Andrew Sveen, Co-Director of Floating-Rate Loans, EVM
Christopher Remington, Institutional Portfolio Manager, EVM
Boston - Last week, we outlined some of the reasons loans are the highest-yielding major fixed-income sector, as of August 31, 2019, eclipsing both high-yield bonds and emerging-markets debt. Loan yields are also high relative to their historical returns.
However, some investors may be asking whether a lower-rate environment will lead to subpar performance from loans, which have interest payments that float with short-term rates. It's a fair question. While every economic environment is different, we have three prior cycles over the past 20 years in which the U.S. Federal Reserve cut rates, and the track record of loans over those periods can be very instructive.
The chart below compares loans, the Bloomberg Barclays US Aggregate Bond Index (the Agg), and stocks, based on the average annual total return over the three years following each initial cut by the Fed.
For the periods following each of the past three cuts, starting in 1998, loans have returned 4.44%, 5.34% and 4.93%, respectively. For comparison, loans have had a long-term average annual return of 4.89% since the S&P/LSTA Index began keeping track in 1997 - that exact figure also happens to be the average of the three periods cited. In other words, facts show that the performance of loans in rate-cut environments has been broadly quite similar to their long-term average, not worse, as popular belief would have it.
How have loans kept pace with their long-term average when rates were falling? Because other factors that affect loan prices (and total return) can offset lower coupon payments, such as:
- Fed rate cutting is generally stimulative of the economy, and thus supportive of corporate issuers.
- Falling short-term rates can be "credit positive" in terms of a company's ability to service its debt.
- A Fed that's "ready to act" can boost investor confidence and by extension, can be good for asset prices.
So while falling rates have the potential for lower coupon income, there are a variety of other factors that can serve as a positive offset in terms of total return.
The chart also shows how the Agg has outperformed loans over the past three periods, by a wide margin. But today's environment is different in a key respect. Falling-rate environments generally favor the Agg, because it has longer duration than loans (which is close to zero) - by definition, bonds with longer duration gain more in price when rates fall. However, in the previous three periods when the Fed began lowering rates, the initial yields on the Agg were all greater than 5%, compared with just 2.1% on August 31, 2019. So today there is much less room for the yield compression that drove gains in the Agg previously.
Bottom line: Investors who equate accommodative Fed policy with subpar loan performance should review the encouraging history of loans in falling-rate environments. Our next blog will examine the importance of active management at this point in the credit cycle.
Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Data provided is for informational use only. Past performance is no guarantee of future results.
Bloomberg Barclays U.S. Aggregate Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities
S&P/LSTA Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market
Standard & Poor's 500 Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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