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Much has been made of the "great rotation" concept, in which investors increase their equity exposure at the expense of their fixed-income allocations. While a strengthening economy may factor into this perceived shift, concerns about an accompanying increase in interest rates may be the greater impetus behind investors' interest in reducing their fixed-income exposure.
After years of aggressive monetary stimulus, many investors may be wary of an eventual tightening in monetary policy, similar to that which occurred in 1994, when the Federal Reserve raised the fed funds rate and the 10-year Treasury note posted a loss of 8.3%. But that loss occurred in what was a vastly different interest-rate environment, when the yield on the 10-year note ranged from about 5.5% to more than 8.0%.
With a current 10-year yield of about 2.05%, there are concerns that a potential tightening of monetary policy could lead to a more intense bout of interest-rate volatility relative to what was experienced two decades ago. Therefore, a shift into equities with the intent of decreasing interest-rate risk may be rational when considering that the S&P 500® Index had a negative, long-term correlation of -0.17 with U.S. Treasuries.
But is an increase in equity exposure the best way to hedge against an increase in interest rates? It turns out that investors looking for even less correlation to Treasuries may not need to venture away from fixed-income. After all, the minimal duration on floating-rate loans historically has been reflected in a negative long-term correlation of -0.31 to Treasuries and the loan markets' gain of 10.3% in 1994.
Source: Bloomberg, Standard & Poor's, MSCI, Russell, and Credit Suisse.
* Treasuries as represented by the Bloomberg EFFA U.S. Government 5- to 7-Year Index.
1 The S&P 500 Index. 2 The Credit Suisse High Yield Index. 3 The MSCI EAFE Index. 4 The Russell 2000 Index. 5 The Credit Suisse Leveraged Loan Index. 3-Year Discount Margin.
Correlation is a number between -1 and +1 that measures the degree of association between two variables. A positive implies a positive association, and a negative value implies an inverse association.
The reduced sensitivity of loans to interest-rate risk has not prevented them from providing relatively attractive yields, considering that the asset class yielded 5.22% as of February 28, 2013. While this is slightly lower than high-yield bonds, floating-rate loans are secured by an issuer's assets and have, historically, experienced less market volatility and higher recoveries in bankruptcy situations when compared with high-yield bonds. And at this point in the credit cycle, bankruptcies remain relatively rare, as the long-term default rate on loans stood at 1.21% at the end of February, less than half of the long-term average.
Source: Barclays, Bloomberg, BofA Merrill Lynch, and Credit Suisse.
1 The BofA Merrill Lynch U.S. Treasury Bill 3-Month Index. 2 The Barclays Corporate A-Rated Index. 3 The Barclays Corporate Baa-Rated Index. 4 The Credit Suisse Leveraged Loan Index, 3-Year Discount Margin. 5 The Credit Suisse High Yield Index.
Average Yield to Maturity (YTM) is a long-term bond yield expressed as an annual rate. The calculation of Average YTM takes into account the current market price, par value, coupon interest rate and time to maturity. It is the rate of return anticipated on a bond if it is held until maturity date.
The combined attributes of the asset class "suggest that exuberance for floating-rate loans is an investment approach that is more rational than irrational in the current environment," said Zane Brown, Lord Abbett Partner and Fixed Income Strategist.
IMPORTANT INFORMATION
All links are directed to Lord Abbett's website.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Floating rate loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Bond prices move inversely to interest rates: When interest rates rise, bond prices fall, and when rates fall, bond prices rise. With floating rate loans, the opposite is true: Loan prices tend to move in the same direction as interest rates, when short-term interest rates rise, loans pay higher income and less when they fall. Corporate bond and stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.
Past performance is no guarantee of future results. Current performance may be higher or lower than the performance data quoted. All indexes are unmanaged and do not reflect reinvestment of dividends and distributions, deduction of management fees, or operating expenses. An investor cannot invest directly in an index.
Investors should consult with a financial advisor on the strategy best for them based on their individual goals, risk tolerance, and investing time horizon.
Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of investments in fixed-income securities will change as interest rates fluctuate. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Investments in high-yield securities (sometimes called junk bonds) carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Income from municipal securities may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. No investing strategy can overcome all market volatility or guarantee future results.
Foreign securities generally pose greater risk than domestic securities, including greater price fluctuations and higher transaction costs. Foreign investments also may be affected by changes in currency rates or currency controls. With respect to certain foreign countries, there is a possibility of nationalization, expropriation, or confiscatory taxation, imposition of withholding or other taxes, and political or social instability that could affect investments in those countries.
Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.
Floating-rate loans have no government guarantee.
The credit quality ratings of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from AAA (highest) to D (lowest). Bonds rated BBB or above are considered investment grade. Credit ratings BB and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities. Credit quality distributions breakdown is not an S&P credit rating or an opinion of S&P as to the creditworthiness of the portfolio.
Index Descriptions
The S&P 500® Index is a market capitalization-weighted index of common stocks.
The Bloomberg EFFA U.S. Government 5- to 7-Year Index is an unmanaged index that tracks movements in the prices of government bonds with 5- to 7-year maturities.
The Credit Suisse High Yield Index is an unmanaged, trader-priced index constructed to mirror the characteristics of the high-yield market. The index includes issues rated BB and below by S&P or Moody's, with par amounts greater than $75 million.
The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. The CS Leveraged Loan Index is an unmanaged, trader-priced index that tracks leveraged loans. The CS Leveraged Loan Index, which includes reinvested dividends, has been taken from published sources.
The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.
The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.
The BofA Merrill Lynch U.S. Treasury Bill 3-Month Index is an unmanaged index that tracks the price and yield of the three-month U.S. Treasury Bill.
The Barclays U.S. Corporate A-Rated Bond Index is a subset of the Barclays Aggregate Bond Index, which includes only corporate bonds with a rating of A.
The Barclays U.S. Corporate Baa-Rated Index is a subset of the Barclays Aggregate Bond Index, which includes only corporate bonds with a rating of Baa1, Baa2, or Baa3.
The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
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