little interest rate risk. However, since most investment-grade loans are issued by financials, they do carry sector risk, which is absent in U.S. Treasuries.
Coupon payments are usually semi-annual in the case of Treasuries, whereas investment-grade loans usually pay quarterly interest based on a contractual schedule of reference rate reset dates.
As Treasuries are one of the lowest fixed-income securities, their yield is used as a proxy for the risk-free rate. In contrast, investment-grade loans usually pay interest as a percentage over the risk-free rate, which implies that they’re riskier assets.
To read more about some of the ETFs through which an investor can have exposure to both Treasuries and investment-grade loans, continue to Part 4 of this series.
© 2013 Market Realist, Inc.
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