Senior floating-rate loans have long been viewed as a solution for periods of rising interest rates, but what is perhaps less well-known is that the asset class has also seen good historical returns in flat interest-rate environments. In fact, loans historically have outperformed the broader bond market in both flat and rising rate environments2. In our view, loans are likely to be an increasingly important source of diversification and a low-cost hedge against inflation.
The context of monetary policy rates remaining lower-for-longer is very important, but so is the fact that—now with a vaccination roll-out and fiscal stimulus—pent-up demand, inventory constraints and a reopening economy could create a potent recipe for very strong growth, rising inflation and a steepening yield curve. Senior floating-rate loans could be a prudent allocation in either a stable or rising rate environment.
Why Loans Now?
A combination of attractive yield per unit of duration, a senior secured position in the capital structure and durable income generation potentially provide significant opportunity, where suitable. Additionally, technicals have become generally more favorable as U.S. loan funds recently saw a sizeable weekly inflow of $1.64 billion (as of January 20) which was the largest since 2016. Add to that increasing CLO production, which is 70% of total demand for loans, and technicals provide an additional tailwind for loans.
What About Defaults and the Outlook for Issuer Fundamentals?
In our view, the yield on loans is generally compensating investors for the moderating pace of defaults we anticipate in 2021, which is just under 2% based on our analysts’ bottom-up estimates. In general, we believe the ability of loans issuers to successfully navigate the latter stages of the pandemic continues to improve, given a 3Q20 earnings season that exceeded expectations, strong cost controls during 2Q20, and open capital markets, which have generally allowed issuers to stabilize margins and improve balance sheets. Progress against the virus, combined with pent-up demand, a very high savings rate and strong fiscal and monetary policy support, should help to deliver improving economic growth and issuer fundamentals this year.
We believe active management in loans focusing on credit selection, relative valuation and downside risk mitigation will remain important drivers of investment results.