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Market View

A combination of the two fixed-income classes could potentially result in attractive income with reduced volatility, in preparation for differing market and economic scenarios.

Investors are faced with two scenarios: In one, the U.S. Federal Reserve will raise interest rates later this year, according to market expectations and the Fed’s own projections. After all, economic growth is steady, if unspectacular, and is likely to strengthen over the year, while the labor market has shown a firming trend over the past several months.

In the other scenario, the Fed won’t hike interest rates later this year, according to other market observers. While economic growth is steady, if unspectacular, recent data have shown signs of weakness, while the March employment report revealed a surprising decline in the pace of job creation.

Well, which one is it going to be—hike or no hike? Which Fed scenario should fixed-income investors be preparing for? We believe it’s not “all about the Fed,” and that investors don’t have to choose one potential policy outcome over the other. We don’t believe in making big bets on the direction of interest rates, since it is so difficult to get it right consistently. Instead, we posit that there is a way to combine two fixed-income asset classes to realize attractive income with less risk in either event.

Let’s start with the first ingredient in this combination. Core fixed-income portfolios are widely recognized for stability via their holdings of securities with high credit quality, providing basic income with low risk. But many investors would like to receive something more than basic income. That’s where the second ingredient, floating-rate bank loans, comes in. A floating-rate investment isn’t simply a way to benefit from an expected rise in interest rates; it also could provide higher income and added portfolio diversification.

Even in a period of falling interest rates, and a protracted spell of outflows from retail bank-loan funds, the floating-rate segment has retained many attractive features. It recently provided high income, coupled with very low duration (see Chart 1). When incorporated with a core strategy, the resulting blend provided higher income than the typical core strategy with lower duration. 

 

Chart 1. Combining Floating Rate and Traditional Core Bonds Provided Higher Income with Lower Duration Than Core Alone
Yield versus duration of indicated asset classes, as of March 31, 2015

Source: Barclays and Credit Suisse. Bank loans represented by the Credit Suisse Leveraged Loan Index (“Leveraged Loans” or “Credit Suisse”); traditional core bonds represented by the Barclays Aggregate U.S. Bond Index (“Barclays Aggregate” or “Barclays Agg”). The blended portfolio represents a 50-50 combination of the Credit Suisse and Barclays Aggregate 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.

 

Building a bond portfolio that includes core bonds and floating-rate loans also can offer an effective means of portfolio diversification, especially given their negative correlation with each other. Over the last five years, combining a bank-loan portfolio equally with a portfolio of high-credit quality fixed-income securities has actually resulted in a combined portfolio with lower risk and higher returns than the high-credit quality bonds alone. As Chart 2 shows, while bank loans (represented by the Credit Suisse Leveraged Loan Index) had a standard deviation of 3.28% over the last five years, high-quality bonds (as represented by the Barclays Aggregate U.S. Bond Index) measured 2.80%. Yet combined equally, the two asset classes registered a standard deviation of just over 2.02%—far lower than either one on its own. 

Why? The lower volatility most likely reflects the tendency of each portion of the portfolio to respond in distinctly opposite ways to movements in interest rates. The Barclays Aggregate has a correlation of 0.87 with U.S. government bonds, nearly 1:1, while bank loans have a correlation of -0.42. So when combined, the two asset classes can potentially work together to help smooth out volatility in varying market environments. One side of the portfolio will likely be performing well, when the other lags.

 

Chart 2. Combining Bank Loans with Traditional Core Bonds Could Tend to Create a Lower-Risk Portfolio
Five-year risk and return of indicated asset classes and blends, April 1, 2010–March 31, 2015

Source: Morningstar. Bank loans represented by the Credit Suisse Leveraged Loan Index (“Leveraged Loans” or “Credit Suisse”); traditional core bonds represented by the Barclays Aggregate U.S. Bond Index (“Barclays Aggregate” or “Barclays Agg”). The blended portfolio represents a 50-50 combination of the Credit Suisse and Barclays Aggregate 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.
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.

 

There are other factors to consider that could work in this combination’s favor, particularly for floating-rate loans in the current market environment, including supply/demand factors. (Please see this recent article by Lord Abbett Portfolio Manager Jeffrey Lapin and Investment Strategist Brian Arsenault for more details on the improved fundamental and technical picture for the market thus far in 2015.) Notwithstanding the recent negative sentiment from retail investors, floating-rate loans have been an attractive asset class over the long term, with stability that rivals that of the Barclays Aggregate. Since the inception of the Credit Suisse Leveraged Loan Index, floating-rate loans:

  • have provided positive returns in 22 of 23 years (the Barclays Aggregate has been positive 20 out of 23 years);
  • have had only four quarters with returns below -2.0% (the Barclays Aggregate has had three); and
  • have displayed less volatility than high-yield bonds, according to data from Barclays and Credit Suisse.

The potential benefits of this multi-sector approach to fixed income are clear. A combination of core and floating-rate strategies could provide attractive income should the U.S. economy remain in its current “muddle-through” phase. It also could help investors prepare for other scenarios. In a rising interest-rate environment, the floating-rate portion would provide higher income and stronger returns. In a situation where the economy softens, rates fall further, and inflation remains low, the traditional high-quality core bonds would benefit. When the two asset classes are combined, the potential result could be attractive income with less volatility and lower interest-rate risk.

So, returning to the question raised at the beginning of the article, will the Fed raise interest rates in 2015? With this combo approach, investors may not have to worry about it too much. And perhaps best of all, while investors wait for a resolution to the Fed question, they can earn attractive income knowing they are likely prepared for the future. 

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

COMBO COMPONENT #1
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.
COMBO COMPONENT #2
The Lord Abbett Total Return Fund has a track record of generating above-average returns with below-average risk in a variety of market environments.

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