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Market View

There’s more to bank loans than a short-term tactical play on rates; investors would be wise to consider a long-term allocation.

The U.S. Federal Reserve (Fed) was in the news once again last week, as the minutes from the December 2016 meeting of the Federal Open Market Committee (the Fed’s policy-making entity) suggested that, according to The Wall Street Journal, officials anticipated raising short-term interest rates “fairly soon” in light not only of an improving economy but also of the possibility that the Trump administration’s proposed economic policies could push up inflation faster than anticipated. Such media reports have prompted many investors to review their fixed-income allocations and reconsider how they should prepare for the potential of higher interest rates.

One asset class that historically has fared well during previous rising-rate periods has been floating-rate bank loans. Retail mutual fund flows seem to indicate that investors are adding to bank loans as a way to position for higher rates. Flows into Morningstar’s Bank Loan category turned positive in July 2016, and net inflows since then (between July 1, 2016, and January 31, 2017; the most recent data available) have totaled more than $16 billion. But that followed a period of two-plus years of consistent outflows (cumulative outflow from April 2014–June 2016, per Morningstar) during which more than $56 billion exited the category, as most investors had expected a prolonged period of low interest rates and inflation.  This pattern of fund flows would suggest that many look to bank loans simply as a tactical play on interest rates. 

Beyond a Play on Interest Rates
We have argued several times previously that those who only focus on this asset class as way to protect their portfolios from rising interest rates are overlooking many benefits that loans have to offer. Based on the long-term performance profile of the asset class, we suggest that bank loans should be a strategic portfolio allocation. Here are a few reasons:

A source of yield without duration—While market yields have risen over the past nine months, we still are in a low-yield environment, with the 10-year U.S. Treasury bond currently offering a yield of less than 2.4% and the broad Bloomberg Barclays U.S. Aggregate Bond Index offering an average yield of 2.6%.  Bank loans offer higher yields, but without the interest-rate sensitivity of traditional fixed-rate bonds. 

 

Table 1. Bank Loans Recently Offered Comparably Favorable Yield with Low Interest-Rate Sensitivity
As of January 31, 2017

Source: Credit Suisse, Bloomberg Barclays, and Bank of America. U.S. bank loans as represented by the Credit Suisse Leverage Loan Index. U.S. government bonds as represented by the Bloomberg Barclays U.S Government Bond Index. U.S. aggregate as represented by the Bloomberg Barclays U.S. Aggregate Bond Index.  BBB-rated corporates as represented by the BofA Merrill Lynch BBB-Rated U.S. Corporate Index.  BB-rated corporates as represented by the BB component of the  BofA Merrill Lynch U.S. High Yield Index. High-yield corporates as represented by the BofA Merrill Lynch U.S. High Yield Index. 
Past performance is no guarantee of future results. Due to market volatility, the asset classes depicted in this table may not perform in a similar manner in the future. 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 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.

 

Since loans have coupons that adjust with short-term rates, typically every 90 days, they can benefit from a rise in the London interbank offered rate (LIBOR), which typically moves with the U.S. fed funds rate. The performance of bank loans during periods of rising rates, and their ability to capitalize on rising short rates, is what many focus on. However, because of their floating-rate coupon, loan prices are not affected by moves in long-term rates. Due to this structure, loans can provide attractive total returns even if short-term rates stay relatively low, and without the interest-rate sensitivity of longer-duration bonds. During 2013, for example, short-term rates remained low, with LIBOR declining over the course of the year. However, loans (as represented by the Credit Suisse Leveraged Loan Index) generated strong returns of 6.15%, while the Bloomberg Barclays Aggregate Index declined by 2.0%, as longer-duration bond prices were affected by rising long-term rates.

Lower volatility—When considering bank loans, investors need to remember that loans have exposure to credit risk. Similar to high-yield bonds, loans represent another type of borrowing by below investment-grade companies. However, bank loans are “senior” in a company’s capital structure, typically secured by assets, which means that in the case of a default or restructuring, loans have a prior claim on the company’s assets, ahead of bondholders. Due to their seniority, and their floating-rate structure, loans historically have had less volatility than high-yield bonds.

