We began the year with a theme – “defending against duration” – and positioned floating rate loans as a way of earning income while avoiding the negative impact a steepening yield curve has on fixed rate bonds. Through May, floating rate loans were up 2.90% year to date while investment grade corporates and core bonds were down 2.68% and 2.29% respectively. This idea was widely adopted as bank loan mutual funds have taken in an impressive $24.4bn this year, nearly recouping last year’s $27 bn of outflows. 1
Figure 1: Defending against duration with floating rate loans
Floating rate loans outperformed investment grade amid rising 10-year
Source: FactSet, Morningstar 12/31/2020 – 5/31/2021. Loans represented by the S&P/LSTA Leveraged Loan Index. Core represented by the Bloomberg Barclays US Aggregate Bond Index. Corporates represented by the ICE BofA Corporate Index. 10-year treasury is the daily yield of US Treasuries with a constant maturity. It is not possible to invest directly in an index. Past Performance does not guarantee future results.
Let’s shift from the 10-year US Treasury to Fed Funds. Typically, the bank loan category sees inflows in anticipation of Fed rate hikes. The rationale is that floating rate loan coupons are structured as a fixed coupon over a floating reference rate. Therefore, as the floating reference rate increases, which is often the case when the Fed Funds rate increases, investors will likely participate in those rate hikes through higher income. With the Fed on pause in the near-term, we believe the inflows have been due to the fact that loans have virtually no duration – the “defending against duration” play. Longer duration investment grade funds have declined in value due to the inverse relationship between rates and prices.
Lately, the 10-year has remained fairly range bound, and is off its March peak of 1.74%, so it makes sense to revisit the asset class value proposition given rate hikes are not imminent. First and foremost, we are constructive on fundamentals as the economy recovers. The default rate has declined to 1.52% and corporate earnings and balance sheets are improving. With a positive credit backdrop, we took a closer look at rates and the relative performance of loans versus the Bloomberg Barclays US Aggregate.
Based on rolling 1-year returns going back almost 30 years, floating rate loans have an average return that is greater than that of core bonds when the Fed is hiking rates. This of course was expected. What is interesting, however, is the performance during periods characterized by the Fed being on hold (and no change in Fed Funds rate). Floating rate loans outperformed bonds during these periods as well.
Figure 2: Rolling 1 year returns vs. core bonds segmented by Fed rate
cycle
Leveraged loans historically outperformed core bonds while Fed on hold
Rolling 1-year returns since 1992
Source: FactSet, Morningstar. Average 1 year rolling returns 01/31/1992 - 12/31/2020. Leveraged Loans represented by the Credit Suisse Leveraged Loan Index. Core bonds represented by the Bloomberg Barclays US Aggregate Bond Index. Loosening represents 1 year periods in which the Fed Funds Target Rate was lowered. Tightening represents periods in which the Fed Funds Target Rate increased. Floating rate loans can also be referred to as leveraged loans or bank loans. An investment cannot be made into an index. Past performance is no guarantee of future results.
Another related topic that is widely talked about in the media as well as being top of mind for investors is inflation. While there is disagreement around how much of the uptick in inflation is transient, most would agree at least some of it will be persistent. When considering how to position a portfolio for inflation, it is important to look beyond traditional inflation hedge measures. Over the last 15 years, the Bank Loan Morningstar category has a higher correlation to inflation than categories though to be inflation hedges such as Commodities Broad Basket and Natural Resources.
Figure 3: The Bank Loan fund category has a higher correlation to inflation than most
Source: Morningstar, as of 03/31/21. Inflation is represented by the IA SBBI US Inflation Index which shows the rate of change in consumer prices in the US. Correlation is a measure of how closely two variables move together over time. A -1.0 equals total negative correlation whereas a 1.0 equals total positive correlation. Correlation is historical and does not guarantee future results. The chart above is for illustration purposes only. Asset classes are represented by Morningstar categories. Past Performance is no guarantee of future results.
By the end of the first quarter, the 10-year Treasury nearly tripled from its record low yield set on August 4, 2020. Since then, the yield has declined and has become somewhat range bound. Still, the case for a strategic allocation to loans persists. Besides being a defensive play against the 10-year and an offensive play on Fed Funds, floating rate loans may provide attractive returns during the interim as well.
1. JP Morgan Credit Strategist Weekly Update, 6/11/2021
About Risk
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
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. Liquidity risk may also refer to the risk that the investment may not be able to pay redemption proceeds within the allowable time period because of unusual market conditions, unusually high volume of redemptions, or other reasons. To meet redemption requests, the investment may be forced to sell securities at an unfavorable time and/or under unfavorable conditions. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. 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.
This material represents an assessment of the market environment as of 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. 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. 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.
Index definitions
Bloomberg Barclays US Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed rate taxable bond market, including Treasurys, 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. The Credit Suisse Leveraged Loan Index is an unmanaged index that represents tradable, senior-secured, U.S.-dollar-denominated non-investment-grade loans. This index includes $US-denominated leveraged loan market. To qualify, loans must have a Moody’s/S&P rating no higher than Baa1/BB+ or Ba1/BBB+. ICE BofAML US Corporate Index tracks the performance of U.S. dollar-denominated investment grade rated 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.
Definitions
Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. Duration is a measure of sensitivity of a bond's or fixed income portfolio's price to changes in interest rates.
Floating rate loans are commercial loans 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.
Yield curves plot interest rates of bonds of equal credit and different maturities.
“New York Life Investments” is both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company. Securities are distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.
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