Since the Federal Reserve has raised short-term rates three times in the past six months and has clearly conveyed its intentions to "normalize" rates in a deliberate and methodical fashion, many investors are concerned about how their portfolios may be affected by a tightening cycle.
Rising rates are usually accompanied by robust business conditions during which economically sensitive investments and exposure to credit risk are well rewarded. Given that backdrop, floating-rate instruments — notably, senior bank loans — are a compelling way to reduce rate exposure.
Experience shows that during rising rate periods, senior bank loans can play a very helpful role in a portfolio, providing both relatively high income and the benefits of economic expansion in a double-barreled defense against interest-rate risk. As shown in Figure 1, senior loans deliver materially lower interest-rate risk (effective duration) than conventional fixed income securities — and higher yields than most. This makes senior loans a potentially effective diversifier against the primary risk faced by all fixed-rate securities when interest rates rise.
The floating-rate interest paid on a senior loan will rise and fall with changes in interest rates, but a change in rates alone rarely impacts the price of that loan. In fact, absent other factors, such as changes in the creditworthiness of a borrower, the price of a senior loan remains generally stable in the face of changes in market rates. Prices might fluctuate for other reasons, but in a broadly diversified loan portfolio such changes have been moderate, except in the event of economic recession or a severe market dislocation (such as in 2008).
Loans pay a two-part coupon — a base rate (typically 60-day London interbank offered rate) plus a contractual credit spread. In the current interest-rate environment, loans generate attractive yields, as shown in Figure 2. Rising short-term rates have historically led to a pickup in demand for the asset class, which can lead to short-term spread compression, but assuming the Federal Reserve continues along its prescribed path, such compression should not materially impact coupons, which remain above the average post-financial crisis average of 4.6%.
With some uncertainty still surrounding the actual trajectory the rise in rates will take, a look at the past experience of various asset classes might inspire confidence about expectations for total returns in such conditions.
There is, of course, no guarantee that loans will outperform as the Fed gradually removes monetary accommodation. However, Figure 3 shows, at the very least, during past tightening periods, loans outperformed the broad bond market (and most other alternatives). Combining all the past tightening periods, leveraged loans produced an average return of 6.45% compared to 2.55% for the Bloomberg Barclays U.S. Aggregate index. Beyond the actual historical experience, the conditions that tend to lead to rate hikes — strong economic growth and potentially rising inflation — also support the case for senior loans as a permanent part of most portfolios, regardless of the timing of Fed policy changes.
While some investors might be reluctant to take on below-investment grade exposure, today's credit risk situation remains relatively benign. In general, corporate leverage ratios are at acceptable levels, and corporations' ability to service debt continues to be, on average, relatively strong. Defaults are near historical lows and expected to remain so at least through 2018. Finally, senior loans are backed by corporate assets as collateral. This has resulted in historically higher recovery rates than those for subordinated/unsecured debt.
Corporate fundamentals favor loans, and their unique diversification benefits vs. fixed-coupon bonds make them a natural counterpoint to all fixed-income investment risks. And if the U.S economy continues to grow at a reasonable rate — as fundamentals suggest it should — it's probable loans will deliver attractive returns relative to other assets regardless of what speed at which the Fed decides to increase short-term rates.
Finally, careful consideration is in order when selecting a senior loan strategy. Many loan funds actively include a sizable allocation to other bond or bond-like assets, which can materially change the risk profile of a portfolio, particularly in a rising rating environment. Similarly, keep in mind that senior loans are below investment grade: broad diversification and in-depth fundamental research aimed at avoiding credit losses are crucial steps in keeping their potentially high income as stable as possible.
Jeff Bakalar is co-head of Voya Investment Management's senior loan group, based in Scottsdale, Ariz. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.