 there’s clearly credit risk. And the bank loans have sold off this year and because there’s this concern regarding energy that I mentioned some data yesterday on the mid-month strategy update where the spread for energy related high-yield bonds is about 12%. And you’re seeing that in the space for bank loans or these floating rate bond funds. So for example right now the bank loan funds on Money For the Rest of Us Plus, I assumed an expected return over the next ten years of 5%. And that assumed about a 3% default rate and 80% recovery. So at the time that those assumptions were put together the bank loans were yielding 5.9% and then once you factor in the default rate that brought it down and the recovery to about 5%.
Now bank loans are yielding 6.87%, so you’ve had about a one percentage point increase in the bank loan. So as the rates go up, and by rates it’s not the underlying original bond, that’s still paying the same yield tied the LIBOR, but the price has fallen. So the prices have fallen 10% or so as there’s been more concern regarding the credit risk. And so the expected defaults, the actual defaults will probably go up. Now it is concentrated in the higher risk credits, as I mentioned just going back to the high-yield situation the yield on the lowest rate, the non-investment grade bonds, the spread to treasure’s about 15%. The highest rated, the double B credits are yielding 4.5% over Treasures. So you’ve had a huge ballooning out of the speculative-grade credits.
So, first off, if you’re worried about interest rates rising don’t substitute directly bank loans or high-yield bonds. Particularly bank loans because you’re thinking of the reduced interest rate risk, because the credit risk is high and as I’ve mentioned I have about 7% of my bond portfolio in non-investment grade bonds and about 2% in bank loans. And those both come through some closed-end fund exposure I have through a Blackrock fund and a DoubleLine fund. And I’m not aggressively positioned in either one because, back to that second question, I am a little wary of investing in non-investment grade bonds including bank loans when you have spreads widening until we get some type of settle down in terms of the oil prices. And to kind of see what the default situation is going be. Now there are assumptions there on Money For the Rest of Us Plus for ten years so maybe some of you have made that allocation, I think those assumptions are still solid as we look out ten years.
But as we are looking at a shorter-term time horizon, if I don’t have non-investment grade bond exposure I’m not necessarily going in right now until I see those spreads widen to where they’re going be and start to contract. That’s what I did back in the 2008, 2009 period, waited until they got as wide as possible. And then the economy started to recover. And then they narrow. And then you get that capital appreciation. And so, on absolute yield basis high-yield bonds are actually very attractive right now. Yielding almost 9% if default rates only come in at 4.5% as Fitch is estimating next year. If they come in higher than that then maybe those yields are justified, the yields are assuming about a 12% default rate right now, which is pretty fascinating.
So, to answer the first question then, it’s not a great substitute to use bank loans and with rates down really, really low there really isn’t a substitute. If you’re worried about rising interest rates then you essentially have to cut your yield and own either cash or a very, very short duration bond fund, which essentially are yielding nothing. The alternative is to invest in something like peer to peer lending, like I have done, where you can get 5-6% after the defaults. But it’s not as liquid, it is not a liquid holding. The shortest term you can do is three years on Lending Club unless you buy something in their secondary market through Folio where you can get them for less than that. Because they’re a secondary market they’re seasoned loans. But that’s another option, but generally speaking the yields are what they are and interest rates are really, really low. And there’s not a great substitute and it’s what’s made investing difficult this past six, seven years for retirees to invest that had been dependent on income.
And then to talk about that second question then, “Is avoiding high-yield indefinitely until the energy woes flush through, is that too conservative?” Not necessarily because I don’t necessarily think one should move … Maybe you can tip-toe in, I tend to use, he asked about an actively managed situation. When I invest in non-investment grade bonds, I tend to invest in active managers, I want somebody looking at the individual credits and making a decision. A manager I trust, as opposed to doing it passively through an ETF. So I don’t own any passive non investment-grade bonds, ETF’s. I prefer to have a manager looking at it, so they can avoid if, if a credits getting downgraded and a default looks imminent hopefully they can get out. Hopefully they weren’t in in the first place, they had enough skill to realize they could get out. So I prefer, I’ve used closed-end funds.
Now I use actual funds. I’ve used for example the Loomis Sayles Bond Fund in the past. That’s a fund that does invest largely in non-investment grade bond, that fund’s also had a difficult year, down about 7% year to date. I specifically remember, as an institutional manager we had Loomis Sayles. And we knew Dan Fuss really well. We had it in our portfolio. And with spread started widening, once that fund was down we pulled out. We pulled out when it was selling off dramatically and then once the spreads got really, really wide then we went back in. They weren’t real happy that we were moving in and out of their fund but my preference is, when spreads are widening like we are now, I don’t go heavily into non investment-grade bonds. I haven’t sold, I’ve kept my positions in the two closed-end funds because they’re selling at significant discounts to the net asset value. I trust the managers. The yields are very, very high, they’re yielding 9% or 10% or so and so I’m willing to hold them through. They’re very much a long term holding.
So as I reflect on these two questions, I think I answered them, there is not a simple set and forget solution to protect against the risk of rising interest rates, if you want a competitive yield. If you want a very, very low yield there is. You just essentially hold cash, a very, very short duration bond fund. If you want a higher yield you have to take credit risk and you can do it through a bank loan, recognizing the credit risk are high, or you can do some peer to peer lending. And that will protect you against the duration risk.
Regarding the second email then, “Should one, if you get a large lump sum at the end of the year should you dollar cost average in? If it were my money what would I do?” I’m a dollar cost averager. I get an annual payment from my former firm. And have typically have averagde in and deployed it into the best opportunities over, I don’t necessarily take an entire year, but certainly take three to four months to get comfortable with the situation. And that’s how I manage the emotions of my investing. And we are humans, we’re emotional, I recognize what the numbers say. If the markets going up it’s better to put it all in at once. And since the market typically goes up it’s better to put it all in at once. I make better investment decisions reflecting on it and putting it in over time.
And so that’s what I do you have to make obviously your own decision regarding that. But it just takes me a while to get used to having that larger dollar amounts, scaling the trades, et cetera. And I don’t like to make any investment moves suddenly, I have always been an incremental investor. I mentioned on the mid-month strategy update this idea that all long time investing is a series of short-term moves. And, now that this particular listener has a sum to invest he’s got to make the short-term decision how to deploy that. This past year, my most recent December payment I put it all in a private investment, so I guess that was an exception. I deployed it into this real estate debt deal that I did. But last year my payment I deployed it over a series of three to four months. I did that the prior year and that’s my typical mode of procedure because I think I make better decisions and am a less emotional investor. And much of investing is controlling our emotions.
So hopefully I answered those two questions from those of you that sent them in. If not you can just follow up with an email and I’ll try to clarify. Any other questions you might have please email me jd@moneyfortherestofus.com. Have a great week.My precious friend and bridesmaid Audrey is vivaciously alive and leading others to fullness of life. Plus, she overcame cancer. Read about it, let her strength awaken your soul, and lean in to the Holy Spirit’s beckoning to victory. You are victorious.
I love telling how I beat cancer. I