In 2022, investors had few places to hide amid one of the worst market years on record. But one fixed-income asset class performed far better than others: Bank loans.
Investment-grade bonds are represented by the Bloomberg US Aggregate Bond Index. High-yield bonds are represented by Bloomberg US Corporate High Yield Bond Index. Bank loans are represented by the Credit Suisse Leveraged Loan Index.
Historically, when investment-grade corporate bonds, high-yield bonds and bank loans have reached the same price and yield levels as today's, they've generated a 12-month return well above each asset class’s 20-year annualized return (7.20% for high-yield bonds; 4.65% for investment-grade corporate bonds; and 4.65% for bank loans).
While high-yield bond prices have made their way back to 2020 levels, bank-loan prices have done well to hold the line above $91, as rising interest rates, low supply and more attractive yield levels have helped loan prices stay afloat amid this year’s turbulent seas. This has also helped loans surpass high-yield bonds in total market value in 2022.
While some may consider a Treasury curve inversion (when shorter-maturity Treasury bonds offer a higher yield than their longer-maturity counterparts) a sign of an impending recession, short-term investment-grade corporate bonds—going back to 1978—have outperformed the Bloomberg US Aggregate Bond Index once the inverted curve normalized. Over the past 44 years when the10-year minus 2-year Treasury curve turned negative and then normalized, short-term investment-grade corporate bonds outperformed the Bloomberg US Aggregate Bond Index by an average of 1.24%.
While bank loan default rates currently stand at 1% (up from a record low of 0.5% this year), the current loan distress rate is still below historical averages (4.79% of the loan market has been trading below $80 vs. the 15-year average of 7.48%). One factor that may have helped keep loan defaults lower has been the growing percentage of loan-only issuers, as weaker covenants make defaults harder to trigger. Today, 61% of the loan market is made up of loan-only structures vs. an average of 51% over the last 15 years.
What once was a relatively simple concept—portfolio diversification—has become ever more complex as investors can now put their money into a wide array of nontraditional securities. One of those asset classes, bank loans, has had an average 12-month risk-adjusted return or Sharpe Ratio that since 1992 has been 154% and 123% higher than the Bloomberg US Aggregate Bond Index and the S&P 500, respectively.
As yields across corporate credit have made their way higher in 2022, investors may now assess whether additional credit risk has been worth the extra pickup in yield.
As investors continue to assess the market ahead for fixed income, higher option-adjusted spread levels and lower duration may make short-term investment-grade corporate bonds a good opportunity to consider, given the rise in interest rates and stubborn inflation. Over the past 10 years, short-term investment grade corporate bonds have generated less than half the volatility of broad investment-grade bonds, as represented by the Bloomberg US Aggregate Bond Index. On top of that, short-term investment-grade corporate bonds currently offer investors 3 basis points of yield for every unit of duration (1.91 years), which would translate into a 5.26% yield vs. just 1 basis points of yield for every unit of duration (6.20 years) for the Bloomberg US Aggregate Bond Index, which would produce a yield of 4.75%.
While investors assess whether the U.S. economy will face a significant recession, we believe that recent risk-on sentiment and company earnings have painted a more hopeful picture. Twice since 2003, short-term investment-grade corporate bond yields and option-adjusted spreads (OAS) have increased prior to major spikes in unemployment since investors have tended to sell all levels of risk when the economy and companies show signs of weakness. But so far this year, yields and OAS have moved higher while unemployment has trended down. For investors, this outlier event may be worth considering when deciding whether to sell short-term investment-grade corporate bonds.
Since the start of 2022, dynamics within markets have shifted as a result of evolving pressures, including higher and persistent inflation, slowing economic growth, supply-chain disruptions, geopolitical uncertainty, and aggressive central bank policies. This has resulted in a broad risk-off approach by many investors as risk-based and fixed-income asset classes have succumbed to these significant challenges. However, one of the benefits of fixed income is the inverse relationship between price and yield. We have seen many portions of the fixed-income market with yields not seen in over a decade. We believe the current yield environment has set the stage for an attractive opportunity to capture potentially elevated yields if prices continue to climb over the coming months/years.
