Update on Floating Rate: Three Reasons to Consider Bank Loans | Lord Abbett
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Market View

Rising inflation expectations, attractive valuations, and favorable supply/demand dynamics suggest the potential for solid performance for the asset class in the months ahead.

Read time: 4 minutes

The U.S. Federal Reserve (Fed) has been insistent that it will keep the fed funds rate near zero through 2022. “We’re not thinking about raising rates,” Fed Chairman Jerome Powell said at a July 29 press conference.

Long-term rates, however, are another story. Some investors have begun shorting 10-year and 30-year Treasuries, betting that yields will rise. The number of derivatives contracts reflecting this bet was recently at a high for the year, according to an October 20 Financial Times report.1 And, in fact, the yield curve has started to steepen modestly.

Three Factors Favoring Bank Loans

Although a large government debt overhang may weigh on economic growth, three factors suggest that long-term yields could continue to increase, suggesting that floating-rate loans may be worth a closer look.

Inflation expectations are rising

With a COVID-19 vaccine on the horizon, a return to a normal level of economic activity could lead to higher inflation. Combined with extraordinary fiscal and monetary stimulus already in place, this could increase inflationary pressures. Furthermore, a win by Vice President Biden in the U.S. presidential election would likely mean a larger increase in government spending, giving inflation an additional boost, in our view.

This, in turn, could lead investors to reduce the duration of their portfolios, potentially resulting in a sell-off in long-term Treasuries that would cause those yields to rise. And, historically, when Treasury yields have risen, bank loans and other credit segments have outperformed (see Figure 1).

A steepening of the yield curve has historically been supportive of flows into loan funds, and loans have served as a favorable way to play reflation, particularly if the market is underestimating the strength and timing of a U.S. economic rebound.

 

Figure 1. Credit Has Performed Well When Treasury Yields Have Risen

Index returns (month-end annualized basis) during periods when the yield on the 10-year U.S. Treasury note increased by 100 basis points or more

1FTSE 10 Year Treasury Bond Index. 2Bloomberg Barclays U.S. Aggregate Bond Index. 3Bloomberg Barclays U.S. Floating Rate Note Index. 4ICE BofA U.S. Corporate BBB-Rated 1-3 Year Index. 5Credit Suisse Leveraged Loan Index. 6ICE BofA U.S. High Yield Constrained Index. 7ICE BofA All Convertibles All Qualities Index. 8S&P 500 Index.
Past performance is not a reliable indicator or guarantee of future results. Performance during other time periods may have been different or negative. Other indexes may not have performed in the same manner under similar conditions. Source: Morningstar. For illustrative 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. No data available for Floating Rate Note Index prior to 2003.

 

Valuations appear attractive versus high yield bonds

Bank loan valuations also suggest this asset class may outperform. Bank loans have lagged of late, primarily because of a reduction in risk-free rates. Since January 2019, when the Fed pivoted from a tightening bias to an easing bias, fund flows into floating-rate strategies have waned, putting pressure on loan prices.

In contrast, as the Fed eased rates, flows into high-yield retail mutual funds turned positive, as investors sought to own higher-duration products that benefit from interest rate declines. As a result, a pricing disparity has opened up between the high yield market and the bank loan market. The Credit Suisse Leveraged Loan Index is trading at its biggest discount to the ICE BofA U.S. High Yield Constrained Index since late 2010.

Some of this pricing disparity is due to a difference in credit ratings, but the actual risk may be less than ratings indicate. U.S. high yield is dominated by BB rated issues, while the leveraged-loan market is dominated by B ratings. But the loss-given-default of a B-rated loan and a BB-rated unsecured bond could be considered reasonably close, given the default and recovery data of these two cohorts. (While first-lien loan recovery has typically been about 30 basis points higher than on unsecured bonds over the long term, Bs default more frequently than BBs.)

In any case, history shows when loans have traded at spreads that are wide relative to high yield bonds, loans have seen gains over the following year (see Figure 2).

 

Figure 2. History Suggests Bank Loans Could Outperform Over the Next 12 Months

Forward 12-month performance difference of loans versus high yield bonds and spread difference of loans to high yield bonds, November 2012–September 2020


Source: Loans = Credit Suisse Leveraged Loan Index (discount margin). High Yield = ICE BofA US High Yield Constrained Index (spread to worst). Data as of September 30, 2020.
Past performance is not a reliable indicator or 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 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.

 

Demand is outpacing supply

The third factor supporting bank loans is market technicals. While new loan supply has waned, demand has grown. As of August 31, loan issuance year-to-date was running at its slowest pace since at least 2015. In addition, the new issue calendar looks light. Meanwhile, the formation of collateralized loan obligations (CLO), which purchase bank loans, has been rising since March.

 

Figure 3. CLO Formation Has Rebounded, Boosting Demand for Bank Loans

Newly formed collateralized loan obligations by month, January 2014–September 2020

Source: Loans = Credit Suisse Leveraged Loan Index (discount margin). High Yield = ICE BofA US High Yield Constrained Index (spread to worst). Data as of September 30, 2020.
Past performance is not a reliable indicator or 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 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.

 

Summing Up

Although short-term rates are likely to remain near record lows for the next couple of years, investors should weigh the three factors favoring bank loans. This asset class has lagged as short-term rates have come down but rising long-term rates and a favorable supply/demand imbalance should encourage investors to reconsider. This is especially true in light of the historical relationship with high yield bonds, which suggests that bank loans could perform well over the near term.

 

1Laurence Fletcher, Eric Platt and Colby Smith, “Investors Bet US Recovery Will Force Long-Term Bond Yields Higher,” Financial Times, October 19, 2020.

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.

This Market View 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.

A basis point is one one-hundredth of a percentage point.

A collateralized loan obligation (CLO) is a single security backed by a pool of loans, collected into a marketable

instrument via process known as securitization. CLOs are often backed by corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts.

A discount margin (DM) is the average expected return earned in addition to the index underlying, or reference rate of, the floating-rate security.

Spread-to-worst is the difference between the yield-to-worst of a bond and yield-to-worst of a U.S. Treasury security with a

similar duration. The yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. 

The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

The Bloomberg Barclays U.S. Floating-Rate Note (FRN) Index measures the performance of USD denominated, investment-grade, floating-rate notes across corporate and government-related sectors. 

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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

The ICE BofA 1-3 Year U.S. Corporate BBB-Rated Index is a rating-specific unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with between one and three year remaining to final maturity.

The ICE BofAML All Convertibles, All Qualities Index contains issues that have a greater than $50 million aggregate market value. The issues are U.S. dollar-denominated, sold into the U.S. market and publicly traded in the United States.

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

ICE BofA Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA 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 ICE BofA 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 S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

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

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization

(NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from

‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below

are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than

investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

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 this Market View are as of the date of publication and are subject to change. Additionally, the opinions may

not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research, or investment

advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice.

This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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