Where to find durable income and lower risk

• A steepening curve is a historical norm at the end of a recession/beginning of an expansion, but this recovery is far from normal and, in our view, is likely to have much higher growth than is typical.
• Investors know that a steepening yield curve negatively impacts the returns of long‐duration fixed income, but this time the impact could be more dramatic given the very low starting yields at the onset of this expansion.

Why senior floating rate loans and why now?

Focus on yield without duration is key in this environment

Senior floating-rate loans currently offer the most attractive yield relative to duration among fixed-income alternatives.

The yield curve is steepening as a result of shifting investor expectations about growth and inflation even though policy rates are anchored near zero in the intermediate-term. The floating rate nature of senior loans provides a low‐cost hedge against rising inflation expectations, which markets have been anticipating as shown by inflation breakevens in the chart below.

Senior floating-rate loans have typically been viewed as a solution in periods when the Federal Reserve is increasing policy rates, but it’s not widely known that the asset class has also seen good historical returns in flat policy‐rate environments. In fact, the S&P Leveraged Loans Index historically has outperformed the broader bond market—measured by the Bloomberg Barclays U.S. Aggregate Bond Index—in both flat and rising policy rate environments.

It is also worth noting that a steeper yield curve has historically been a positive indicator of future economic growth. Based on historical trends—with the fed funds rate at roughly zero—10‐year Treasury bond yields could approach a range of 2.5% to 3.5% at some point in this expansion, especially given the stimulus in the pipeline and the reopening of the services economy as more of the population gets vaccinated. In the event of another 75- to 180-basis‐point increase in Treasury yields, we believe an allocation to senior floating rate loans would be prudent, where suitable.

In prior periods back to 1998 where the 10‐Year U.S. Treasury yield rose by 100 basis points or more, the S&P Leveraged Loan Index has outperformed the Barclays U.S. Aggregate Bond Index nine out of nine times.

Loans are senior‐secured and provide durable income generation

Over the past 32 years, the average recovery rate on loans that default has been roughly 65% – 70%, meaning that credit losses amount to 30% – 35% of the 3.1% average annual default rate, or about 1%. (1) This implies that about 99% of principal has been returned to investors over a period that has included a number of recessions, which means that almost all the annual income that is generated from a portfolio of loans has been retained by investors.

Technical Tailwinds and Improving Issuer Fundamentals Favor Loans

• Defaults have been trending downward, and there is generally much better visibility into troubled credits given that issuers have been stress‐tested in a pandemic‐induced recession.
• January was the third consecutive month without a default in the loan market, and February only saw two defaults in the secularly challenged Retail and Textiles & Apparel sectors.
• The bottom‐up default estimate for 2021 from our research team stands at just under 2%, and recently JP Morgan revised its 2021 and 2020 default projections to 2.0% for each year from 3.5% previously.
• Loan issuers overall cut costs aggressively in 2Q20 and 3Q20, saw better‐than‐expected operating results, raised significant liquidity via refinancings and lowered borrowing costs. Issuers in the loan market are generally well-positioned to benefit as nominal topline growth accelerates in the coming quarters. That said, loans are an asset class that requires active management for successful investment outcomes, as credit selection and avoiding credit deterioration have been key drivers of returns over time.