Text on screen: PIMCO
Text on screen: David Forgash, Head of Leveraged Loan Portfolio Management
Forgash: Bank Loans, also known as Senior Loans or Leveraged Loans represent a compelling opportunity for fixed income investors—especially in today’s interest rate environment.
There are 3 Key Reasons:
Text on screen: TITLE – The case for bank loans; SUBTITLE – Senior loans are a good way to diversify an interest-rate sensitive portfolio, offering exposure to higher-yielding, floating-rate credit at the top of a company’s capital structure.
Image on screen: A diagram displays three benefits of investing in bank loans. On the left, the word LOANS is surrounded by a circle of three arrows, which point one after another in a clockwise direction. Each arrow represents a benefit, explained on the right. The first benefit, in blue, describes how senior loans offer attractive income with low duration, buoyed by rising rates. The second benefit, in green, notes how senior loans offer an alternative to high yield with a seniority of payment, thus meaning a higher recovery rate than high yield bonds. The third benefit, in red, notes how senior loans act as a robust fixed-income diversifier, with a low correlation to traditional fixed-income categories, and have a higher correlation to the Consumer Price Index.
First, is that bank loans have floating rates. So in periods of rising rates, they offer low duration - or interest rate sensitivity.
A second investor benefit is yield. Bank loans tend to provide attractive yields; on par with “high yield” bonds. But with lower volatility and higher “seniority” in the capital structure.
And third, when considering the rest of your portfolio, loans can be a powerful diversifier. Due to their very low historical correlation to traditional fixed income categories, and their relatively high correlation to inflation.
These are some of the reasons that adding a long-term allocation to Loans in the context of a traditional bond portfolio can provide important, defensive benefits.
As well as potentially deliver attractive returns.
Now let’s dive a bit deeper into each of these benefits.
First, their role as a defense against rising rates.
Periods of rising rates are thought to be one of the more pernicious environments for fixed income securities.
Bank loans are one of the few categories of fixed income for which that statement is the opposite—the coupon on senior loans tend to adjust upward with interest rates, “floating” with a spread above LIBOR or SOFR.
Text on screen: TITLE – Loans historically outperform the broad fixed income category in rising rate periods; SUBTITLE – Bank loans have historically performed well during periods of rising rates due to their inherent “floating rate” nature
Image on screen: A bar chart compares the performance of bank loans with that of the Bloomberg U.S. Aggregate during five different periods of rising rates. In each of the periods since 2010, bank loans offered a positive return, while the category of fixed-income was negative. For example, in the latest period shown, from August 2021 to April 2022, bank loans had a return of 1.44%, shown as a blue bar rising above a horizontal line representing zero. Fixed-income lost 10.28% over the same time period, shown as a green bar extending downward below the zero-line. Other periods also had large divergences: during August 2010 to March 2011, bank loans returned 6.27%, while fixed income lost 1.33%. From July 2012 to December 2013, bank loans returned 9.55%, compared with a 1.14% loss for fixed income. For July 2016 to January 2017, the results were 3.31% for bank loans versus negative 5.77% for fixed income, and August 2017 to October 2018, they were 5.86% versus negative 2.11%.
You can see a marked difference in “core” bonds and “Loans”, when you compare their performance in rising rate environments.
In almost all historical rising rate periods, the broader bond market has suffered, while Loans have outperformed
This typically happens when the economy is growing and the Fed is taking steps to cool things off, like in the taper tantrum of 2013, or more recently in summer of 2017.
With the Fed again engaged in raising rates, loans have outperformed other areas of fixed income.
It’s then, that the inclusion of Loans can have a countervailing impact.
A defense, against the effects of rising rates, on the “overall portfolio”.
Another key benefit to loans is the appeal of a higher yielding component in the bond portfolio.
Income, is one of the distinguishing characteristics of the bond portfolio, and that search for yield has been persistent over the last decade—when rates had been at rock bottom levels.
