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Market View

During the recent market volatility, loans outperformed both high-yield and investment-grade bonds.

 

In Brief

  • Bank loans have represented an area of relative stability during the recent bout of financial market volatility.
  • Apart from their short-term appeal in times of rising rates, we believe bank loans have many potential portfolio benefits, including attractive income and diversification.
  • We think loans also may be well positioned going forward, amid expectations of continued U.S. economic growth and more U.S. Federal Reserve rate hikes.

 

After an extended period of relative calm, the markets have gone through a bout of volatility. U.S. equity indexes reached record levels in late January 2018, before delivering investors a sharp, swift 10% correction by early February, followed by partial recovery. One potential cause of this equity volatility was investor concern about higher interest rates, as the yield on the 10-year U.S. Treasury note reached 2.95% on February 21, a four-year high, as reported by Bloomberg. As investors went into “risk-off” mode, high-yield credit spreads widened, by about 60 basis points, over a two-week period between late January and early February, Bloomberg reported, a modest move relative to the big correction in stocks.

One area of relative stability during this period of volatility in equities, rates, and credit was floating-rate bank loans.

Similar to high-yield bonds, floating-rate loans are a type of borrowing by below-investment-grade companies. However, since loans generally are senior to bonds in a company’s capital structure, they tend to be more defensive than high-yield bonds during difficult periods in the credit markets. And, given that loans have floating coupons, typically adjusting every 30 to 90 days based on a short-term rate such as the three-month Libor (London interbank offered rate), loans have tended to outperform traditional fixed-rate bonds during periods of rising rates.

Further, during this recent period of volatility, loans have outperformed both high-yield and investment-grade bonds. For the year-to-date period, as of February 21, 2018, the representative Credit Suisse Leveraged Loan Index (“Leveraged Loan Index”) has generated a return of 1.1%, compared to modestly negative returns for high-yield bonds (as represented by the ICE BofA Merrill Lynch U.S. High-Yield Index), and a 2.5% loss in the Bloomberg Barclays U.S. Aggregate Bond Index (“Aggregate Index”), representing investment-grade bonds. Over time, one would expect high-yield bonds to outperform bank loans. However, February (as of February 23, 2018) is on track to be the fifth consecutive month that loans have outperformed high-yield bonds—a stretch of outperformance that has not happened in the past decade.

A Longer-Term View
A review of bank-loan mutual-fund flows suggests that this is an asset class that many investors tactically move in and out of while they try to time moves in interest rates. Industry flows are either strongly positive or strongly negative over long stretches of time. Over the years, we have maintained that bank loans have many portfolio benefits, besides just their performance in rising rates.

We last highlighted the potential benefits of bank loans in a Market View in early September 2017. Coincidently, that was just before the yield on the 10-year U.S. Treasury note hit a recent low of 2.04%, on September 7. Since that low point in yields, the Aggregate Index has lost more than 2.8%, while the Leveraged Loan Index posted a positive return of 2.6%. (See Chart 1.) Looking back a little farther, the 10-year Treasury yield hit a low of 1.36% on July 8, 2016. Since that time, loans have generated a cumulative return of 10.8%, versus a 2.4% loss for the Aggregate Index.

 

Chart 1. Since the Summer of 2016, Bank Loans Have Outperformed Core Bonds
Performance of bank loans versus Bloomberg Barclays Aggregate, data for the period June 30, 2016–February 21, 2018 

Source: Credit Suisse and Bloomberg Barclays.
Past performance is not a reliable indicator or guarantee of future results. 1 U.S. bank loans as represented by the Credit Suisse Leveraged Loan Index. 2 U.S. investment-grade bonds as represented by the Bloomberg Barclays U.S. Aggregate Bond Index. 3U.S. high-yield bonds as represented by the ICE BofA Merrill Lynch U.S. High Yield Index. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrated purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Loans have outperformed the Aggregate Index in recent years, as they have the benefit of carry from their higher coupons, and as rising rates have affected the performance of longer-duration, investment-grade bonds. But that does not mean that an investor should only own loans based on a prediction of future rate moves. To reiterate, regardless of what happens with the direction of interest rates, bank loans deserve consideration as part of a diversified fixed-income portfolio, offering investors the potential for:

  • Higher income relative to most investment-grade asset classes;
  • Less duration risk than traditional fixed-rate bonds;
  • Lower volatility than high-yield bonds;
  • Attractive risk-adjusted returns relative to other fixed-income asset classes; and
  • Valuable diversification benefits, given their negative correlation to investment-grade bonds.

Chart 2, which looks at trailing risk-adjusted returns over the past five years, suggests that investors would have been well served by maintaining an allocation to loans as a complement to their core bond holdings. Not only have loans generated higher returns than investment-grade bonds, with lower volatility, but they also have delivered higher risk-adjusted returns (as measured by the Sharpe ratio) than both the Aggregate Index and the ICE BofA Merrill Lynch U.S. High Yield Index. [Of course bank loans are not without risk. The principal risks associated with bank loans are credit quality, market liquidity, default risk, and price volatility.]

 

Chart 2. Historically, Loans Have Had Higher Risk-Adjusted Returns than High-Yield or Investment-Grade Bonds
Trailing five years as of January 31, 2018

Source: Morningstar.
Past performance is not a reliable indicator or guarantee of future results. 1Bank loans as represented by the Credit Suisse Leveraged Loan Index. 2U.S. high-yield bonds as represented by the ICE BofA Merrill Lynch U.S. High-Yield Bond Index. 3U.S. Investment-grade bonds as represented by the Bloomberg Barclays U.S. Aggregate Bond Index. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. While bank loans are secured by collateral and considered senior in the capital structure, the issuing companies are often rated below investment grade and may carry higher risk of default. High-yield debt securities have greater credit and liquidity risk than investment grade obligations.

