Boston - After a dramatic backup in U.S. Treasury yields in late February and early March, are we entering a new bear market in bonds? Our fixed income investment experts present their views on the market environment in a series of blogs, starting with floating-rate loans.
For many fixed income investors, February 2021 was quite a wake-up call. The yield on the 10-year U.S. Treasury gained 45 basis points (bps) to 1.46% during the month — its largest one-month rise since 2016 — as concerns about the impact of stronger economic growth, massive stimulus and higher inflation expectations all came to the fore.
Though the short end of the yield curve weakened over the month as well, the real drama came on February 25, when the yield on the five-year U.S. Treasury note spiked by almost 40%, from 22 bps to 81 bps — the largest-ever one-day jump on record.
As we turned the corner into March, yields subsided modestly and the Treasury market calmed down. On March 4, however, stocks and bonds sold off again, following remarks by U.S. Federal Reserve Chair Jerome Powell.
Possibility of renewed growth and reflation
Despite recent volatility, we believe it's too soon to declare that the inflationary scenario is indeed the most likely one, given the many uncertainties surrounding the recovery's path. Nonetheless, we think one thing is clear: Investors may want to make sure that their portfolios are prepared for the possibility of renewed growth and reflation ahead.
One answer is the floating-rate senior loan asset class. These corporate loans offer investors a unique tool to prepare for an environment such as the one that appears to be unfolding. An improving economy boosts the financial strength of loan issuers, making it a conducive backdrop for allocating to corporate credit strategies.
At the same time, loans' adjustable coupon structure translates to virtually no interest-rate duration (price sensitivity to interest-rate changes), which is why loans have been one of the only asset classes spared amid the recent bond market volatility. The exhibit shows how loans have outperformed bonds in 221 of 336 rolling one-year periods since 1992.
Loans have outperformed bonds in rising-rate and flat markets alike
Sources: Eaton Vance, Credit Suisse, Bloomberg, U.S. Federal Reserve as of 12/31/2020. 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 Credit Suisse Institutional Leveraged Loan Index and bonds are represented by the Bloomberg Barclays U.S. Aggregate Index. Analysis includes all rolling one-year periods since inception of Credit Suisse Institutional Leveraged Loan Index in February 1992.
A key takeaway is that loans outperformed both in flat periods, when rates didn't rise (because loans tend to out-yield bonds), and in the rising-rate years, when bonds were hurt because of their sensitivity to yield changes. As of February 28, 2021, the 4.33% yield on the S&P/LSTA Leveraged Loan Index was the highest available on domestic fixed income sectors. To us, this could represent a "win-win" position — the inflationary/rising-rate scenario doesn't have to materialize for investors to benefit.
Potential tailwind of renewed investor demand
Loans have another potential tailwind in today's environment — renewed investor demand. Retail investors started pulling cash from loan funds in 2018. These outflows persisted throughout 2020's pandemic-induced sell-off and during the subsequent rebound later in the year. Now, however, net flows into loan funds have again turned positive as investors appear to be bracing for the environment ahead.
During the previous regime of inflows from 2016 to 2018, investors allocated $35 billion of net purchases into loan funds, and the share of outstanding loans held by mutual funds hit a cyclical high of 17%, according to Bank of America research.
Today, loans held by retail funds sit at a cyclical low of 6.5%, but over the past few months this figure has begun to track in the other direction. We believe February's bond action delivered a strong message — one that could fuel continued inflows as investors look for attractive answers to the bond market challenges on display.
Factors pushing up inflation and rates
While it's impossible to precisely handicap the case for inflation and rising rates, a growing number of factors are pushing that scenario onto investors' radar. For example, with massive direct stimulus payments, personal savings have been estimated to be $1.5 trillion higher than before the pandemic — even prior to the most recent $600 payments. And the Biden-Harris administration appears poised to deliver even more fiscal support as 2021 rolls on.
We see U.S. consumers in much better shape and itching to spend, and this important segment represents a significant majority of economic growth historically. As a refresher, massive stimulus combined with loose monetary policy were the key ingredients for rising inflation in the past, after World War II in the late 1940s and during the Vietnam War era of the 1960s and 1970s.
All these factors have helped push up inflation expectations over the past 12 months, as measured by the five-year breakeven inflation rate1 now at 2.43% — its highest level since 2008.
To be sure, the jury is still out on whether rising rates and inflation will continue their march higher. There are indeed counterpoints — a weaker labor market, for example — but it will take time to know.
Bottom line: Recent bond market volatility should underscore that the ultra-low rate environment which has prevailed for so long can no longer be taken for granted — not even at the short end of the yield curve. Loans may offer an excellent tool for investors to prepare for the changing risk profile of today's bond market.
- The breakeven inflation rate is a common metric for inflation expectations, and represents the difference between the nominal five-year U.S. Treasury rate and the real (adjusted for inflation) rate on five-year U.S. Treasury Inflation Protected Securities (TIPS).
Bloomberg Barclays U.S. Aggregate Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities.
Credit Suisse Institutional Leveraged Loan Index is an unmanaged index of the institutional leverage loan market.
S&P/LSTA Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.