Given the introduction of “tapering” by the Federal Reserve and the slow yet steadily improving economic environment, investors face the real possibility of encountering a period of rising interest rates over the coming years. When interest rates increase, traditional bond prices typically decrease. In response, investors may want to seek out strategies with lower interest rate sensitivity than the categories they have historically considered to be their “core” fixed-income investments. 

Investors generally rely on core positions to consistently deliver desirable attributes to their portfolios regardless of market environment. In my experience, the three most important attributes sought out by fixed-income investors are: 1) high income potential, 2) low volatility and 3) strong diversification potential. 

Senior loans are widely recognized for their typically low interest rate sensitivity and historically solid performance in rising interest rate environments. However, they have also consistently provided the aforementioned attributes to investors over several market cycles including periods of rising, stable, and declining interest rates. And in my view they should continue to do so for the foreseeable future. It is important to note that short-term interest rates and longer-term treasury rates may or may not move in tandem directionally or in magnitude. As a result, I believe fixed-income investors will be well served by viewing an allocation to senior loans as a long-term, core position in their portfolios.

High Income Potential

Due to the current low interest rate environment, investors face challenges when it comes to generating sufficient levels of income to meet their needs. Across domestic fixed income offerings, senior loan yield levels have historically exceeded U.S. Treasury yields, investment-grade corporate bond yields and inflation rates (albeit with greater credit risk potential as they are non-investment-grade rated). Senior loan yields historically fall just below those of high-yield bonds because loans are typically senior and secured obligations in an issuer’s capital structure whereas high-yield bonds are usually subordinated and unsecured. The high income levels generated by loans have contributed to a solid total return profile across a wide variety of interest rate environments. While past performance is no guarantee of future results, senior loans have delivered positive returns in 21 of the last 22 calendar years, posting an annualized return of 6.03% over that period.1

Low Relative Volatility

Investors may be attracted to both senior loans and high-yield bonds because of their high income potential. However, due to their floating rate coupons, senior loans have the added benefit of carrying extremely low interest rate sensitivity (if any), especially compared to high-yield bonds or any long duration fixed-income product for that matter.  Thus, while interest rate fluctuations may have little impact on senior loan prices, they may result in meaningful volatility in high yield bond prices. This disparity is the primary reason that senior loans have displayed historically lower volatility than high-yield bonds. At the same time, senior loans may provide better downside price protection relative to high-yield bonds should a company experience distress or, in rare cases, default. The reason again is that senior loans typically hold a senior and secured position in the capital structure and have therefore generally garnered higher recovery rates.

Diversifying a Portfolio

Over the past 20 years, senior loans have also exhibited relatively low correlations to other asset classes, delivering strong diversification benefits. Importantly, historical senior loan correlations to U.S. and international stocks have been meaningfully lower than those of high-yield bonds. The reasons are twofold. First, high-yield bonds and equity have subordinated claims in a company’s capital structure. This means that both may suffer more in “risk off” or recessionary environments, and prosper more in expansionary markets, relative to senior loans. Second, a sustained tightening cycle in interest rates is generally less favorable for stocks and duration-carrying high-yield bonds than for senior loans, which have minimal interest rate risk.  (Duration measures interest rate sensitivity; the longer the duration the greater the expected volatility as rates change.) Due to their floating rate coupons, senior loans have also historically exhibited very low or even negative correlations with most other major fixed-income categories as well, making them a potentially strong diversifier all around.

Operating in a Durable and Evolving Capital Market

Further supporting the case for the asset class is the senior loan market’s exponential growth and proven durability. The senior loan market has seen very rapid growth over the last 10 years, with the number of securities outstanding in the market doubling to over 1,500 and the size of the market more than quadrupling to nearly $900 billion as of June 2014.2

As a result of this impressive growth, the senior loan market has become quite durable while remaining very much open with transactions occurring frequently during the last two market swoons of late 2008 and August 2011. I believe that continued investor demand will lead to additional market growth, especially given long-term U.S. Treasury rates’ potential to move higher.