The U.S. Federal Reserve is expected to raise interest rates multiple times this year, which makes now a good time for investors to explore how senior loans may help portfolios in a rising rate environment.
Investors today are faced with two significant challenges in fixed income:
- How to protect against interest rate risk
- Where to find yield
In this piece, we will discuss how senior loans may offer a strong solution to each of these challenges.
Rising interest rates
When investing in fixed income, investors must consider both credit risk and interest rate risk. Rising interest rates can have just as harmful an impact on fixed income portfolios as credit risk. Investing for income while not losing principal in a rising rate environment can be challenging, but senior loans may help fixed income investors achieve their investment objectives in a wide variety of market conditions. That is especially true in a rising rate environment because of their high relative yields and limited exposure to interest rate risk due to their short duration.
The U.S. Federal Reserve (the Fed) policymakers are widely expected to raise interest rates three to four times this year, starting as early as March. The Invesco Global Senior Loan team believes investors should consider repositioning their fixed income portfolios to better prepare for rising rates. Structurally, senior loans pay interest based on floating rates, so loans have significantly much less duration (or interest rate risk) than many fixed income categories.
Senior loans have performed well during periods of rising rates
Index returns when the 10 year U.S. Treasury increased more than 100bps
High income potential
Even if the widely expected Fed rate hikes are surprisingly fewer or postponed, we believe the high levels of income typically produced by senior loans should keep them competitive in terms of total return prospects for 2022, relative to other fixed income categories.
The senior loan market, like any other capital market, is subject to a certain amount of price volatility based on investor sentiment, technical factors of supply and demand, and/or valuations. Yet, because senior loans sit atop a company’s capital structure and are secured by the company’s assets, they can be an effective tool for delivering income generation and capital preservation objectives. We believe senior loans should be a core allocation in all fixed income portfolios and, for the reasons cited above, we believe senior loans may be an especially appealing option for 2022.
U.S. senior secured loans offer one of the best yields in fixed income
Senior loans may deliver several compelling characteristics that can make them an attractive long-term core holding in fixed income portfolios in various environments. In today’s market environment, two of those characteristics are particularly relevant:
- Senior loans can help protect against interest rate risk as they have extremely short duration of approximately 0.25 years on average.
- Senior loans generally deliver relatively high levels of income/yield compared to other fixed income asset classes.
Invesco Canada offers exposure to senior loans through the Invesco Floating Rate Income Fund.