Consider Senior Loans for an Attractive Yield and Portfolio Diversification

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David Forgash, Head of Leveraged Loan Portfolio Management, PIMCO: Bank loans, also known as senior loans or leveraged loans, represent an attractive opportunity for fixed income investors, especially in the current interest rate environment.

There are 3 main reasons:

First, bank loans have floating rates. So, in times of rising rates, they offer low duration – or interest rate sensitivity.

A second advantage for investors is yield. Bank loans tend to offer attractive yields, on par with “high yield” bonds, but with lower volatility and higher “seniority” in the capital structure.

And third, looking at the rest of your portfolio, loans can be a powerful diversifier due to their historically very low correlation to traditional fixed income categories and their relatively high correlation to inflation. .

These are some of the reasons why adding a long-term allocation to loans in the context of a traditional bond portfolio can provide significant defensive advantages, as well as potentially attractive returns.

Now let’s dive a little deeper into each of these advantages.

First, their role as defense against rising interest rates.

Periods of rising rates are considered one of the most pernicious environments for fixed income securities. Bank loans are one of the few categories of fixed income securities for which this statement is contrary – the coupon on senior loans tends to adjust upwards with interest rates, “floating” with a higher spread LIBOR or SOFR.

You can see a stark difference between core bonds and loans when you compare their performance in rising rate environments. In almost every historical period of rising rates, the broader bond market has suffered, while loans outperformed. This usually happens when the economy is growing and the Fed takes action to calm things down, such as during the taper tantrum of 2013, or more recently in the summer of 2017.

As the Fed again pledged to hike rates, loans outperformed other fixed income sectors. This is where the inclusion of loans can have an offsetting effect. A defense against the effects of rising rates on the entire portfolio.

Another key benefit of loans is the attraction of a higher yielding component to the bond portfolio.

Income is one of the distinguishing characteristics of the bond portfolio, and who seek performance has been persistent over the past decade – when rates had bottomed out.

The income, or performance benefit, of loans has a clear appeal…and not just when interest rates rise. Long-term, in periods of “rising” and “falling” ratesthey provided a return in line with high yield bonds, but with significant differences from HY – which as a category has a duration of more than 4 years.

This brings us to the final point – the diversification and impact on the portfolio that the inclusion of loans can have.

In addition to their other advantages, the loans have a low correlation – in fact, negative correlation – “core” bonds represented by the aggregate index, as well as most of the components of the bond portfolio. From Treasuries to mortgages to high quality companies, this correlation is quite low.

Interestingly, loans also have a upper correlation to consumer price inflation, or CPI, than most other fixed income categories. This double-barrel and diversification effect makes loans a particularly effective “add-on” to the broader bond portfolio when incorporated at the strategic level on the whole allocation.

Disclosure

Past performance is not a guarantee or reliable indicator of future results.

A word on risk: Invest in senior loansincluding bank loans, exposes the portfolio to increased credit risk, call risk, settlement risk and liquidity risk. bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, so prepayments cannot be accurately predicted. There can be no assurance that the liquidation of any security for a secured bank loan would satisfy the obligation of the borrower, or that such security could be liquidated. Diversification does not insure against loss.

Correlation is a statistical measure of how two stocks move relative to each other. The correlation of various indices or securities to each other or to inflation is based on data over a certain period of time. These correlations may vary significantly in the future or over different time periods, which may result in greater volatility.

Bloomberg US Aggregate Index The Bloomberg US Aggregate Index represents SEC-registered, taxable, dollar-denominated securities. The index covers the US investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities. These large sectors are subdivided into more specific indices which are calculated and communicated regularly. The Bloomberg Investment Grade Corporate Index is an unmanaged index that is the Corporate component of the US Credit Index. The index includes both companies and companies and consists of debentures issued by US companies and specified foreign securities and secured notes that meet specified maturity, liquidity and quality requirements. The business sectors are industrials, utilities, and finance, which include both US and non-US businesses. The non-commercial sectors are sovereign, supranational, foreign agencies and foreign local authorities. ICE BofA Merrill Lynch US High Yield Index is an unmanaged index composed of bonds issued in US domestic markets with at least one year remaining to maturity. All bonds must have a credit rating below investment grade, but not in default. Credit Suisse Leveraged Loan Index The Credit Suisse Leveraged Loan Index is designed to reflect the investment universe of the US dollar-denominated leveraged loan market. New loans are added to the index on their date of issuance if they meet the following criteria: Loans must be rated “5B” or lower; only funded term loans are included; the duration must be at least one year; and issuers must be domiciled in developed countries (developing country issuers are excluded). Fallen Angels are added to the index subject to the new lending criteria. Consumer Price Index (US) The Consumer Price Index (CPI) is an unmanaged index representing the rate of consumer price inflation in the United States, as determined by the United States Department of Labor Statistics. There can be no assurance that the CPI or other indexes will reflect the exact level of inflation at any given time. Bloomberg US TIPS Index is an unmanaged market index composed of all U.S. Treasury inflation-protected securities rated investment grade (Baa3 or better), having at least one year to final maturity and a nominal amount outstanding of at least 500 millions of dollars. It is not possible to invest directly in an unmanaged index.

PIMCO in general provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This document contains the opinions of the manager and these opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein was obtained from sources believed to be reliable, but not guaranteed. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Investments LLC, US distributor, 1633 Broadway, New York, NY, 10019 is a PIMCO company. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a registered trademark of Allianz Asset Management of America LP in the United States and throughout the world. ©2022, PIMCO.

CMR2022-0606-2232971

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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