The strategic and tactical case for loans

Loans have long been a core component of institutional fixed income portfolios, offering diversification benefits and a relatively stable return profile. Several key factors underpin their strategic attractiveness:

A fixed income diversifier

Unlike traditional bonds, which have fixed coupons and can suffer price declines when interest rates rise, loans are typically floating rate instruments, meaning their coupons adjust with prevailing interest rates. This reduces their interest rate sensitivity and low correlations versus other parts of the fixed income market.

Stability and long-term performance

Historical data highlights the consistency of loan returns. Over the past 32 years, the leveraged loan market has seen only three negative calendar years – an impressive track record compared to many other fixed income asset classes. Even in volatile periods, loans have demonstrated resilience, underpinned by their senior secured status, which ensures they are among the first to be repaid in the event of corporate distress.

Built-in collateral and market stability

Another advantage of loans is the presence of collateral backing. Unlike unsecured debt, loans are typically secured by specific assets providing an additional layer of investor protection. Furthermore, a significant portion of the investor base consists of institutional buyers, such as banks, pension funds, and insurance companies. This institutional participation helps stabilize the market, even during periods of heightened volatility.

Low correlation with other asset classes

In addition to their strategic role within fixed income portfolios, loans provide broader diversification benefits across asset classes. Senior loans have historically exhibited low correlation with equities and traditional fixed income helping to reduce overall portfolio volatility.

Correlation of senior loans to various assets classes

While the strategic case for loans is well established, the tactical case is equally compelling.

Loan demand and rising rate sensitivity

Historically, loans have been favored by investors when interest rates are rising, as their floating rate nature means higher income as rates increase. However, with rate cuts, some investors question the continued relevance of loans.

The answer lies in their appeal beyond rate cycles. Even in a declining rate environment, loans continue to attract institutional investors due to their yield and credit spread advantages. The loan market has historically grown even in post-tightening periods, demonstrating its resilience and demand sustainability.

Spreads as key indicator

While absolute yields have risen across fixed income, spreads remain the key metric for assessing value. Spread levels represent the risk premium investors earn over risk-free rates, and despite overall higher yields, spreads in the loan market are only slightly tighter than their 15-year average. This is compared to other parts of the credit market, which are at long term lows in terms of the spreads currently being offered.

Given the spread compression across broader credit market, the premium available in loans remains attractive.

Senior loans as a defensive play

Senior loans and collateralized loan obligations (CLOs) have characteristics that help them withstand market volatility. In the event of default, leveraged loans have historically fared better than high yield bonds, reducing investor losses. Post-bankruptcy recoveries over the last 10 years for senior loan holders have averaged around 55 cents on the dollar, while the average for high yield bond holders has been around 37 cents on the dollar.

Historical recovery rates

CLOs in particular, act as structural buffers in the market. These actively managed vehicles pool senior loans and create tranches with varying levels of risk and return. This structure provides flexibility, allowing managers to adapt portfolios dynamically while maintaining stability even in downturns.

The portfolio simulation below shows how different allocations may affect different risk and return profiles.