It's a stretch to say markets were roiled by the news – stocks jumped on Wednesday and Thursday – but the Federal Reserve on Wednesday made clear tapering is coming and that a 2022 interest rate is on the table.
Predictably, market participants are turning attention to assets that could benefit from and be vulnerable to rising interest rates and that means advisors have plenty of opportunities to engage clients on the fixed income portions of their portfolios.
As advisors well know, 2021 is already a trying year on the fixed income front and that was the case before it became apparent the Fed is comfortable with accelerating its rate hike timeline. Clients are being pinched by rock-bottom yields on municipal bonds and Treasuries while credit spreads are depressed, indicating the reward for taking on risk above Treasuries isn't what it used to be.
Ominous as all that is, the current fixed income and interest rate landscape is conducive to advisors adding value for clients by introducing them to bond assets they may not be familiar with, inlcuding bank loans.
Good Time to Consider Bank Loans
Also known as leveraged or senior loans, bank loans are high-yield corporate debt that have floating rate components, making the asset as ideal income-generating tool in rising rate climates.
“Floating-rate bank loans exhibit characteristics that make them a potentially useful component of a diversified fixed income portfolio. Specifically, floating-rate bank loans may be an effective hedge against rising interest rates and inflation because their rates reset as market interest rates rise,” according to Victory Capital Management.
Due to the floating rate element, bank loans offer clients significantly reduced duration risk, which is an obvious consideration against rising rate backdrops. Conversely, because leveraged loans are corporate debt, the asset class exposes investors to credit opportunities.
Another point of education advisors can mention to clients is credit quality. As noted above, bank loans are often referred to as senior loans because these bonds are higher up in the pecking order than traditional junk bonds. The benefit is that senior loans usually have higher credit quality and the bondholders claims' must be dealt prior to those of traditional bondholders in the event of issuer default.
The trade-off is that a typical bank loan benchmark, such as the S&P/LSTA U.S. Leveraged Loan 100 Index, will sport a lower yield than the Markit iBoxx USD Liquid High Yield Index. The trade-off is fair when assessing the long-term track record of bank loans.
“The Credit Suisse Leveraged Loan Index, a widely used benchmark for the asset class, has had only two negative years since 1992: once during the height of the global financial crisis in 2008, and a marginal negative return in 2015. On average this index has returned 5.5% annually,” notes Victory Capital.
Bank Loan Correlation Call
These days, advisors aren't only contending with low yields on fixed income instruments and the specter of higher interest rates, they're also grappling with how to generate adequate income while keeping correlations to a minimum within client portfolios.
Fortunately, bank loans display relatively low historical correlations to other bond assets and dividend equities.
“Correlation is the tendency of different types of investments to move in tandem, and it can be a vexing issue for investors seeking to diversify their portfolios, particularly if they have little tolerance for significant swings in valuation. Bank loans have had a low correlation to traditional fixed-income investments and to equities,” concludes Victory Capital.
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