In recent years, the volatility has been extremely low. In fact, over the trailing five years ended January 31, 2017, loans have had lower volatility than high-yield corporate bonds (as represented by the BofA Merrill Lynch U.S. High Yield Index), investment-grade corporate bonds (as represented by the BofA ML BBB-rated U.S. Corporate Bond Index), and even U.S. government bonds (as represented by the Bloomberg Barclays U.S. Government Bond Index). Over longer periods, the numbers will look different, especially when you include the financial crisis of 2008–09 and the subsequent recovery in 2009, a period when all credit-related sectors suffered extreme bouts of volatility. But over the long term, the volatility of loans relative to U.S. high-yield bonds and U.S equities remains appealing. Dating back to the inception of the Credit Suisse Leveraged Loan Index in January 1, 1992 through January 31, 2017, bank loans have experienced only two-thirds the volatility of the high-yield bond market and only one-third of the volatility of the equity market.  Loans even have had lower volatility than investment-grade, 'BBB' rated corporate bonds. 

 

Table 2: Loans Historically Have Had Lower Volatility than Corporate Bonds and U.S. Equities
January 1, 1992 – January 31, 2017

Source: Credit Suisse, Bloomberg Barclays, and Bank of America.  50% U.S. aggregate/50% loans as represented by a 50/50 blend of the Bloomberg Barclays U.S. Aggregate Bond Index and the Credit Suisse Leverage Loan Index. U.S. bank loans as represented by the Credit Suisse Leverage Loan Index.  U.S. aggregate as represented by the Bloomberg Barclays U.S. Aggregate Bond Index.  BBB-rated corporates as represented by the BofA Merrill Lynch BBB-Rated U.S. Corporate Index. High-yield corporates as represented by the BofA Merrill Lynch U.S. High Yield Index.  U.S. equities as represented by the S&P 500® Index.
Past performance is no guarantee of future results. Due to market volatility, the asset classes depicted in this table may not perform in a similar manner in the future. 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 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.

 

Attractive risk-adjusted returns—Historically, the low volatility of loans has resulted in attractive returns for their level of risk.  As illustrated in Chart 1, loans have had higher returns than most investment-grade bond indexes over the five year-period ended January 31, 2017. While returns of high-yield bonds and equities have exceeded that of loans, the low volatility has led to loans offering the highest risk-adjusted returns of these asset classes (as measured by the Sharpe ratio) over the trailing three- and five-year periods. Keep in mind that short-term rates have stayed low during this period, so loans generated a superior performance profile without the benefit of rising short-term rates boosting their coupons.

 

Chart 1. Over the Past Five Years, Loans’ Low Volatility Has Resulted in Comparatively Attractive Risk-Adjusted Returns 
Trailing five years as of January 31, 2017

Source: Credit Suisse, Bloomberg Barclays, and Bank of America. U.S. bank loans as represented by the Credit Suisse Leveraged Loan Index. U.S. aggregate as represented by the Bloomberg Barclays U.S. Aggregate Bond Index. U.S. government as represented by the Bloomberg Barclays U.S. Government Bond Index. U.S. high yield as represented by the BofA Merrill Lynch U.S. High Yield Index.  U.S. Corporate BBB as represented by the BofA Merrill Lynch U.S. Corporate Bond BBB 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 portfolio managed by Lord Abbett 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.

 

Portfolio diversification—While bank loans have attractive characteristics on their own, one of their key benefits comes to life when you combine loans with other asset classes. Over the long term, bank loans have had negative correlation with U.S. government bonds and the broad investment-grade bond market and low correlation with other asset classes such as investment-grade corporate bonds and U.S. equities (as represented by the S&P 500® Index). Most people would say that bank loans (a below investment-grade asset class) are a riskier asset class than the Bloomberg Barclays Aggregate Index (which is all investment grade, and heavily concentrated in government-related securities).  However, since they are driven by very different factors (for example, credit exposure versus interest rate exposure, fixed rate versus floating rate) and have negative correlation with each other, an equal weighted portfolio of bank loans and the Bloomberg Barclays U.S. Aggregate Bond Index historically has had lower volatility than the Bloomberg Barclays U.S. Aggregate on its own.

As mentioned earlier, the Credit Suisse Leveraged Loan Index has had higher returns with lower volatility than the Bloomberg Barclays U.S. Aggregate Index, while having fewer months with negative returns over the past five years.  So it should be clear that the blended portfolio would have lower volatility and a higher Sharpe ratio than the Bloomberg Barclays U.S. Aggregate alone.  But what may be surprising, if you extended that analysis back to the inception of the index in 1992, a period where loans had higher volatility, the blended portfolio would have had lower volatility and a higher Sharpe ratio than the Bloomberg Barclays U.S. Aggregate.

