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The appeal of floating-rate loans usually peaks when interest rates are rising. But they may help diversify your portfolio in any environment.
Floating-rate loans are known by many names, including bank loans, senior loans and leveraged loans. They’re typically extended to companies with higher levels of debt relative to their cash flows, and because of this, they carry greater credit risk than investment-grade bonds. But unlike traditional bonds, floating-rate loans don’t make a fixed-interest payment, or coupon, each period. Instead, their coupons reset every 30, 60 or 90 days, floating up or down with the changes in prevailing interest rates. This floating feature makes loan prices less sensitive to shifts in interest rates, so there tends to be a significant uptick in how much is flowing into the asset class when the Federal Reserve is actively raising rates in response to a growing economy and improved labor market. And, as you can guess, this trend tends to reverse when rates aren’t rising.
Past performance gives this approach credibility. When rates are rising, the median annual return for floating-rate loans, as gauged by the Credit Suisse Leveraged Loan index, is more than 6% higher than for U.S. Treasuries and the Bloomberg Barclays U.S. Aggregate Bond Index. But what’s possibly overlooked is that floating-rate loans have also delivered attractive absolute and relative performance regardless of the broader interest-rate environment. Because yield is such a significant component of total return, floating-rate loans also have outperformed U.S. Treasuries and the Bloomberg Barclays Aggregate Bond Index when rates are flat. It’s only when rates fall that we have seen floating-rate loans become a relative “underperformer.”
Floating-rate loans may add diversification in any interest-rate environment.
Although their interest-rate related benefits are what drive investors’ flows into and out of the asset class, floating-rate loans can help diversify a portfolio at any time — and this benefit can be overlooked. Most of the return in floating-rate loans comes from their exposure to credit risk (exposure to corporations) while the Bloomberg Barclays U.S. Aggregate Bond Index gets most of its return from duration risk (interest-rate sensitivity). So, historically they’ve had low correlation to each other and behave differently in different market environments.
We can illustrate the benefit of adding floating-rate loans to an otherwise all-traditional, investment-grade, fixed-rate bond portfolio by drawing an efficient frontier. At a 65% Bloomberg Barclays U.S. Aggregate Bond Index/35% floating-rate loans split, a portfolio’s overall volatility is lower and the return is higher because sources of risk are diversified, and there is more yield in the portfolio.
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A 35% allocation to floating-rate loans is pretty significant and higher than we would recommend, but it’s meant to help illustrate the diversifying power of floating-rate loans. Other factors, such as where we are in the credit cycle, valuation and the market’s appetite for risk must be considered when investing in bank loans. We believe the asset class warrants an allocation, at some level, throughout the entire cycle.
Floating-rate loans are popular when interest rates are rising, but they may have diversification benefits in any interest-rate environment.