Historically, while correlations for many assets classes have increased, bank loans have still offered the lowest correlation to broad investment-grade bonds of major fixed-income sectors. Even more impressive, as of July 29, 2022, bank loans carried a lower correlation to investment-grade bonds than U.S. large-cap and U.S. small-cap stocks at 0.16 vs. 0.68 for large caps and 0.73 for small caps. Meanwhile, as of July 29, 2022, high-yield bonds were near their record 12-month high correlation to broad investment-grade bonds at 0.75 (0.85 is the all-time high).
Since 1999, when spread levels were greater than 1%, 1-3 year corporate bonds have outperformed Treasury bonds of the same maturities 99% of the time. During that same period, when spreads were greater than 1.5%, that number jumped to 100%. Also since 1999, 5-7 year corporate bonds have shown similar levels of outperformance to their Treasury counterparts when spreads eclipsed 1%. During that same period, when spreads were greater than 1.5%, 5-7 year corporates have never underperformed their Treasury counterparts.
Since 1996, whenever the Federal Reserve reached the end of a rate-hiking cycle, longer-duration spread sectors have outperformed their shorter-duration peers in the following 12-months.
Given recent volatility in risk assets, U.S. corporate-debt sectors have seen yields push well past where they started the year. For those investors looking for income, as well as asset classes that have historically done well in past Federal Reserve rate-hiking cycles, corporate debt might be a good option to consider.
For almost three decades, bank loans have performed well during periods of market volatility.
Despite current market performance, investors appear to be quite optimistic, pulling more money out of money-market funds in the first five months of 2022 than they have in any year in the past decade. So, where is that money going? Year-to-date, large-cap blend, large-cap value, foreign-large blend, long government, and bank-loan funds have seen $171 billion dollars of inflows (approximately 72% of the outflows of money-market funds). Bank-loans remain a top performer for year-to-date returns.
Investors searching for yield might do well to consider an investment's risk-adjusted returns, especially with today’s volatility. High-yield bonds and bank loans have historically been two of the top performing asset classes in past Federal Reserve hiking cycles. But even with the 1.29% extra yield oﬀered by high-yield bonds, on a risk-adjusted yield basis, bank loans may oﬀer a more attractive opportunity (4.70% vs.1.34% for high-yield bonds) for those looking to add yield without the volatility that may come with it.
For what has historically been a shelter for investors when volatility has increased, the Bloomberg US Aggregate Bond Index may be facing its worst year return since 1976 and the second year in a row of negative returns. However, bank loans have been one asset class of the fixed-income market that have so far managed to weather the storms of 2022 and generate mostly positive returns for investors year-to-date.
As investors try to balance the major headwinds of rising interest rates and global conflict, finding shelter in short-term, investment-grade fixed income may be a consideration, as yields for front-end fixed income have returned to pre-pandemic levels. While some investors may prefer to seek safe harbor in U.S. Treasuries, short-term, investment-grade corporate bonds might be a better alternative.
Strong demand and a potential favorable environment have been a couple of carryover tailwinds from 2021 for bank loans. Through Feb. 24, the average new-issue loan deal was $959.1 million vs. $781.8 million from the same period in 2021.
The floating-rate nature of the asset class has helped investors during periods of rising interest rates, as the interest rate on loans typically resets every 30-90 days based on the new rate environment and generally move in tandem with the federal funds rate.
Default rates have always been a major factor for investors considering floating-rate loans, which is a primarily non-investment-grade asset class. But with default rates currently tracking well below their historic average of 2.53% (the percentage for January 2022 clocked in at 0.29%), the historical default risk could be significantly reduced in the near term.
Floating-rate loans have historically done well generating returns in rate-hike cycles, which typically have been a difficult period for traditional fixed-income asset classes.
Markets have been volatile so far in 2022. In just one day in January, the Dow Jones Industrial Average fell and gained over 1,000 points. Although a 1,000-plus daily swing sounds overwhelming, the Chicago Board Options Exchange’s Volatility Index (VIX or, informally, the “Fear Index”) has been much higher in the past.
Loan issuance slowed during the last quarter of 2021 to $126.8 billion, but it was more than enough to help 2021 set a record issuance of $615.2 billion. Numerous records were set in 2021 specific to the loan-asset class, including loan and CLO issuance, single-B issuance, and mergers-and-acquisition activity.
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