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Fixed-Income Insights

The asset class continues to merit consideration for inclusion in fixed income portfolios, historically producing high income and attractive risk-adjusted returns while offering portfolio diversification.

The year 2014 has been a great example of why interest-rate anticipation is not the best approach to generating consistent returns in a fixed-income portfolio. The year began with the yield on the 10-year U.S. Treasury bond at just above 3.0%, according to Bloomberg, and most experts predicted rates would continue on their upward trajectory. However, Treasury securities surprised most by rallying throughout the year, pushing yields down below 2% in mid-October, before bouncing back to around 2.35% in early November. Data suggesting low inflation, combined with slower economic growth and fears of deflation in certain parts of the global economy, have caused investors to reassess their views on the path of interest rates.

In this environment, longer-duration assets have performed well, with the Barclays U.S. Aggregate Bond Index up more than 5.0%, according to Barclays, and the 10-year Treasury bond up more than 8.6% year to date, as of November 12, 2014, benefiting from the decline in rates. Floating-rate loans (as measured by the Credit Suisse Leveraged Loan Index), which do not benefit from declining interest rates, have generated a positive return of just less than 3.0%, according to Credit Suisse.  

As we noted earlier this year, the outperformance of longer-duration assets, along with reduced fears of rising rates, has led to reduced demand for floating-rate mutual funds. One other source of negativity among financial advisors has been the objection that floating-rate funds had become a popular retail trade. The fear has been that significant retail outflows in a less-liquid asset class would lead to sharply negative returns for loan funds. The decision was to avoid the asset class, or sell out of their loan funds before their peers. As a result, floating-rate funds have been in consistent outflows since mid-April, including a total of more than $20 billion for the Lipper bank loan category. Despite these outflows, the asset class has held up well. Over the six-month period ended October 31, 2014, the Credit Suisse Leveraged Loan Index returned 1.2%, according to Credit Suisse. While this lagged the 2.4% return of the longer-duration Barclays U.S. Aggregate Bond Index, this was better than the 1.0% return of the BofA Merrill Lynch High Yield Index (BofA Merrill Lynch daya) and the 0.5% return of the Barclays 1-3 Year Government/Credit Index (Barclays data). 

The loan market held up well in the face of retail outflows, due in part to the fact that mutual funds make up a relatively small part of the overall loan market. While the bank-loan mutual fund category is about twice the size it was two years ago, with approximately $140 billion in assets, mutual funds still account for only about 16% of the $880 billion bank-loan market (as measured by the Credit Suisse Institutional Leveraged Loan Index, a subset of the Credit Suisse Leveraged Loan Index). Institutional investors such as collateralized loan obligations (CLOs), insurance companies, and hedge funds account for the bulk of the demand. In fact, during this same six-month period of retail outflows, demand was more than offset by $85 billion in demand from new CLO origination, according to data from J.P. Morgan.

It is interesting to note that the retail outflows have occurred while the asset class has generated attractive risk-adjusted returns compared to other areas of the fixed-income market. In fact, as illustrated in Chart 1, the CS Leveraged Loan Index has delivered higher risk-adjusted returns (measured by the Sharpe ratio) than both investment-grade bonds (as measured by the Barclays U.S. Aggregate Bond Index) and high-yield bonds (as measured by the BofA Merrill Lynch High Yield Index) over the trailing three- and five-year periods.

 

Chart 1. Bank Loans Have Offered a More Attractive Risk / Reward Profile
Three- and five-year annual returns, standard deviations, and Sharpe ratios, October 1, 2011—September 30, 2014

Source: Zephyr StyleADVISOR.
High-yield bonds are represented by the BofA Merrill Lynch High Yield Master II Bond Index. Bank loans are represented by the Credit Suisse Leveraged Loan Index.
Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses and expenses, and are not available for direct investment.
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. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan's value. No investing strategy can overcome all market volatility or guarantee future results.