 

Looking Ahead
While loans have generated strong performance in recent years, they also may be well positioned going forward. One of the catalysts for the recent volatility was continued signs of an improving U.S. economy, with its accompanying potential for higher rates. A growing economy, with no signs of recession in sight, should lead to a continued environment of low defaults in the credit markets, creating a solid fundamental credit environment for loans.

At the same time, this economic environment should allow the U.S. Federal Reserve (Fed) to continue on its path of interest-rate normalization, causing short-term rates to continue their upward trajectory. Three-month Libor (the common reference rate for floating-rate loans) historically has moved in tandem with changes in the fed funds rate. As the Fed has increased short-term rates, three-month Libor has climbed to 1.92%, the highest level in nearly a decade. (See Chart 3.)

 

Chart 3. Short Rates Have Been Adjusting Higher
Trailing three years as of February 23, 2018

Source: Credit Suisse and Bloomberg.
Past performance is not a reliable indicator or guarantee of future results. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

With recent data on the economy and inflation, market indicators are pricing in a higher probability of Fed actions in 2018. In fact, as Chart 4 shows, futures markets are now placing a 40% probability of four or more rate hikes in 2018, compared with less than a 5% probability of that occurring just three months ago.

 

Chart 4. The Market Is Now Pricing in a Greater Probability of Three or Even Four Rate Hikes in 2018
Implied probability of U.S. Federal Reserve interest-rate moves; data from September 1, 2017–February 23, 2018 

Source: Bloomberg World Interest Rate Probability. Implied probability of future fed funds increase based on the Overnight Indexed Swap (OIS) rate, as of February 22, 2018.
Past performance is not a reliable indicator or guarantee of future results. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

While the average coupon in the loan index recently crept up to 5.26%, the increase has not kept pace with the increase in the three-month Libor. What has happened? Borrowers have taken advantage of the strong demand for loans and the favorable environment for credit by refinancing their outstanding loans at lower spreads. As a result, higher Libor rates have been offset by lower spreads from refinancing, leading to a modest increase in the average coupon rate in the loan index. Even though loan coupons have not floated higher as many investors had hoped, the income generated by loans has remained attractive relative to most investment-grade asset classes, which come with much greater duration and interest-rate risk. This potential for re-pricing may continue to limit the upside in coupon adjustments. But as recent performance indicates, the income component of loans can generate attractive returns relative to other fixed-income asset classes, even without the benefit of increasing coupons.

On a final note, we have heard from some clients who remarked that during the recent equity correction they were looking to reduce exposure to credit-sensitive sectors such as bank loans, instead moving to core bonds in order to offset equity volatility. One should keep in mind, however, that if rising rates are one cause of equity volatility, a core bond holding with a six-year duration might not offer the protection that these investors expect. In such an environment, investors may want to limit their duration exposure with an allocation to floating-rate loans. In coming weeks, we will address how short-duration and ultra-short bond strategies may play a role in portfolios to offer potential income, stability, and limited interest-rate risk. 

 

A Note about Risk: 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 interest rates rise, the prices of debt securities tend to fall. 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. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Lower-rated bonds carry greater risks than higher-rated bonds. The principal risks associated with bank loans are credit quality, market liquidity, default risk and price volatility. While bank loans are secured by collateral and considered senior in the capital structure, the issuing companies are often rated below investment grade and may carry higher risk of default.

Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer maturity of a security, the greater the effect a change in interest rates is likely to have on its price. No investing strategy can overcome all market volatility or guarantee future results.

Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.

There is no guarantee that the floating-rate loan market will perform in a similar manner under similar conditions in the future.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described above.

Any examples provided are for informational purposes only and are not intended to be reflective of actual results.

Glossary

A basis point (bps) is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.

coupon is the annual interest rate paid on a bond, expressed as a percentage of the face value.

Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices.

Fed funds are overnight borrowings between banks and other entities to maintain their bank reserves at the U.S. Federal Reserve (Fed). Banks keep reserves at Fed banks to meet their reserve requirements and to clear financial transactions.

The London interbank offered rate (Libor) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It serves as the first step to calculating interest rates on various loans throughout the world.

The Overnight Indexed Swap (OIS) is a swap derived from the overnight rate, which is generally fixed by a central bank. The OIS allows Libor-based banks to borrow at a fixed rate of interest over the same period. In the United States, the spread is based on the Libor eurodollar rate and the Fed’s fed funds rate.

A yield or credit spread is the difference between the quoted rates of return on two different investments, usually of different credit qualities but similar maturities. It is often an indication of the risk premium for one investment product over another.

Sharpe ratio is a way to examine the performance of an investment by adjusting for its risk. It is the average return earned in excess of the risk-free rate per unit of volatility or total risk.

Standard deviation is a measure of the dispersion of a set of data from its mean.

Treasuries are debt securities issued by the U.S. government and are secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

The ICE BofA Merrill Lynch U.S. High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.

Source Merrill Lynch, Pierce, Fenner & Smith Incorporated (“BofAML”), used with permission. BofAML PERMITS USE OF THE BofAML INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD, ABBETT & CO. LLC., OR ANY OF ITS PRODUCTS OR SERVICES.

The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index composed of investment-grade securities from the Bloomberg Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

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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CONTRIBUTING STRATEGIST

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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