 

Chart 2.  Historically, an Equal Blend of Loans and U.S. Aggregate Has Had Less Volatility than U.S. Aggregate Alone
January 1, 1992 – January 31, 2017

Source: Credit Suisse and Bloomberg Barclays. 50% U.S. aggregate/50% loans as represented by a 50/50 blend of the Bloomberg Barclays U.S. Aggregate Bond Index and the Credit Suisse Leverage Loan Index.   U.S. bank loans as represented by the Credit Suisse Leverage Loan Index. U.S. aggregate as represented by the Bloomberg Barclays U.S. Aggregate Bond 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 portfolio managed by Lord Abbett 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.

 

Certainly, there are environments when bank loans will struggle. Since loans provide exposure to below investment-grade credit, a sharp economic downturn leading to a recession in the U.S. economy could trigger an increase in credit issues and negative performance for bank loans. But in such an environment, high-quality investment grade bonds would tend to do well. This negative correlation is why these asset classes work well together. 

But for now, a U.S. recession does not appear to be on the horizon. Recent data would suggest that the picture for economic growth and the underlying fundamentals for credit risk are improving. In such an environment, loans should continue to provide attractive income even if rates remain low, and can benefit if short-term rates continue to move higher.

Summing Up
Bank loans are in demand today as many people expect a period of rising rates going forward. But there will come a time when market sentiment may change, and the expectations for further rate hikes may diminish. If that happens, should investors then abandon the asset class? We would suggest not. The long-term attributes outlined above (yield relative to duration, low volatility, attractive risk-adjusted returns, and valuable portfolio diversification benefits) would indicate that bank loans deserve an allocation in many investors’ portfolios, without requiring a tactical call on rising interest rates. 

 

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. 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.

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.

The London Interbank Offered Rate (LIBOR) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year.

The Sharpe ratio is a measure for calculating risk-adjusted return. 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 Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.

The Bloomberg Barclays U.S. Government Bond Index is a market value-weighted index composed of all publicly issued nonconvertible, domestic debt of the U.S. government or any agency thereof , quasi-federal corporations, or corporate debt guaranteed by the U.S. government. Flower bonds and pass-through issues are excluded. Total return consists of price appreciation/depreciation plus income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. The CS Leveraged Loan Index is an unmanaged, trader-priced index that tracks leveraged loans. The CS Leveraged Loan Index, which includes reinvested dividends, has been taken from published sources.

The BofA Merrill Lynch BBB-Rated U.S. Corporate Index is a component of the BofA Merrill Lynch U.S. Corporate Index, which tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million. Original issue zero coupon bonds, 144a securities (with and without registration rights), and pay-in-kind securities (including toggle notes) are included in the index. Callable perpetual securities are included provided they are at least one year from the first call date. Fixed-to-floating rate securities are included provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Contingent capital securities are excluded, but capital securities where conversion can be mandated by a regulatory authority, but which have no specified trigger, are included. Other hybrid capital securities, such as those issues that potentially convert into preference shares, those with both cumulative and noncumulative coupon deferral provisions, and those with alternative coupon satisfaction mechanisms, are also included in the index. Equity-linked securities, securities in legal default, hybrid securitized corporates, eurodollar bonds (USD securities not issued in the US domestic market), taxable and tax-exempt US municipal securities and DRD-eligible securities are excluded from the index.

The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $100 million. In addition, qualifying securities must have risk exposure to countries that are members of the FX-G10, Western Europe or territories of the US and Western Europe. The FX-G10 includes all Euro members, the US, Japan, the UK, Canada, Australia, New Zealand, Switzerland, Norway and Sweden. Original issue zero coupon bonds, 144a securities (both with and without registration rights), and pay-in-kind securities are included in the index. Callable perpetual securities are included provided they are at least one year from the first call date. Fixed-to-floating rate securities are included provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Contingent capital securities are excluded, but capital securities where conversion can be mandated by a regulatory authority, but which have no specified trigger, are included. Other hybrid capital securities, such as those legacy issues that potentially convert into preference shares, those with both cumulative and non-cumulative coupon deferral provisions, and those with alternative coupon satisfaction mechanisms, are also included in the index. Securities issued or marketed primarily to retail investors, equity-linked securities, securities in legal default, hybrid securitized corporates, euro dollar bonds (USD securities not issued in the US domestic market), taxable and tax-exempt US municipal securities and DRD-eligible securities are excluded from the index. Index constituents are capitalization-weighted based on their current amount outstanding times the market price plus accrued interest.

The BofA Merrill Lynch BB-rated Corporate Index is a component of the BofA Merrill Lynch U.S. High Yield Index.

The S&P 500 Index is widely regarded as the standard f or 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 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.

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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