The general tenor of financial markets had been sunnier during the early stages of 2023—at least up until the unexpected turmoil in the banking sector. Was this simply a relief rally after a brutal year? Or maybe investors were hopeful that the Federal Reserve was finished raising interest rates?

Whatever the case, fixed income investors should not forget the lessons learned in 2022, nor the fact that an environment of elevated inflation and restrictive monetary policy endures for the moment.

Thus, while investors may be hoping that a more accommodative monetary policy will soon be here, many are also wondering if rates might stay “higher for longer.” This new theme has been reiterated by various Federal Reserve governors in speeches and communiques, and it certainly has ramifications for fixed income investors.

Disciplined Diversification
All this simply illustrates why it’s vital to maintain diversification across various fixed income sectors, including an allocation to strategies that might be well suited for this tricky environment. The leveraged bank loan asset class, for example, aims to generate attractive yields in excess of inflation, while also offering a potential hedge against a restrictive monetary policy that might last longer than previously expected. 

From an interest rate risk perspective, the case for floating rate bank loans is also clear. It’s one of the few fixed income vehicles that should hold up relatively well in a rising-rate environment. This was evidenced most recently in 2022 when the leveraged bank loan asset class was a top-performing fixed income asset class in the face of the Fed’s aggressive rate hikes.

In part, this reflects the variable interest rate nature of this asset class. The yield on leveraged bank loans adjusts periodically based on a short maturity interest rate benchmark (typically the three-month London Interbank Offered Rate known as LIBOR or the Secured Overnight Financing Rate SOFR), and thus they have demonstrated the ability to outperform traditional bonds in rising rate environments.

It’s also important for investors to keep an eye on the real yield (i.e. yield captured minus the rate of inflation). In this context, fixed income investors still have limited options even as yields have become more attractive across most fixed income sectors. As of late March 2023, the yield on the Morningstar LSTA US Leveraged Loan Index—the benchmark for the asset class—was 10.47%, which offered a healthy spread over the February CPI of 6.0%. In doing so, floating-rate bank loans might prove to be a good strategic addition to any diversified fixed income portfolio. 

A Matter of Choice
If investors want to hedge a portion of their fixed income portfolio against a higher-for-longer environment, the next question becomes a matter of tactics. There are passive approaches to the leveraged bank loan asset class, but active approaches offer investors a chance to benefit from a manager’s experience, analysis, and security selection in this niche. Thus, it’s important to understand and evaluate the differences between the various options. Here are two key considerations in evaluating these leveraged bank loan funds. 

• Size. A nimble fund with 150 loans in a portfolio may be preferable to a larger fund with a portfolio with upwards of 600 loans (or a passive fund with even more). A targeted, high-conviction approach may provide adequate diversification while avoiding potential sectors of the economy that could struggle in the current higher-inflation environment. 
• Quality. Because these securities are considered below investment grade, a manager’s ability to conduct thorough credit analysis is critical. Too many lower-quality loans (or subordinate debt) may allow a fund to advertise a higher yield, but at what cost? Choosing a fund that skews toward higher-quality loans should lower the embedded risks of this investment.