In Hiking Cycles, Why Consider Floating-Rate Loans?
Floating-rate loans may provide higher levels of income than other fixed-income asset classes, along with serving as a potential hedge against rising interest rates.Download PDF
Historically, during rate-hike cycles, floating-rate loans—whose coupons have tended to rise as interest rates increase—can become attractive to those investors seeking an asset class that may provide a high level of income, a potential defense against rate hikes and diversification.
Historically, Lower Duration Has Generated Higher Income in Rising Rate Environments
Floating-rate loans (bank loans) have historically provided more income per year of duration than other traditional fixed-income asset classes, typically resulting in lower interest-rate sensitivity than traditional fixed-income asset classes.
Higher Income Potential with Lower Duration
A Source of Diversification
One of the risks inherent in traditional fixed-income asset classes is interest-rate risk, which can be measured by their correlation to U.S. Treasuries. Floating-rate loans have historically carried a low or negative correlation to U.S. Treasuries, having provided positive returns in rising interest-rate environments. This is because floating-rate loans generally have a lower sensitivity to interest-rate movements than other fixed-income asset classes since coupon rates can be periodically reset. This can provide a diversification benefit when added to a portfolio.
20-Year Correlation to U.S. Treasuries
Minimizing Risk: Senior-Secured Loans in a Low-Default Environment
The challenge investors face when constructing a diversified fixed-income portfolio is identifying asset classes that have the potential for attractive returns with minimal risk. Investors should be aware that during periods of economic decline, floating rate loans can struggle as these securities can be exposed to increased credit risk. However, thanks to the current strong economy, defaults on floating-rate loans in 2021 stood at a decade-low 0.6%, and many expect defaults to remain low, at least in the near term. But even in cases of default, floating-rate loans—in contrast to other high-yield asset classes—sit at the top of a company’s capital structure, are usually secured by assets, and may feature terms or covenants that offer holders of loans some measure of downside protection (for example, minimum levels of liquidity).
Bank Loan portfolios primarily invest in floating-rate bank loans instead of bonds. In exchange for their credit risk, these loans offer high interest payments that typically float above a common short-term benchmark such as the London interbank offered rate, or LIBOR.
Duration measures a fund’s sensitivity to interest-rate risk where the longer a fund’s duration, the more sensitive, and vice versa.
The Bloomberg US Corporate Index includes publicly issued U.S. corporate and specified foreign debentures
and secured notes that meet the specified maturity, liquidity, and quality requirements.
The Bloomberg US Corporate High Yield Index covers the universe of fixed rate, non-investment-grade debt.
The Bloomberg US Mortgage-Backed Securities Index, is a market value-weighted index composed of agency mortgage backed pass-through securities of the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac) with a minimum $150 million par amount outstanding and a weighted-average maturity of at least 1 year.
The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar denominated leveraged loan market.
Correlation is a statistical measurement that shows the degree to which two securities move in relation to each other.
Standard Deviation measures the dispersion of a data set relative to its mean and can be used as a measurement of volatility and/or risk of a security.
About Principal Risks: All investing involves risks including the possible loss of the principal amount invested. There is no guarantee the Fund will achieve its investment goal. Corporate bonds are subject to issuer risk in that their value may decline for reasons directly related to the issuer of the security. Not all U.S. government securities are checked or guaranteed by the U.S. government, and different government securities are subject to varying degrees of credit risk. Mortgage-related and other asset-backed securities are subject to certain rules affecting the housing market or the market for the assets underlying such securities. The Fund is subject to liquidity risk (the risk that an investment may be difficult to purchase, value, and sell particularly during adverse market conditions, because there is a limited market for the investment, or there are restrictions on resale) and credit risk (the risk an issuer may be unable or unwilling to meet its financial obligations, risking default). High-yield/high-risk bonds (“junk bonds”) and floating-rate loans (usually rated below investment grade) have greater risk of default than higher-rated securities/higher-quality bonds that may have a lower yield. The Fund is also subject to foreign-markets risk.
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Pacific Funds are distributed by Pacific Select Distributors, LLC (member FINRA & SIPC), a subsidiary of Pacific Life Insurance Company (Newport Beach, CA), and are available through licensed third parties. Pacific Funds refers to Pacific Funds Series Trust.