 

The attractive risk-reward profile of the asset class can especially be seen in difficult markets. While it has generally been a positive environment in the credit markets for the past few years, there has been a fair amount of volatility, with alternating “risk-on” and “risk-off” periods. For example, since the beginning of 2012, there were three quarters of negative returns for the Barclays U.S. Aggregate Index during the rising rate period of 2013. The CS Leveraged Loan Index was positive in each of these quarters, outperforming the Barclays U.S Aggregate Bond Index by an average of 240 basis points (bps). There also had been two quarters of negative returns in the high-yield bond market, as credit spreads widened. The CS Leveraged Loan Index also outperformed the BofA Merrill Lynch High Yield Bond Index in each of these “risk-off” periods, by an average of 167 bps.

What is perhaps most impressive, the loan index generated positive returns in the midst of the “taper tantrum” during the second quarter of 2013, when Treasury yields rose and credit spreads widened.  The CS Loan Index was +0.43%, while the BofA Merrill Lynch High Yield and the Barclays Aggregate indexes were down -1.31% and -2.32%, respectively. This should come as no surprise, as we have pointed to these traits as some of the long-term benefits of the asset class: historically negative correlation with government bond returns, with less volatility than high yield bond returns.

 

Table 1. Bank Loans Performed Well During Difficult Markets
Historical quarterly returns, first quarter 2012–third quarter 2014
Source: Morningstar.
High-yield bonds are represented by the BofA Merrill Lynch High Yield Master II Bond Index. Bank loans are represented by the Credit Suisse Leveraged Loan Index.
Past performance is no guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future.  Performance during other time periods may have been different or negative. For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses and expenses, and are not available for direct investment.

 

With the expectation of continued growth in the U.S. economy, and a positive environment for corporate credit, floating-rate bank loans deserve consideration as part of a diversified fixed-income portfolio. Floating-rate funds generate relatively high income, without the duration of longer-maturity bonds, and offer portfolio diversification due to their negative correlation with investment-grade bonds. 

The power of diversification can be seen in Chart 2. Here we plot the trailing five-year performance of the Barclays U.S. Aggregate Bond Index, the CS Leveraged Loan Index, and a 50/50 blend of the two.  Loans have provided higher returns, albeit with higher volatility, over the past five years. But what about a portfolio that blends the two asset classes together? What is surprising to many is that by adding loans to the Barclays U.S. Bond Aggregate, an investor would have increased returns while lowering volatility.

 

Chart 2. The Power of Diversification: A 50/50 Blend Increased Returns While Reducing Volatility
Five-year returns and standard deviations, October 1, 2009–September 30, 2014

Source: Zephyr StyleADVISOR.
Bank loans are represented by the Credit Suisse Leveraged Loan Index; traditional core bonds are represented by the Barclays Aggregate U.S. Bond Index. The blended portfolio represents a 50-50 combination of the Credit Suisse and Barclays indexes.
Past performance is no guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses and expenses, and are not available for direct investment.
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. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. No investing strategy can overcome all market volatility or guarantee future results.

 

Summary
Reduced fears of rising interest rates are one reason for reduced retail demand for floating-rate funds. While technical factors are always a concern and retail flows are a factor, it is important to realize that bank-loan mutual funds are a small part of the overall loan market.

We are not suggesting that interest rates will head substantially higher in the near term. But it is prudent to prepare fixed-income portfolios for multiple economic environments. With the recent volatility in the credit markets, loan prices are down from their peak. In fact, as of October 2014, less than 3% of the loan market was trading at a dollar price above par; that compares to almost 84% of the market trading above par in January of this year. For those who recognize the long-term benefits of the asset class, this may present an opportunity to add to positions at more attractive levels.

 

Table 2. Bank Loans Now Trade Below Par, and Continue to Offer Attractive Yields
Credit Suisse Leveraged Loan Index, October 31, 2014

Source:  Credit Suisse.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses and expenses, and are not available for direct investment.
The average price refers to the average of all the prices of the loans in the Credit Suisse Leveraged Loan Index. Average price is the central or typical value in a set of price data. Average current yield is the annual income (interest or dividends) divided by the current price of the security. Average coupon weight is computed by weighing the coupon rate of each bond in the portfolio by its market value.

 

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