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Fixed income
Rising rates? Senior loans may be the answer ...
As investors continue to position for higher interest rates, even with growing geopolitical concern, one asset class in particular continues to get a lot of attention: floating rate senior corporate loans. When we consider their fundamental characteristics, this is not surprising.
Due to the interest rates on loans being, generally, tied to a 1- or 3-month reference rate, the asset class has effectively zero duration. As our CIO Saira Malik wrote in her recent commentary, in a time of rising rates duration is a key characteristic to consider when examining fixed income asset classes. With their floating rate coupon structure, loans instead are basically a pure form of credit risk. As such, loans are well positioned against a backdrop of continued economic growth and the higher interest rates that are likely to follow. The loan asset class is also nearly entirely dominated by U.S.-based issuers with U.S.-oriented businesses, which may prove beneficial given concerns overseas. As a result, the asset class has seen strong demand since the beginning of 2021, which has continued despite recently elevated volatility. Given that strong demand, valuations in loans make credit selection as important as ever, though the recent volatility has created some new opportunities. In our opinion, for income-oriented investors looking to allocate capital into a rising rate environment loans could well be a powerful part of the solution, if troubled credits and defaults can be avoided.
Loans have proven resilient
In 2021, the market saw volatility in both the front and back end of the yield curve. Throughout this period, loans remained remarkably stable considering the volatility seen by other fixed income asset classes. Even high yield bonds, which are less duration sensitive than investment grade bonds, and are close to a hybrid equity-fixed income asset class, have oscillated in response to moves in the rate market.
The stability of senior loans is arguably what investors should be most focused on. Somewhat coincidentally, despite different volatility profiles, loans and high yield bonds ended 2021 with nearly identical total returns. So far in 2022, however, high yield has again seen significant volatility. This time it is being caused by a combination of the threat of higher rates and also geopolitical uncertainty. Loans, again, have been quite resilient.
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Endnotes
Sources
Sources
Gross Domestic Product: U.S. Department of Commerce; Treasury Yields and Ratios: Bloomberg (subscription required); Municipal Bond Yields: Municipal Market Data; ICI Fund Flows: http://www.ici.org/research/stats; Municipal Issuance: Seibert Research; Defaults: Municipals Weekly, Bank of America/Merrill Lynch Research, July 7, 2017; State Revenues: The Nelson A. Rockefeller Institute of Government, State Revenue Report, June 2017; State Budget Reserves: Pew Charitable Trust. Global Growth: International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD); Standard & Poor’s and Investortools: http://www.invtools.com/; Flow of Funds, The Federal Reserve Board: http://www.federalreserve.gov/releases/Z1/Current/z1.pdf; Payroll Data: Bureau of Labor Statistics; Bond Ratings: Standard & Poor’s, Moody’s, Fitch; New Money Project Financing: The Bond Buyer; Consumer Price Index: http://www.bls.gov/cpi/ http://research.stlouisfed.org/fred2/series/CPIAUCNS; State of Connecticut Fiscal Year 2017 Comprehensive Annual Financial Report; State of Connecticut Annual Information Statement; State of California Official Statement dated March 6, 2018; Moody’s Analytics, California, April 2, 2018; BLS.gov; State of California, Comprehensive Annual Financial Report, FYE June 30, 2017; New Fiscal Plan for Puerto Rico, Restoring Growth and Prosperity, April 2018; Puerto Rico’s Financial Oversight and Management Board hearing on April 19, 2018; The Bond Buyer, Governor’s opposition to Puerto Rico fiscal plan could end up in court, April 20, 2018
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A word on risk
All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments.
