With about $17 trillion in negative-yielding debt worldwide¹ and the U.S. Federal Reserve (Fed) committed to a zero-rate regime, why might investors consider floating-rate funds now? The answer is a blend of inflation fears, already rising rates, low absolute yields, and concerns about equity valuations.
A refresher: what is floating-rate debt?
As we described in November 2020, floating-rate debt is a generally senior obligation of a company whose credit rating is typically below investment grade. Its coupon varies based on short-term interest rates, and investors concerned about rising rates may find it attractive.
Issuers of floating-rate debt usually find easier access to credit from banks than from the public capital markets, so the category is often referred to as “bank loans.” The incremental credit risk usually associated with these issuers gives this market the nickname “leveraged.” The income from these leveraged loans typically comes from the sum of a short-term floating reference rate and a fixed spread over that rate.
Inflation is becoming a larger concern
In an environment with low inflation, or even deflation, investors typically accept low interest rates and may not express much worry about an eventual increase. Economists generally believe that rising inflation makes lenders demand higher interest rates to offset the reduced future purchasing power of the money they’re temporarily parting with. But in recent years we’ve seen mostly low inflation, which, by preserving the value of money, makes repaying debts more challenging. The Fed has, in fact, committed to allowing the economy to run “hot” and exceed, for some time, its long-term objective of 2% inflation,² measured by Core PCE,³ if the pandemic-damaged economy can get there with the help of widespread vaccinations.
But the Fed’s zero-rate policy has, to some economists and investors, created a dangerous environment where first financial assets, and later real goods and services, may reach inflated levels. Few things speak of inflated levels more than negative-yielding bonds, making floating-rate securities a potentially intriguing hedge. Surveying the prospects for renewed inflation, the well-known economic journalist Neil Irwin⁴ wrote in The New York Times of four types of inflation risks.
After a sharp pandemic-caused downturn, inflation may be returning
Source: FactSet, 12/31/20. YoY: year over year.
The first is the “yo-yo” effect, which may be all but preordained. Last year’s sharp decline in inflation associated with shutting down the economy means that we’re highly likely to see a significant year-over-year increase this spring. By itself, that may not mean much, and it may already be priced into the interest-rate increase we discuss shortly.
The second is the “hungry bear,” in which pent-up demand, particularly for restaurants, travel, and the like, drives prices sharply higher once the pandemic recedes with vaccinations kicking in.
Next comes the “sloshing bathtub,” a function of the fiscal and monetary support provided to help offset the pandemic, much of which has so far been saved. When this excess liquidity begins to flow into the economy, prices are bound to rise.
Finally, and perhaps most ominously, is the “great reflation,” caused by long-term changes, including a shrinking global workforce. Irwin cites the demographic research of the British economist Charles Goodhart, who has argued that a mix of fewer working-age people and increased government debt will lead to a substantial inflationary revival.⁵ Other factors may also be at work. A shortage of shipping containers brought on by an unexpectedly strong recovery in certain regions and sectors has driven some prices up as much as 300% from last March—an extreme example of Irwin’s yo-yo effect.⁶
Floating-rate funds may offer yield advantages, especially as rates rise
The 10-year U.S. Treasury’s yield, possibly motivated by the prospect of increased stimulus in a Democratic-controlled Congress, has already risen by about 35 basis points (bps) since we wrote in November, to 1.20% in mid-February. It’s more than doubled from its summer lows.⁷ That said, it’s still challenging to find yield that can keep up with current inflation, let alone potentially higher levels down the road. The S&P/LSTA Leveraged Loan Index (LLI)⁸ was yielding 4.48% at the end of January, nearly 300bps above the latest inflation readings and over 250bps above the Bloomberg Barclays U.S. Corporate Investment Grade Index.⁹
The yield advantage comes, as we mention earlier, largely from the credit quality of the issuers. But in an improving economy with potentially higher interest rates and rising inflation, taking some credit risk can be a way of playing defense rather than having the income-generating portion of a portfolio tied almost exclusively to rate levels. Floating-rate funds also may allow for more opportunities from active management.
While leveraged loan default rates have risen over the course of the pandemic, they haven’t approached the levels many were fearing. Defaults have risen from an annualized rate of 1.6% at the end of 2019 to 3.9% (by issuer) as of the end of January 2021.⁸
Balancing record stock prices without duration risk
Fixed income traditionally functions as ballast to offset some of the risk of downturns in the equity markets. With many stocks at or near all-time highs, it might seem an appropriate time to make sure enough ballast is in place. Yet with a significant portion of the market offering yields that are negative or at least below inflation, it’s fair to question how effective hedge income-generating securities may be. In other words, their duration risk may offset their nominal capital-preservation attributes. Since leveraged loans have essentially no duration, they help investors avoid this area of risk.
Is now the right time for floating rate?
Rising rates, multipronged inflation concerns, and record stock prices: they all seem to point to considering a bank loan fund for your portfolio. Even if only some of these conditions worsen, finding the appropriate income-generating securities could become more difficult. An experienced manager may be able to sift through a multitude of opportunities to find securities that may generate attractive yields in today’s market while potentially balancing the risk of equities.
1 FactSet, 1/31/21. 2 npr.org, 8/27/20. 3 FactSet, 1/31/21. The Core Personal Consumption Expenditures (PCE) Price Index measures the prices paid by consumers for goods and services, excluding more volatile food and energy prices. It is not possible to invest in an index. 4 nytimes.com, 1/16/21. Mr. Irwin’s books include The Alchemists: Three Central Bankers and a World on Fire, about the events leading up to, during, and after the global financial crisis of 2007-2009. 5 “The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival,” Goodhart, Pradhan and Posen, 9/24/20, virtual event. 6 cnbc.com, 1/24/21. 7 Macrobond, 2/12/21. 8 S&P/LSTA LLI Fact Sheet, 1/31/21. The S&P/LSTA Leveraged Loan Index (LLI) tracks the market-weighted performance of U.S. dollar-denominated institutional leveraged loan portfolios. It is not possible to invest directly in an index. 9 FactSet, 1/31/21. The Bloomberg Barclays U.S. Corporate Investment Grade Index tracks the investment-grade, fixed-rate, taxable corporate bond market. It is not possible to invest directly in an index.