When rising rates are mentioned in the context of Fed policy, it is short term rates that are being discussed. However, most core bond portfolios are more exposed to longer term rates, such as the 10-year treasury. So even if rates in the front of the curve remain near zero, the 10-year treasury can still rise resulting in a steepening of the yield curve – and negatively affect bond prices.
The 10-year almost doubled from its record low of 0.52% set in August 2020 through mid-November, without much movement on the front end of the curve. During that 3-month period of curve steepening, US Treasuries and investment grade corporates sold-off, while floating rate loans appreciated in value as shown in Figure 1.
Investors tend to gravitate towards floating rate loans only when short term rates are expected to increase. However loans can benefit a portfolio when longer term rates are rising as well. Since floating rate loans have a coupon that resets, they have almost no duration. According to bond math, a small increase in yield can depreciate enough principal from a core bond investment to offset a full year’s worth of income. Playing defense against long duration when the curve is steepening is just as important as playing offense when the Fed is increasing short term rates.
Figure 1: Loans Outperformed Investment Grade as the Curve Steepened
Source: Factset, Morningstar 8/4/2020 – 11/10/2020. Loans represented by the S&P/LSTA Leveraged Loan Index; Corporates represented by the ICE Bofa Corporate Index; Treasuries represented by the Bloomberg Barclays US Treasury Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Challenging Income Environment
With core bonds yielding only modestly over 1% and investment grade corporates less than 2%, income is difficult to come by.1 Floating rate loans are yielding 4.9%, considerably more than investment grade bonds and comparable to other higher yielding asset classes, but with virtually no interest rate risk. Investors in longer duration asset classes have fared well over the last couple of years, but it is important not to chase yesterday’s returns. Duration certainly hasn’t been a problem, but it very well may be in 2021.
Figure 2: Floating Rate Loans Offers Income without Duration
Source: S&P/LSTA, Bloomberg Barclays, ICE Indices, JP Morgan. Loans represented by the S&P/LSTA Leveraged Loan Index; Investment Grade Corporates represented by the Bloomberg Barclays US Corporate Index; MBS represented by the Bloomberg Barclays US MBS Index. Emerging Market Debt represented by the JPM EMBI Global Diversified Index, Short Duration Corporates represented by the Bloomberg Barclays US Corporate 1-3Y Index Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Attractive Relative Value
During the spring of 2020, risk assets responded very favorably to “unlimited Quantitative Easing” and various credit facilities put into place to support financial markets. Notably, floating rate loans were not part of any of these programs. The asset class was still a peripheral beneficiary, as general confidence and a risk-on sentiment supported the market. However, given the propensity of loans to only be in favor amid rising short term rates, they were not bid up to the same degree as bonds. Figure 3 compares floating rate loan, core bond, MBS (mortgage backed securities), and investment grade corporate bond prices to their respective 10-year medians. Investment grade bonds are all trading through their 10 year medians while loans, at a five point discount to par, remain below their median.
Figure 3: Investment Grade Bonds are Trading Above 10 Year Median Price Levels
Source: S&P/LSTA, Bloomberg Barclays.12/31/2010 – 11/30/2020. Loans represented by the S&P/LSTA Leveraged Loan Index; Investment Grade Corporates represented by the Bloomberg Barclays US Corporate Index; MBS represented by the Bloomberg Barclays US MBS Index. Core Bonds represented by the Bloomberg Barclays us Aggregate Bond Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Floating Rate Loans in a Portfolio Context
The question often comes up, “high yield or floating rate loans?” but this does not have to be an either-or decision. There is room for both asset classes in a portfolio and loans can function as a complement to high yield bonds. Even though they are both non-investment grade, there are diversification benefits in terms of individual issuers. Many loan issuers don’t issue bonds so a loan allocation can provide unique issuer exposures and vice versa. On a sector basis, energy is the largest sector in the high yield market at 13%, but it is only 3% of the loan market.
Similarly, fixed income portfolios with a high exposure to investment grade bonds may benefit from a floating rate allocation. Loans are negatively correlated to US Treasuries, have low correlations to core bonds and municipals, and are moderately correlated to corporates. By investing in loans, an investor may be able to generate incremental yield and reduce duration without increasing portfolio risk due to diversification.
Figure 4: Floating Rate Loans Can Help Diversify an Investment Grade Bond Portfolio
Source: Morningstar 12/31/2020 - 11/30/2020. Loans represented by the S&P/LSTA Leveraged Loan Index; Investment Grade Corporates represented by the Bloomberg Barclays US Corporate Index; MBS represented by the Bloomberg Barclays US MBS Index. Emerging Market Debt represented by the JPM EMBI Global Diversified Index, Short Duration Corporates represented by the Bloomberg Barclays US Corporate 1-3Y Index Stocks represented by the S&P 500 Index. Municipals represented by the Bloomberg Barclays Municipal Bond Index. Core Bonds represented by the Bloomberg Barclays us Aggregate Bond Index Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
The benefits of including floating rate loans in a fixed income portfolio are not limited to participating in Fed rate hikes. In the current environment, rather than considering floating rate loans only to participate in rate hikes, investors can think of the asset class as a defensive play against duration. Longer term rates are likely to increase before short term rates, which means reducing duration can mitigate the interest rate risk of a portfolio. By timing the market based on Fed expectations investors may enter with the masses losing value in the process, and at the same time, see longer duration assets struggle against a steepening curve. Given the current attractive entry point, income generation potential, and reduction in interest rate sensitivity, floating rate loans represent a compelling income solution.
1 Bloomberg Barclays 11/30/20
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are
also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer’s ability to make such payments may cause the price of that bond to decline. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
ICE BofAML U.S. High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
S&P/LSTA Leveraged Loan Index is a broad index designed to reflect the performance of U.S. dollar facilities in the leveraged loan market.
Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
S&P 500 Index is widely regarded as the standard for measuring large-cap U.S. stock market performance.
U.S. MBS Index is a component of the U.S. Aggregate index. The MBS Index covers the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).
U.S Corporate Investment Grade Index is publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.
U.S Corporate Investment Grade 1-3Y Index is publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity of 1-3 years, liquidity, and quality requirements. To qualify, bonds must be SEC-registered
U.S Corporate Investment Grade BBB Index is publicly issued U.S. corporate and specified foreign debentures and secured notes that are rated BBB. To qualify, bonds must be SEC-registered
Bloomberg Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market
Bloomberg Barclays High Yield Municipal Bond Index is a rules-based, market-value-weighted index containing non-investment grade issuers engineered for the long-term tax-exempt bond market
JP Morgan EMBI Global Diversified Index include US dollar-denominated Brady bonds, Eurobonds, and traded loans issued by sovereign and quasi-sovereign entities. The index only includes emerging markets issuers which are defined as countries with a combination of World Bank-defined per capita income brackets and each country’s debt restructuring history
Yield Curves plot interest rates of bonds of equal credit and different maturities.
Floating Rate Loans are commercial loan provided by a group of lenders. A loan is first structured, arranged, and administered by one or several commercial or investment banks, known as arrangers. It is then sold (or syndicated) to other banks or institutional investors. Floating rate loans can also be referred to as leveraged loans, bank loans, or senior secured credits.
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