If nothing else, the last two years have shown us the importance of diversification. Expectations of Fed rate policy decisions have been everchanging. The 10 US Treasury yield touched 5% for the first time since 2007. It is important to build a diversified portfolio that can perform well across a range of outcomes, and not rely solely on one particular outcome. Positioning a portfolio for interest rate exposure with a long duration was rewarded in 2020 when rates plummeted but was quite costly in subsequent years when rates rose.
One way of diversifying traditional fixed income exposure is through a strategic allocation to floating rate loans. Floating rate loans are a compelling addition to portfolios because they act as a hedge against fixed coupon bonds, reducing interest rate risk while generating high levels of income. Their coupons have two components - a fixed spread and a floating rate reference rate, which is closely tied to Fed Funds. Because of this, some investors try to time the asset class, entering when rate hikes are set to commence and exiting before the Fed pauses. Of course, timing markets and making bets on macroeconomic trends is very difficult. In our view, this approach has led to the asset class being underutilized over the past 12-18 months, overexposing portfolios to rate risk and underexposing them to credit.
Loan mutual funds saw massive inflows in 2021 as US Treasury yields began to rise with the pandemic recovery, putting price pressure on longer duration bond. The tide turned in 2022 and loan funds began experiencing redemptions as investors anticipated a “Fed pivot” along with economic concerns. Despite waning enthusiasm for loans, the asset class proved to be resilient in 2022, declining just 77 bps compared to high yield, investment grade corporates and the Bloomberg Aggregate Index which were all down double digits. The outperformance continued this year and through 10/31, loans are up 10.14% year to date, drastically outperforming other areas of fixed income.
Historically, when the Fed is hiking rates, floating rate loan coupons increase and at the same time, longer duration bonds can struggle if Treasury yields are also increasing. On the other hand, when the Fed has cut rates, longer duration bonds have outperformed floating rate loans. Less obvious is that over the last 30 years, floating rate loans have outperformed core bonds while the Fed has been on hold. The below chart shows rolling 1-year periods based upon Fed policy since 1992, and we found that on average, loans outperformed core bonds both when the Fed has been on hold and when they were hiking rates. With expectations of “higher for longer”, there is a case to be made for investing in floating rate loans.
Loans outperformed core bonds during Fed pauses
Since the summer of 2022, the loan market has outperformed core bonds by almost 1800 bps. This is noteworthy because that is when floating rate loan outflows were accelerating as strategists were starting to recommend adding duration. This is a case in point demonstrating how hard it can be to time rates and the penalty for being incorrect. Having an allocation to both strategies would put performance in between and alleviate the need to make the correct bet.
When making the case for floating-rate loans, it is more of a question of “why always” rather than “why now.” Timing entry and exit points in investing has proven to be extraordinarily difficult, especially being able to do so on a consistent basis. A key tenet of investing has always been diversification, and this has never been more important than in the recent past when there have been so many potential outcomes, given broad uncertainty — monetary policy, fiscal policy, inflation, geopolitical events, etc. These past 12-18 months have shown that treating the asset class as a tactical trade can have an high opportunity cost. It’s time to think of floating-rate loans as a strategic allocation.
Standard deviation is a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance.
The Sharpe ratio divides a portfolio's excess returns by a measure of its volatility to assess risk-adjusted performance.
Duration is a measure of the sensitivity of a fixed-income investment, such as a bond or a bond portfolio, to changes in interest rates.
The Morningstar LSTA US Leveraged Loan Index is designed to deliver comprehensive, precise coverage of the US leveraged loan market.
The ICE BofA U.S. High Yield Index is an unmanaged index that tracks the performance of U.S. dollar denominated, below investment-grade rated corporate debt publicly issued in the U.S. domestic market.
The J.P. Morgan CEMBI Broad Diversified Core Index (CEMBI CORE) tracks the performance of US dollar-denominated bonds issued by emerging market corporate entities.
The J.P. Morgan ESG EMBI Global Diversified Index (JESG EMBIG) tracks liquid, US Dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.
The Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market.
The Bloomberg US Aggregate Bond Index, or the Agg, is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States.
The Bloomberg Global Aggregate Bond Index (USD Hedged) represents a close estimation of the performance that can be achieved by hedging the currency exposure of its parent index, the Bloomberg Global Aggregate Bond Index, to USD.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity. Interest income on these securities is exempt from state and local taxes.
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.
Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, non-diversification, borrower industry concentration, and limited liquidity.
Investing in below-investment-grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. These securities can also be subject to greater price volatility. Diversification cannot assure a profit or protect against loss in a declining market.
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1. As measured by the ICE BofA Broad US Taxable Municipal Securities Index and the Bloomberg Global Aggregate Corporates Index.
2. Moody’s Trends in Global Corporates Rating Transitions, Moody’s US Municipal Bond Defaults and Recoveries as of October 18, 2023
3. Source: Bloomberg
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COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
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THE FOLLOWING INDICES MAY BE REFERENCED IN THIS DOCUMENT:
Bloomberg U.S. Aggregate Bond Index: The Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. Must have at least one year to final maturity regardless of call features. Must have at least $300 million par amount outstanding. Must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. Must be dollar-denominated and non-convertible.
Bloomberg Global Aggregate Corporate Index: Bloomberg Global Aggregate Corporate Index is a flagship measure of global investment grade, fixed-rate corporate debt. This multi-currency benchmark includes bonds from developed and emerging markets issuers within the industrial, utility and financial sectors. You cannot invest directly in an index.
ICE BofA Broad U.S. Taxable Municipal Securities Index: ICE BofA Broad U.S. Taxable Municipal Securities Index tracks the performance of U.S. dollar denominated debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market. Qualifying securities must be subject to U.S. federal taxes and must have at least 18 months to maturity at point of issuance, at least one year remaining term to final maturity to enter the index and one month remaining term to final maturity to remain in the index, a 2 fixed coupon schedule (including zero coupon bonds) and an investment grade rating (based on an average of Moody’s, S&P and Fitch). The call date on which a pre-refunded bond will be redeemed is used for purposes of determining qualification with respect to final maturity requirements. Minimum size requirements vary based on the initial term to final maturity at time of issuance. Securities with an initial term to final maturity greater than or equal to one year and less than five years must have a current amount outstanding of at least $10 million. Securities with an initial term to final maturity greater than or equal to five years and less than ten years must have a current amount outstanding of at least $15 million. Securities with an initial term to final maturity of ten years or more must have a current amount outstanding of at least $25 million. “Direct pay” Build America Bonds (i.e., a direct federal subsidy is paid to the issuer) qualify for inclusion in the index, but “tax-credit” Build America Bonds (i.e., where the investor receives a tax credit on the interest payments) do not. Local bonds issued by U.S. territories within their jurisdictions that are tax exempt within the U.S. territory but not elsewhere are excluded from the Index. All 144a securities, both with and without registration rights, and securities in legal default are excluded from the Index. Index constituents are market capitalization weighted. Accrued interest is calculated assuming next-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the index.
Municipal bond risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes, which could affect the market for and value of municipal securities. Bonds subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. Diversification cannot assure a profit or protect against loss in a declining market.
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