The income, or yield benefit, of loans has clear appeal…and not just during rising rate periods.
Text on screen: TITLE – Loans deliver high yield with low uuration; SUBTITLE – Senior loans currently provide more yield and less duration than most other fixed income asset classes; SUBTITLE – Yield to worst (%) vs Duration
Image on screen: A graph plots yield versus duration for senior loans and three other fixed-income asset classes. Yield to worst is shown on the Y-axis and duration on the X-axis. The plot for senior loans is situated on the upper left-hand side of the chart, with a yield-to-worst of about 6.2% and close to zero duration. U.S. high yield is in the center of the graph, with about 4.3% yield and four years of duration. U.S. aggregate is lower and further to the right, with about 3% yield and almost seven years of duration. Further to the right and slightly higher is U.S. investment grade, with about 3.75% yield and more than eight years of duration.
Over the long term, in both “rising” and “falling” rate periods, they have delivered yield in line with High Yield bonds. But with important differences from HY—which, as a category, has duration of over 4 years.
That brings us to the final point—diversification; and the portfolio impact that the inclusion of loans can have.
In addition to their other benefits, loans have low correlation—in fact negative correlation--to “core” bonds proxied by the Aggregate Index, as well as most components of the bond portfolio.
From treasuries, to mortgages, to investment grade corporates, that correlation is quite low.
Text on screen: TITLE – Senior loans can be a robust diversifier to traditional bonds (and inflation)
Image on screen: Two bar charts show how senior loans correlate to other fixed-income classes and the Consumer Price Index. On the left, a bar chart shows the correlation of various asset classes to the Bloomberg U.S. Aggregate. Correlation is shown on the Y-axis. For bank loans, there is practically none, at negative 0.01. That compares with 0.23 for high yield bonds, 0.88 for high grade corporates, and 0.90 for 10-year Treasuries. On the right, a bar chart shows that bank loans have a 0.27 correlation to the CPI. That’s higher than that of high-yield bonds, at 0.10, Treasury inflation-protected securities, at 0.08, and the aggregate index, at negative 0.15.
Interestingly; Loans also have a HIGHER correlation to Consumer Price Inflation or CPI than most other fixed income categories. This double-barrel, diversifying impact makes loans a particularly effective “additive” to the broader bond portfolio, when incorporated at a strategic level across the allocation.
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Past performance is not a guarantee or a reliable indicator of future results.
A word about risk: Investing in senior loans, including bank loans, exposes the a portfolio to heightened credit risk, call risk, settlement risk and liquidity risk. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Diversification does not ensure against loss.
Correlation is a statistical measure of how two securities move in relation to each other. The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.
Bloomberg U.S. Aggregate Index Bloomberg U.S. Aggregate 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. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Bloomberg Investment Grade Corporate Index is an unmanaged index that is the Corporate component of the U.S. Credit Index. The index includes both corporate and non-corporate sectors and are publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. The corporate sectors are Industrial, Utility, and Finance, which include both U.S. and non-U.S. corporations. The non-corporate sectors are Sovereign, Supranational, Foreign Agency, and Foreign Local Government. ICE BofA Merrill Lynch U.S. High Yield Index is an unmanaged index consisting of bonds that are issued in U.S. Domestic markets with at least one year remaining until maturity. All bonds must have a credit rating below investment grade but not in default. Credit Suisse Leveraged Loan Index The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the $U.S.- denominated leveraged loan market. New loans are added to the index on their issuance date if they qualify according to the following criteria: Loans must be rated “5B” or lower; only funded term loans are included; the tenor must be at least one year; and the Issuers must be domiciled in developed countries (Issuers from developing countries are excluded). Fallen angels are added to the index subject to the new loan criteria. Consumer Price Index (U.S.) The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. Bloomberg U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation-Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $500 million par amount outstanding. It is not possible to invest directly in an unmanaged index.
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