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Market View

Regardless of when—or whether—the U.S. Federal Reserve decides to announce another interest-rate hike, bank loans remain poised to offer attractive income and the potential for capital appreciation.

During much of the past few years, the U.S. Federal Reserve (Fed) maintained a fed funds target rate of 0–0.25%, before finally delivering a quarter-point hike in December 2015. That “zero-rate” policy path, and the investor expectations it fostered, had a significant effect on many major asset classes. Case in point: U.S. bank-loan, or floating-rate, mutual funds. After huge inflows in 2013, these funds have been out of favor among retail investors over the past couple of years, as fears of rising interest rates diminished.

But those who just focused on the Fed are missing the benefits of the asset class. As we outlined in previous Market Views, bank loans historically have offered attractive income, low duration, and portfolio diversification benefits.

Back in February, we noted one other appealing feature: the attractive valuations on offer for the asset class. We believe this still holds true today. Even though the credit markets have recovered (and high-yield bonds have rallied sharply), yield spreads on the representative Credit Suisse Leveraged Loan Index are still wider than historical averages, with prices of underlying bank loans still near multiyear lows (see Chart 1). 

 

Chart 1. Low U.S. Loan Prices May Represent a Valuation Opportunity
Average price of bank loans, May 31, 1996–May 31, 2016

Source: Credit Suisse. Leveraged loans represented by the Credit Suisse Leveraged Loan Index.
Past performance is no guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any portfolio managed by Lord Abbett 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.


These factors, coupled with recent developments on the Fed front, may prompt investors to take a fresh look at floating rate. Commentary from Fed officials in April and May led many market participants to recalibrate their interest-rate expectations. Market expectations shifted to assign a greater probability that the central bank would announce a second tightening move at its June meeting, with the prospect of more hikes in the months to come. 

To be sure, the release of the May U.S. employment report on June 3, which showed well below expected nonfarm payroll growth of 38,000, virtually extinguished expectations for a rate hike in June. But fed funds futures data from Bloomberg still indicate the market believes there is a significant chance of hikes at subsequent Fed meetings in 2016—a 31% probability in July, 46% in September, 50% in November, and 67% in December.

Should the Fed resume tightening, what could floating-rate investors expect? A look at recent history may be useful. There have been three Fed-tightening cycles since the beginning of reliable bank-loan index data in 1992. In each of those periods, bank loans (as measured by the Credit Suisse Leveraged Loan Index) outperformed the broad bond-market benchmark, the Barclays U.S. Aggregate Bond Index (Barclays Aggregate). As Table 1 demonstrates, the three Fed-tightening periods that began in 1994, 2000, and 2004 represent a range of rate hikes and time frames.

 

Table 1. Bank Loans Have Performed Well, on Average, During Previous Fed Tightening Cycles
Total return by index during indicated periods of Federal Reserve rate hikes

Source: Federal Reserve Bank of New York, Barclays, Credit Suisse. Barclays Aggregate=Barclays U.S. Aggregate Bond Index. CS Leveraged Loan Index=Credit Suisse Leveraged Loan Index. Historical data for Credit Suisse Leveraged Loan Index is monthly; returns reflect nearest month-end.

Past performance is no guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any portfolio managed by Lord Abbett 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. Due to market volatility, the market may not perform in a similar manner in the future.
The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall.

 

The three-cycle average performance of 6.04% for the leveraged loan index compares favorably to the 1.01% logged by the Barclays Aggregate. While past performance is no guarantee that bank loans will again perform in a similar manner in the next rate-hike cycle, current Fed guidance suggests that its policy decisions will coincide with evidence of self-sustaining U.S. economic strength. More robust U.S. growth likely would also support the economically sensitive bank loan sector.

Bank loans have the advantage of relatively high income without the duration of traditional fixed-rate bonds. Therefore, they are not adversely affected by periods of rising yields on longer-term U.S. Treasury bonds, as are many other segments of the bond market.  A look at the performance of bank loans during periods of significant increases in U.S. Treasury yields bears this out. Table 2 shows that during seven periods of increases of 100 basis points (bps) or greater in the 10-year U.S. Treasury yield, bank loans performed well, outpacing the Barclays Aggregate and the benchmark U.S. government security. 

 

Table 2. Bank Loans Historically Also Have Fared Well When Treasury Yields Move Higher
Total return by index during indicated periods of increases of 100 bps or more in 10-year U.S. Treasury yields

Source: Federal Reserve Bank of New York, Barclays, Citigroup, Credit Suisse. 10-Year U.S. Treasury=Citigroup 10 Year Treasury Bond Index. Barclays Aggregate=Barclays U.S. Aggregate Bond Index. CS Leveraged Loan Index=Credit Suisse Leveraged Loan Index. Historical data for Credit Suisse Leveraged Loan Index is monthly; returns reflect nearest month-end.
Past performance is no guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any portfolio managed by Lord Abbett 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. Due to market volatility, the market may not perform in a similar manner in the future.
The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. 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.

 

But what if the Fed decides not to raise rates at all in 2016? It’s important to note that in the absence of a Fed move, bank loans still offer attractive income and the opportunity for price appreciation, given the low levels of loan prices discussed earlier. “You don’t need the Fed to get attractive returns on bank loans,” notes Stephen Hillebrecht, Lord Abbett Fixed Income Product Strategist. But if the Fed does hike, and coupons on floating-rate loans adjust accordingly, “it will be icing on the cake.”

What is the important takeaway from all this for floating-rate investors? As we also have said before, making accurate calls on the direction of interest rates is difficult. Investors might be better served by selecting investments with characteristics that compare favorably through a variety of interest-rate environments. This is especially true of bank loans. If the Fed stays on hold, they will still provide the benefits of attractive income and portfolio diversification, along with the potential for longer-term capital appreciation. If the Fed is more aggressive, and launches stage two of its interest-rate “liftoff,” investors could benefit from the upward adjustment in loan coupons. Either way, bank loans could offer an attractive option for investors.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

Related Fund
The Lord Abbett Floating Rate mutual fund seeks to deliver a high level of current income by investing primarily in a variety of below investment grade loans.

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