Boston - For the floating-rate loan asset class, 2021 was a year of superlatives, with any number of metrics at or near record levels, like issuance volume, demand, absence of defaults, and total loans outstanding. For us, the most important message from last year's buoyant market is that loans have been living up to the expectations of both investors and issuers.
In 2022, we expect many of the same positive dynamics to prevail, against a backdrop of generally positive credit conditions. While the Omicron variant highlights how the pandemic remains a major economic variable, we don't believe it will overcome the sweeping economic tailwinds and ongoing policy support.
Inflation concerns are also likely to persist in 2022, which moves loans — and their floating-rate capability — onto center stage for investors seeking to hedge the possibility of rising rates.
Over the course of 2021, as news of tightened monetary policy, rising rates and inflation periodically wracked the markets, and the Bloomberg Aggregate Index lost 1.54%, loans returned 5.20%, as measured by the S&P/LSTA Leveraged Loan Index. In a nutshell, this explains the advantage of the near-zero interest-rate duration of loans in today's environment (Exhibit A).
Floating-rate loans and high-yield bonds rose to the top as other sectors sold off in 2021
Sources: Eaton Vance, S&P/LSTA, Bloomberg, as of 12/31/21. Data provided is for informational use only. Past performance is no guarantee of future results. It is not possible to invest directly in an Index. Loans are represented by the S&P/LSTA Leveraged Loan Index, an unmanaged index of the institutional leveraged loan market. High-yield bonds are represented by the ICE BofA U.S. High Yield Index, an unmanaged index of below-investment-grade U.S. corporate bonds. Municipal bonds are represented by the Bloomberg Municipal Bond Index, an unmanaged index of municipal bonds traded in the U.S. Mortgage-backed securities are represented by the Bloomberg U.S. Mortgage Backed Securities (MBS) Index, which measures agency mortgage-backed pass-through securities issued by GNMA, FNMA and FHLMC. The Bloomberg U.S. Aggregate Index is included as a broad measure of U.S. investment-grade bonds, and an unmanaged index comprising domestic investment-grade bonds, including corporate, government and mortgage-backed securities. U.S. Treasury is represented by the Bloomberg U.S. Treasury Index, which measures public debt instruments issued by the U.S. Treasury. Emerging markets debt is represented by the J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified, an unmanaged index of USD-denominated bonds with maturities of more than one year issued by emerging markets governments. U.S. corporate investment-grade is represented by the Bloomberg U.S. Corporate Investment Grade Index, an unmanaged index that measures the performance of investment-grade corporate securities within the Bloomberg U.S. Aggregate Index.
The performance spread of 6.74 percentage points between loans and the Aggregate Index shows why we have long called loans the "anti-bond." Loans can be not only an attractive source of income, but also a unique tool for portfolio diversification — especially when inflationary forces are building and the long duration of many bond sectors is a growing risk factor.
Learning from past inflation
The last serious inflationary environments in the U.S. were in the 1960s and 1970s, and both decades were characterized by loose monetary policy and massive fiscal stimulus, reminiscent of the mix of policy conditions today. Reflecting the tight relationship between the Consumer Price Index (CPI) and rates over those periods, the positive correlation reached 0.96 in the 1960s and 0.83 in the 1970s (Exhibit B).
Of course, corporate loans as an asset class were only in their infancy during those inflationary times, but performance year to date relative to bonds underscores how valuable they can be if we have anything like a repeat of that era.
Improving credit conditions
The appeal of loans in 2021 was further strengthened by improving credit conditions. The economic rebound — combined with the easy access to the capital markets provided not just by loans but by the high-yield sector — has powered a remarkable surge of upgrades. Likewise, defaults have plummeted to 0.29%, just 12 basis points shy of the 0.17% record set in 2011, based on the trailing 12-month average on December 31, compared with the historical average of 2.83% since 1999.
The thriving loan market has helped create what might be called a "virtuous circle" in the economy. It has provided companies with ample access to liquidity, fuel for balance sheet recapitalizations, refinancings and a record wave of acquisition-related activity — all of which are driving the continued economic recovery. The new borrowing has extended maturities for issuers, while also lowering borrowing costs, both of which are credit positive.
For some idea of the magnitude of issuer enthusiasm, institutional loan volume for 2021 was a record $615 billion, topping the previous peak of $503 billion set in 2017, according to LCD.
Earlier we noted that current yield is likely to provide most of the return — a "coupon clipping" environment. As of December 31, the yield to worst stood at 4.20%. While at the lower range of historical yields, that still makes loans the second highest yielding U.S. fixed income sector, next to the 4.32% on U.S. high yield bonds. And of course the yield on loans can float if short-term rates rise.
The challenges to growth prospects from the ongoing pandemic and continuing supply chain bottlenecks may also have an impact on credit conditions — pressure that will likely vary by sector and issuer. Loans are below-investment-grade assets, and even during strong parts of the business cycle we typically turn down about 75% of the deals we review.
Thus, our view is that the 2022 environment will be especially supportive of active management in the loan space. We believe that the credit exposure of an actively managed loan portfolio offers a better risk/reward profile than the interest-rate risk embedded in long-duration indexes like the Bloomberg Aggregate.
Regardless of what 2022 brings, loans have proven to be a remarkably resilient asset class over several decades of changing markets — since 1997, the Leveraged Loan Index has posted an annual total return of 4.9%.
Bottom line: With inflation playing a starring role as a major risk factor, we believe loans belong on center stage, deserving consideration for helping to conserve fixed income portfolios in rising rate environments.