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Market View

The asset class continues to offer attractive income, and current loan prices and yield spreads may signal the potential for capital appreciation.

Investors who think of floating-rate funds (also known as senior loan or bank loan funds) only as a tactical play on the direction of interest rates may be missing a larger opportunity, even if the U.S. Federal Reserve (Fed) decides to hike interest rates at a slower-than-anticipated pace in the coming months. While investors have cooled on this asset class in recent months, bank loans continue to offer attractive income with low volatility.

In 2013, bank loans gained popularity with individual investors as the “taper tantrum”—a media description of the market’s negative reaction to indications from then-Fed chairman Ben Bernanke that the central bank would begin to unwind its quantitative easing program—boosted yields on U.S. Treasury securities, as investors looked to protect themselves from a rising interest-rate environment. Since April 2014, however, worries of rising rates have dissipated amid concerns over slow U.S. economic growth and low inflation. The yield on the 10-year U.S. Treasury note, which peaked at around 3% at the end of 2013, declined to 2.27% by the end of 2015, and was below 1.7% as of February 26, 2016, according to Bloomberg.

With less fear of rising rates, retail investor appetite for floating-rate funds has diminished, as indicated by Lipper data showing outflows from the category for 32 consecutive weeks through February 24. Despite being out of favor during this period of falling rates, the asset class has held up relatively well. As Table 1 shows, bank loans have exhibited less risk (as represented by standard deviation) than either high-yield bonds (as represented by the Credit Suisse High Yield Index [High Yield Index]) or high-quality core bonds (as represented by the Barclays U.S. Aggregate Bond Index [Barclays Aggregate]) over the past three years, while providing returns superior to those of the High Yield index and roughly comparable to the Barclays Aggregate.

 

Table 1. Loans Have Provided Solid Returns with Less Risk
Three-year return and standard deviation for indicated indexes, as of January 31, 2016

Source: Barclays and Credit Suisse.
Bank loan returns represented by the Credit Suisse Leveraged Loan Index. High yield returns represented by the Credit Suisse High Yield Index. Barclays Aggregate refers to the Barclays U.S. Aggregate Bond Index.
Past performance is no guarantee of future results. The historical data are for illustrative purposes only, do not represent 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.

 

Bank loans (as represented by the Credit Suisse Leveraged Loan Index [Leveraged Loan Index]) also can provide valuable portfolio diversification benefits, as they historically have displayed a negative correlation with Treasuries (as represented by the Barclays U.S. Government Bond Index) and far lower volatility of returns than stocks (as represented by the S&P 500 Index). (See Table 2.) As we wrote in a previous Market View, a combination of floating-rate and core bonds can actually reduce overall portfolio risk.

 

Table 2. Loans Have Offered Diversification Benefits
Historical volatility of returns and correlation with Credit Suisse Leveraged Loan Index (CS Loan Index) for indicated dates

Source: Zephyr Style Advisor. Data as of December 31, 2015. CS Leveraged Loan Index=Credit Suisse Leveraged Loan Index. CS High Yield Bond Index=Credit Suisse High Yield Bond Index.
Past performance is no guarantee of future results. The historical data are for illustrative purposes only, do not represent 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.

 

With prices of underlying bank loans near multiyear lows (see Chart 1), floating-rate funds also may offer a valuation opportunity. The average price of loans in the Leveraged Loan Index recently was below $90—a level last seen in early 2010, as the markets were recovering from the credit crisis of 2008–09. Prior to that, you have to go back to the 2002–03 period (during the aftermath of the bursting of the tech/telecom bubble) to find prices below $90. 

 

Chart 1. Low U.S. Loan Prices May Represent a Valuation Opportunity
Average price of bank loans, February 28, 1996–February 24, 2016

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 are not available for direct investment.

 

Another way to view valuation is by looking at yield spreads in the loan market (see Chart 2, which depicts spreads using the three-year discount margin in the Leveraged Loan Index). As of February 26, the average spread in the Leveraged Loan Index was nearly 700 basis points (bps), the highest level in nearly five years and over 200 bps above the long-term average.

Considering the average coupon in the Leveraged Loan Index recently was at 4.8%, the high income and historically low valuations suggest an opportunity for attractive total return in loans, even without the benefit that most investors look to: the tailwind of the Fed raising short-term interest rates.

 

Chart 2. U.S. Loan Spreads Are 200 Basis Points above the Long-Term Average
Discount margin spread, February 28, 1996–February 24, 2016



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 are not available for direct investment.

 

One other point to consider: The bank loan sector has a very low exposure to the energy and metals and mining sectors, which have been a source of concern in other areas of fixed income, such as high yield. These sectors collectively represented only around 4% of the Leveraged Loan Index (2.6% energy, 1.4% metals and mining) as of February 24, 2016. While Brian Arsenault, Lord Abbett Investment Strategist, Leveraged Credit, recently highlighted the outlook for, and potential opportunities within, the high-yield energy sector, those investors who might prefer a lesser weighting to that sector may wish to consider a floating-rate fund, which provides a portfolio allocation to credit, along with attractive current income and the opportunity for upside when loan valuations return to more normal levels, with minimal exposure to commodities.

Summing Up
Floating-rate loans can provide attractive income with less volatility than high-yield bonds or equities. They also can supply a source of portfolio diversification, given the low or negative historical correlation of floating-rate loans with other major asset classes. And with questions about the potential path of future Fed rate hikes, investors in floating-rate loans don’t need rates to go up to receive attractive yield and income. 

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

AN APPEALING CANDIDATE FOR TOTAL RETURN
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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