The first quarter of 2022 was eventful and eye-opening in many ways. Fixed-income investors have experienced economic contractions, bouts of volatility over the course of a business cycle, credit failures, rapidly changing sector dynamics, war, pandemic and Federal Reserve (Fed) tightening episodes. Most investors, however, have not had to grapple with the prospect of high and persistent inflation. Whether or not this materializes is the crucial question on how to position portfolios over the next few years, as the Fed seeks to choke off inflation without sending the economy into recession. During the quarter, virtually all fixed-income asset classes registered negative total returns as the dramatic rise in Treasury yields led to one of the worst starts of the year. Within leveraged finance, loans were a strong outperformer versus high-yield bonds due to their floating-rate nature and limited duration. While this dynamic may continue in the near term, I worry about the health of the asset class if a soft landing does not materialize.
The investment case for loans versus high-yield bonds is pretty straightforward — they provide a way to gain floating-rate exposure and remain high in the capital structure. At the same time, issuers have flocked to loans that can raise large sums with low absolute yield, loose covenants and limited call protection. The attractiveness of the asset class has led to strong inflows over the last few years and the market has grown to roughly the same size as the domestic high-yield market. Currently, with the growing economy, tight labor market and household net worth at record levels, interest rate risk is a more pressing concern than credit risk. Still, if/when the cycle does turn, loans will cease being a floating-rate hedge and will become traditional credit risk. Looking under the hood might reveal more credit risk than appreciated. A majority of the J.P. Morgan loan index is rated in the single B category, contains a high percentage of loan-only issuers and over the last few years, loans have financed a large share of leveraged buyouts. Also, liquidity can be fleeting since the largest buyer of loans are collateralized loan obligations (CLOs) and a turn in sentiment can cause the CLO “bid” to disappear quickly.
Takeaway
The yield curve is flashing yellow as the market debates whether a slowdown in growth will become more pronounced. While underlying credit quality is currently very solid across corporate credit, higher input costs, supply chain issues and more limited pricing power will cause margins and earnings to deteriorate. Loans, which have been a relative safe haven, may come under pressure, and the benefits of gaining floating-rate exposure will take a back seat to credit risk. Tourists to the asset class may be in for a bumpy ride.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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