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Three Reasons to Consider an Allocation to Leveraged Loans

In looking at the year ahead, we expect an environment that inches ever closer to normal across all facets of the economy. For fixed income investors, normal means the end of accommodative monetary policy and the beginning of a tightening cycle that is likely to challenge returns in 2022. To offset some of these headwinds, we think allocating to leveraged loans is a compelling strategy for fixed income investors. Here are three reasons why leveraged loans have the potential to perform well in the year ahead.

Benefits of Leveraged Loans Highlighted by Policy Normalization

As we look to the policy front, the timing and pace of interest rate hikes remains uncertain, but the path for interest rates is likely higher in 2022. For traditional fixed income assets, rising rates often mean falling prices and generally weaker returns. Leveraged loans behave differently, making them one of the few fixed income segments that stand to benefit from a rising rate environment. Because of leveraged loans’ floating-rate structure, increases in short-term rates result in higher coupons, making the asset class far less sensitive to rate rises across the yield curve. This floating-rate feature has helped the asset class generate strong positive returns during previous tightening cycles while traditional fixed-rate bonds have lagged.

Exhibit 1: Fixed Income Returns During Tightening Cycles 

Historical Federal Funds Rate

Source: Artisan Partners/Bloomberg/Credit Suisse/BofA. Indices: Leveraged Loans (Credit Suisse Leveraged Loan Index); Aggregate Bond (Bloomberg US Aggregate Bond Index); IG Corporate (ICE BofA US Corporate Index). Past performance is not indicative of future results.

Fundamental and Technical Backdrops Remain Supportive

The loan market continues to be supported by strong and improving fundamentals. Revenue and operating earnings are trending above pre-pandemic levels, while above-average profit margins are offsetting pressures from higher input and wage costs. This position of strength has allowed borrowers to repair pandemic-related damage to their balance sheets and now focus on capital management for investment and shareholder returns.

At the same time, liquidity in the loan market remains as robust as ever. Investors have sought out loans as protection against higher rates and to capture incremental yield, creating a seemingly limitless bid for floating-rate structures. Retail loan funds have enjoyed a prolonged period of inflows while collateralized loan obligations—the biggest demand driver for floating-rate products—have seen their biggest year of issuance on record. The strong demand has created widespread liquidity, keeping a lid on distress and defaults in the marketplace.

Exhibit 2: Leveraged Loan Defaults and Distress

Source: JPMorgan. As of 30 November 2021. Based on constituents in the JPMorgan Leveraged Loan Index. Distressed loans represented by % of market trading below $80.

Relative Value Favors Loans

Leveraged loans remain one of the highest yielding segments on an absolute and risk-adjusted basis. They also offer better spreads and higher yields relative to most fixed income segments, while also being in a position of greater strength on a risk-adjusted basis. And given leveraged loans’ senior status in the capital structure, their credit and default risks are lower, recovery rates are higher and price volatility minimized relative to other parts of the capital structure.

Exhibit 3: Yield vs. Duration

Source: Artisan Partners/ICE BofA/JPMorgan/Credit Suisse. As of 30 Nov 2021. Indices—US Leveraged Loans: Credit Suisse Leveraged Loan Index; US High Yield: ICE BofA US High Yield Index; European High Yield: ICE BofA Euro High Yield Index; EM Debt: JPMorgan EMBI Global Diversified Index; IG Corporate: ICE BofA US Corporate Bond Index; Aggregate Bond: Bloomberg US Agg Bond Index; Municipal Bond: ICE BofA Municipal Index. Past performance is not indicative of future results.

Key Takeaways

As we look to the year ahead, we believe leveraged loans remain a compelling option for fixed income investors. Expectations for higher interest rates and limited defaults should drive further upside for the asset class. That said, hiking cycles also have historically led to increased risk asset volatility, leading to more price dispersion and differentiation across industries and capital structures. We believe this type of environment favors an active approach—where disciplined underwriting is required, and deep credit work is essential to successfully navigate changing market conditions.

Fixed income securities carry interest rate risk and credit risk for both the issuer and counterparty and investors may lose principal value. In general, when interest rates rise, fixed income values fall. High income securities (junk bonds) are speculative, experience greater price volatility and have a higher degree of credit and liquidity risk than bonds with a higher credit rating. Loans carry risks including insolvency of the borrower, lending bank or other intermediary. Loans may be secured, unsecured, or not fully collateralized, trade infrequently, experience delayed settlement, and be subject to resale restrictions.