asset allocation  | january 26, 2021

Three Reasons to Favor Floating Rate Loans in Today's Market

Our Asset Allocation Committee is overweight to floating rate loans.

3:47

Sébastien Page

Head of Global Multi-Asset

 

Key Insights

  • Our asset allocation committee is overweight to floating rate loans because they offer certain potential advantages in today’s market.

  • Loans’ shorter duration profile would likely offer some degree of insulation from higher interest rates, and while they are subject to higher credit risk, they could offer risk-adjusted access to high yield issuers.

  • Leveraged loans also offer favorable relative value over other high yielding investments.

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In our recent Global Market Outlook for 2021, one of my colleagues, David Giroux, highlighted floating rate bank loans as offering potential advantages in today’s market. David is our CIO of Multi-Asset and Equity and a highly respected Investment Pro, so when he mentions an opportunity, we all listen very closely.

Our asset allocation committee holds a similar view on floating rate loans. Within our fixed income allocations, we have reallocated a portion from high yield into floating rate loans. Let me explain our thinking.

To start let me give a quick definition: Floating rate bank loans, they’re just another form of corporate debt, similar to high yield bonds, although they have some unique features. They’re called floating rate because bank loan coupons adjust to reflect short-term interest rates, typically every 90 days.

There are three reasons why we like leveraged loans right now.

Shorter duration. A higher standing in the capital structure so lower credit risk than many high yield bonds. And attractive relative valuations.

First, the shorter duration profile.

Duration is a key measure of interest rate risk, and the floating rate feature of bank loans gives them a very low, sometimes even negative, duration profile, which means they could do well in a rising rate environment especially relative to other fixed income asset classes.

This matters now because short-term rates are at or close to zero while prospects for the recovery continue to improve. In that environment, loans would likely offer some degree of insulation from rising rates while delivering attractive yields.

Second. A higher standing in the capital structure.

Leveraged loans are generally secured and have higher repayment priority than many high yield bonds if the issuer defaults. Historically, this has resulted in higher recoveries in default situations. At the end of last year, high yield default rates stood at around 6%, while loan default rates were significantly lower at around 4%*. So we believe loans can give you good risk-adjusted access to high yield issuers.

Third reason: attractive relative valuations.

Today, you have favorable relative value in floating rate loans. Yields on bank loans and high yield bonds have essentially converged**. So if you can own two securities at the same price, why not own the security that should behave more defensively in this environment?

There are risks to bank loans. They can become illiquid, especially in moments of market stress and of course they are subject to credit risk. Assessing credit quality requires identifying the winners and avoiding losers through credit analysis, or active management.

Overall, however, I see a compelling case for bank loans in the current environment. I’d agree with David Giroux’s assessment. 

*As of 12/31/20. High yield default rate source: J.P. Morgan. Loans default rate source: S&P/LSTA
**As of 12/31/20. Source: J.P. Morgan Chase & Co. High yield represented by the J.P. Morgan Global High Yield Index; bank loans represented by the J.P. Morgan Leveraged Loan Index.  Yields are subject to change.

Floating rate bank loans, or leveraged, loans, are syndicated loans to companies that are then sold to mutual funds and other institutional investors.  Floating rate loans along with high yield bonds represent two forms of non-investment-grade credit.

RISKS: Investments in floating rate bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency.  They are subject to prepayment risk (that can reduce the potential for gains).  The loans are usually considered speculative and involve a greater risk of default and price decline than higher-rated bonds.  Active management does not ensure a favorable outcome, and there is no assurance that any investment objective will be achieved.

Additional Disclosures

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Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of January 2021 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.  

202101-1482698

 

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