The interest rate market is rebounding strongly. After three years of anticipated higher interest rates, the market has finally responded to expectations. The U.S. 10-year Treasury bond rate is approaching 3 percent and, for the first time in nearly 10 years, the three-month London Interbank Offered Rate, also referred to as LIBOR, has moved above 2 percent.
For investors, this means now is the time to have a posture toward rising interest rates in your fixed income portfolio. The current landscape gives way to a source of attractive returns for those seeking to maintain exposure to fixed income, in the form of floating-rate exposure — or bank loans.
A bank loan is a debt financing obligation, issued by a bank or similar financial institution. The obligation is to a company that holds legal claim to the borrower’s assets above all other debt obligations. Because of this structure, the loan is considered senior to all other claims against the borrower.
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In the event of a bankruptcy, for example, the senior bank loan is the first to be repaid.
What makes bank loans an interesting investment are its floating rates feature. The asset’s rate fluctuates according to LIBOR or another interest rate benchmark.
For example, if a bank loan’s rate is LIBOR plus 5 percent and LIBOR is 4 percent, the loan yield is 9 percent. Due to the fact that loan rates often change monthly or quarterly, interest on the loan may increase or decrease at regular intervals. This provides investors the ability to generate a higher coupon as short-term interest rates move versus the coupon being earned from fixed bonds that will not change regardless of movement from interest rates. This helps protect investors from rising short-term interest rates (which makes bond prices decrease) and against inflation.
Now is the time to consider bank loans, which have outperformed both investment-grade and high-yield bonds with significantly lower volatility.
Last year saw a solid performance in the bank-loan market, with a return of 4.75 percent. This return handily beat long-duration fixed-income asset classes such as investment-grade and government bonds, which lost value.
Over the next 18 to 24 months, a continuation of this outperformance is expected. During the first two months of 2018, the positive return trend has continued as bank loans have returned 1.23 percent.
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This positive trend, across all bank loans, is expected to continue for several reasons.
First, continued concern over higher rates and the anticipation of four more Federal Reserve rate hikes in 2018 will likely cause the trend toward higher rates to persist.
Second, continued firmer global economic conditions, higher deficits and a rise in inflation expectations will only put additional pressure on domestic and global interest rates.
Lastly, improving consumer and corporate confidence and U.S. tax reform will increase momentum in the U.S. economy and corporate earnings.
The last few quarters have highlighted strength in the corporate sector. With stable-to-improving corporate earnings, we expect to see some of the strongest revenue and earnings performance in years. The stability allows the record pace of refinancing, across loans, to continue in 2018.
As a result, the credit cycle has been extended for at least a few more years and maintained a cap on default rates across the sector. With expected default rates to remain below 2 percent, which is well below the 3.5 percent long-term average, this asset class is expected to continue its strong relative performance.
The loan asset class will also benefit from an increased demand from both retail and institutional investors. Loan mutual funds inflows in 2017 totaled $16 billion. They are expected to grow to more than $20 billion this year as investors reallocate from pure high yield and long duration funds.
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Interest rates are a primary concern for 2018, and as such, the loan asset class is an attractive spot for allocation shift within fixed income. The ability for bank loans to reset quarterly coupons, based on the movements of LIBOR, positions investors to benefit from short-term interest rate increases. The asset class has provided strong historical performance and is buoyed by current stable fundamentals. They are well-positioned to generate positive returns.
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Bank Loans Becoming an Investing Option originally appeared on usnews.com
