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Market View

Attractive yields, diversification benefits, and historical performance when rates rise add to the appeal.   

In last week’s Market View, we pointed out that during years in which cash outperforms both stocks and bonds—which is possible this year—stocks and bonds historically both have bounced back nicely in the following one-, two-, and three-year periods.

This week, we’d like to highlight one segment of the fixed-income market that is performing relatively well:  bank loans, also known as floating-rate or leveraged loans. And we would also like to suggest that adding loans to a portfolio of investment-grade bonds may offer valuable diversification benefits and better prepare the portfolio for performance in both risk-on and in risk-off environments.   

This year, through September 30, bank loans are up 1.61%, according to the Credit Suisse Leveraged Loan Index. That’s better than both the high-yield market (-2.42%, according to the Credit Suisse High Yield Index) and the investment-grade market (1.13%, according to the Barclays U.S. Aggregate). 

Why have bank loans held up so well? One reason is technical. As we noted earlier this year, demand for loans has remained strong in 2015, even in the absence of strong inflows to retail mutual funds, as buying from collateralized loan obligations (CLOs) has remained strong. 

A second reason for bank loans’ strong performance relative to high-yield bonds this year is their sector exposure. Compared with the high-yield market, the energy and metals and mining sectors—which have been hit hard in 2015 with falling commodity prices—make up a comparatively small portion of the bank-loan market. The energy sector, for example, recently accounted for approximately 14% of the high-yield bond market, but less than 4% of the bank loan market. Likewise, the metals and mining sector accounted for nearly 4% of the high-yield market and less than 2% of bank loans (all sector weights according to J.P. Morgan as of September 30, 2015).   

So much for this year—what about over the long term? Are there compelling reasons for investors to consider adding bank loans to their portfolios?

Three features make bank loans worthy of consideration. One is their yield, which the Credit Suisse Leveraged Loan Index indicates is just over 5% (current yield). Of course, the flipside of a high yield is an attractive price, and as Chart 1 illustrates, bank loan prices are at a three-year low. This means that with loan prices averaging less than $95, investors may be in a position to capture some price appreciation as well.

 

Chart 1. Bank Loan Prices Are at Their Lowest in Three Years
Average price of bank loans, September 2010–September 2015

Source: Credit Suisse. Leveraged loans represented by the Credit Suisse Leveraged Loan Index.
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.

 

A second feature of bank loans is their diversification benefits. Chart 2 shows that by combining leveraged loans (as represented by the Credit Suisse Leveraged Loan Index) in a 50-50 combination with a portfolio of investment-grade securities (as represented by the Barclays U.S. Aggregate Bond Index, the “Agg”), an investor can significantly reduce portfolio risk. In fact, over the past five years, the 50-50 portfolio has had nearly 30% less volatility than the Agg. Because loans are negatively correlated with the Agg, according to Credit Suisse, the two halves of the portfolio should counterbalance each other as the investment environment cycles between risk-on and risk-off.

 

Chart 2. Combining Leveraged Loans with the Barclays U.S. Bond Aggregate Reduces Risk
Five-year total return and standard deviation

Source: Morningstar. Leveraged loans 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. 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.

 

A third attractive feature of bank loans, of course, is their floating interest rate. Bank loans have outperformed many other fixed-income classes in 2015, even in the absence of a move by the Federal Reserve. But, as Zane Brown, Lord Abbett Partner and Fixed Income Strategist, has noted before, floating-rate loans historically have fared well when the Fed has hiked the fed funds rate.

A move by the Fed may not be imminent, but as we have shown, bank loans don’t need action by the Fed to become attractive. The income and the diversification benefits alone mean that bank loans should be part of an investor’s portfolio.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

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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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