Leveraged loans can be an attractive addition to a well-diversified growth portfolio in a world hungry for yield and threatened by rising interest rates. With the exception of 2008 the global loan market has generated positive performance every year since 1998. Their senior position in the capital structure and floating rate nature make loans an attractive diversifier, both within return-seeking fixed income and across total growth portfolios. They have traditionally shown correlation benefits relative to equity and negative correlation with governments and investment grade credit.
The asset class has the potential to generate higher total returns relative to traditional fixed income, and offer comfort to those investors concerned about rising interest rates as well as those overly exposed to equities. This is especially the case in the current environment where corporate issuers have reduced enterprise leverage and extended maturities through refinancing, thus reducing the potential for near-term defaults.
Loans are floating, as opposed to fixed, rate debt instruments issued by sub-investment grade companies. The sub-investment grade credit rating means loans are expected to outperform investment grade credit over the long-term, albeit with higher volatility, and the floating nature of their coupons means this outperformance should be greater in a rising rate environment. They are also more senior in the capital structure than other asset classes such as high yield bonds, providing a level of protection in the event of default. However, in highlighting these benefits, investors should also understand that loans are usually callable at any time at a small premium, meaning that if prices trade above the call price, there is the risk that they will be called.
From an equity holder’s point of view, loans can also be an attractive alternative as they are a lower risk way to invest in a company. Loan investors get their return from contractual coupon payments, rather than declared dividends and their position at the top of the capital structure provides security if the business deteriorates. They can be particularly attractive in low but positive GDP environments which provide sufficient growth to cover coupon payments but insufficient growth to generate significant capital appreciation which would benefit equity holders.
As with any asset class, there are risks to investing in loans and, as sub-investment grade securities they naturally have greater credit risk than investment grade securities.
As with any asset class however, investing does not come without risks. Loans are sub-investment grade securities and therefore naturally have greater credit risk than investment grade securities. However, against a backdrop of impending rate rises and the enhanced yields relative to investment grade bonds and greater security relative to equities that loans can potentially offer, the case for allocating a proportion of an investor’s portfolio as means to diversify to return-seeking fixed income is compelling.
Adam Smears is head of fixed income research at Russell Investments