Consider Senior Loans For Attractive Yield And Portfolio Diversification

Jun. 30, 2022 8:15 AM ETAAA, BKLN, SRLN, SNLN, FTSL, FLRT, FLBL, SEIX, PDIIX, PHMIX, PIMIX, PFORX, PIGIX, PFIIX, PFMIX, PAIDX, PSCSX, PTTRX1 Comment5 Likes
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Summary

  • Bank loans have floating rates. So in periods of rising rates, they offer low duration - or interest rate sensitivity.
  • Bank loans tend to provide attractive yields, on par with “high yield” bonds, but with lower volatility and higher “seniority” in the capital structure.
  • 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.

Investment management. Portfolio diversification.

Olivier Le Moal/iStock via Getty Images

Transcript

David Forgash, Head of Leveraged Loan Portfolio Management, PIMCO: 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:

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.

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 the 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. 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.

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.

Disclosure

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.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Investments LLC, U.S. distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2022, PIMCO.

CMR2022-0606-2232971

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