In a low yield environment with increasing interest rates, investors often allocate to floating rate bank loans (leveraged loans) for the additional yield and to mitigate rising interest rate risk. When rates drop, investors who swap out of these assets may be missing out on more than just the yield pick-up. They may be forgoing an opportunity to smooth volatility and further diversify their portfolios.
We take a closer look at the argument for maintaining a consistent allocation to bank loans across rate environments and discover some interesting comparisons to core bonds and the US equity market along the way.
Bank Loans Compared to Bonds – It’s Not Just About the Floating Rate
The last year has been unusual for the markets – the historical negative correlation between bonds and equities (when equities rise, bonds fall and vice versa) seems to be a thing of the past. Despite the continued strength of the markets the Fed has cut rates three times, succeeding in extending the cycle and giving a boost to bond returns as yields declined (price and yield have an inverse relationship).
Investors seeking income look to bank loans for the greater yield, and also view them as a tactical call on rising interest rates. However, they tend to get a little spooked when rates decline. Taking a broader view is instructive. First up, comparing the performance of a benchmark for leveraged loans to a benchmark for the broad bond market reveals that over the long-term, loans can outperform.
Index Performance Comparison (as of September 30, 2019)
As of September 30, 2019. Bank loans are represented by the Credit Suisse Leveraged Loan Index; Bonds are represented by the Bloomberg Barclays U.S. Aggregate Bond Index. It is not possible to invest directly in an index. Past performance is not indicative of future results.
While bank loans are below investment grade and may carry higher levels of risk than investment grade bonds, a comparison of the Sharpe ratios over the three-and five-year periods reveals something interesting: Bank loans offered more attractive risk-adjusted return.
Sharpe Ratio Comparison (as of September 30, 2019)
Bank Loans, CS Leveraged Loan Index; Bonds, Bloomberg Barclays U.S. Aggregate Bond Index. Trailing three- and five- year returns ended September 30, 2019. Sharpe ratio is a way to examine the performance of an investment by adjusting for its risk. It is the average annual return earned in excess of the risk-free rate per unit of volatility or total risk. It is not possible to invest directly in an index.
Bank loans are collateralized, senior secured debt, at the top of a company’s corporate capital structure. The historical recovery rate for these types of securities is 81% – much higher than most other types of higher-yielding debt.1
Finally, because bank loans are negatively correlated to bonds, adding bank loans to a core bond portfolio can provide portfolio diversification.
So, How Do Bank Loans Compare to Equities?
The analysis versus equities is even more cogent. The recent tendency for bond and equity markets to move in tandem means investors may have lost a source of diversification. Leveraged loans may be able to fill that gap. Looking at the S&P 500 as a proxy for the equity markets, from January 31, 2000 to December 31, 2018, the S&P 500 had 82 down months.
In 76 of these months, bank loans turned in better performance than equities. Translated to a percentage, 93% of the time, leveraged loans outperformed when equities (as represented by the S&P 500) had a downturn.
Over the same period, loans have had only two down years, in 2008 and then a very slight negative performance in 2015. This long-term history of positive annual performance speaks to the resiliency of loans across market downturns.
Source: Ares Management. Data monthly from January 31, 2000 to December 31, 2018. Loans represented by the Credit Suisse Leveraged Loan Index (All loans). Past performance is not indicative of future results.
The Reward for Consistent Investing
Given the persistence of the low-yield environment, floating rate loans can offer investors a source of increased yield. However, regarding them as only a tactical investment in a rising rate environment misses some significant portfolio benefits. Beyond the yield premium, these assets offer risk-adjusted returns that can beat the broad bond market, the portfolio diversification benefits of an uncorrelated asset class, and a consistency that can help smooth returns across market cycles.
To learn more about bank loans, please contact your financial advisor.