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In recent months, investors have flocked to floating-rate loans for their comparatively attractive yields and relative stability amid volatility in other fixed-income sectors. Bank-loan funds, too, have had continued, strong inflows (including record inflows during the week ended August 7, 2013) since interest rates began to climb in May amid concerns that the Federal Reserve would begin to withdraw monetary accommodation from the U.S. economy.1
While flows have ebbed somewhat in recent weeks, the longer-term trend remains relatively strong, as loan funds have had 71 consecutive weeks of inflows through October 23, 2013, according to Lipper data.
Strong retail fund flows and a dearth of net new issuance of leveraged loans have provided substantial support to the floating-rate market, said Jeffrey Lapin, Lord Abbett Portfolio Manager of Bank Loans. He added that underlying market fundamentals remain favorable, including low default rates, "fairly good" corporate balance sheets, and modest growth in the U.S. economy.
Amid the fixed-income market volatility that has occurred since interest rates began to rise in May 2013, floating-rate loans (as represented by the Credit Suisse Leveraged Loan Index) have offered relatively steady, stable returns compared to other fixed income categories. [Floating-rate loans may not have behaved in this manner previous to this time period. They may not perform in a similar manner in future time periods or during other time periods.]
1 Barclays U.S. Treasury U.S. TIPS Index.
2 Citigroup 10-Year U.S. Treasury Index.
3 Barclays U.S. Aggregate Bond Index.
4 BofA Merrill Lynch High Yield Master II Constrained Index.
5 Barclays High Yield 'Baa'-Rated 1-5 Year Index.
6 Credit Suisse Leveraged Loan Index.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund 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. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Floating-rate (or leveraged) loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Bond prices move inversely to interest rates: when interest rates rise, bond prices fall, and when rates fall, bond prices rise. With floating-rate loans, the opposite is true: loan prices tend to move in the same direction as interest rates; when short-term interest rates rise, loans pay higher income, and they pay less when rates fall. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of loss in the timely payment of interest and principal Like traditional Treasury bonds, Treasury Inflation-Protected Securities (TIPS) are issued by the U.S. Treasury and are guaranteed by the U.S. government. Although, TIPS are inflation-linked bonds that are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. In contrast, a Treasury bond's principal value is fixed. TIPS can be volatile and decline in value over the short term. This typically happens when interest rates rise.
Past performance is no guarantee of future results. Please refer to "Important Information" regarding the economic indicator data in these charts and index information.
This performance illustrates loans' historical negative performance correlation with more interest-rate sensitive securities like Treasuries. Over the last twenty years, loans' correlation with Treasuries has been -0.30, according to Morningstar.
But not all floating-rate loans are created equal. The relative stability of overall returns in floating-rate loans since May 2013 needs to be understood in context. The asset class is comprised of different segments of credit quality. Chart 2 shows the total return posted by the different credit-quality tiers within the Credit Suisse Leveraged Loan Index. The chart reveals that returns on different tiers have varied widely over the past several months.
Source: Credit Suisse.
Note: Upper Tier: Split 'BBB' and BB rated loans; Middle Tier: Split 'BB' and 'B' rated loans; Lower Tier: 'CCC' and Split 'CCC' rated bonds, and default loans as rated by a nationally recognized statistical rating organization (NRSRO) such as Standard & Poor's Moody or Fitch. Split ratings refer to when the same bond is rated differently by the rating agencies.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund 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. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Past performance is no guarantee of future results. Please refer to "Important Information" regarding the economic indicator data in these charts and index information. Lower-rated debt securities may involve greater risk than higher-rated debt securities. High-yielding, non investment-grade bonds involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.
One of the keys to keeping returns in a floating-rate portfolio relatively stable over time is the appropriate weighting of each credit-quality tier in the portfolio. And that's where active management comes into play.
Lapin provides an example of how his team has responded to market developments. "We've swapped into higher-grade items or we've taken off some exposure [to higher-risk securities] generally, and will continue to do this."
As for the longer term, Lapin expects steady economic improvement for the next six to 12 months. As a result, "I think loans will do just fine," said Lapin.
Although past performance is not a reliable indicator or guarantee of future results, there are other factors that argue in floating-rate loans' favor: historically attractive income, portfolio diversification (floating-rate loans have a negative historical correlation with Treasuries), and less volatility than high-yield debt or equities.
"The asset class should retain its relative historical stability due to its location at the top of the capital structure, its minimal durations, and the prospects for relatively healthy corporate credit fundamentals going forward," said Zane Brown, Lord Abbett Partner and Fixed Income Strategist.
1 "Leveraged Loan Fund Inflows Accelerate to $746 Million This Week," LeveragedLoan.com, October 25, 2013.
A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate. As interest rates fall, the prices of debt securities tend to rise, and as interest rates rise, the prices of debt securities tend to fall. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer term debt securities are usually more sensitive to interest rate changes. The longer the maturity date of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated debt securities may involve greater risks than higher rated debt securities. 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 of become illiquid, which would adversely affect the loan’s value. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of loss in the timely payment of interest and principal.
No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.
Diversification does not guarantee a profit or protect against loss in declining markets.
Correlation, measured on a scale of -1.0 to +1.0, is the extent to which the values of two investments move in tandem with one another. A perfect positive correlation of +1.0 between two investments implies that as one security moves, either up or down, the other security will move in the same direction. Alternatively, a perfect negative correlation of -1.0 between two investments implies that they will move in opposite directions. A correlation of 0 implies that the movements of the two investments are not related but completely random.
The Barclays U.S. Treasury U.S. TIPS Index consists of inflation-protection securities issued by the U.S. Treasury. Securities must have at least one year to final maturity.
The Citigroup 10-Year U.S. Treasury Index is composed of all U.S. Treasury notes and bonds with remaining maturities of 10 years and is a subset of the Citigroup Broad Investment-Grade Bond Index.
The 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 BofA Merrill Lynch High Yield Master II Constrained Index is a market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than 'BB-'/'Baa3,' but are not in default. The BofA Merrill Lynch U.S. High Yield Master II Constrained Index limits any individual issuer to a maximum of 2% benchmark exposure.
The Barclays High Yield 'Baa'-Rated 1-5 Year Index is a rating- and maturity-specific subset of the Barclays U.S. Aggregate Bond Index.
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 credit quality ratings of the securities in a portfolio are 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. Credit quality distributions breakdown is not an S&P credit rating or an opinion of Standard & Poor's as to the creditworthiness of the portfolio.
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.