Inflows into bank-loan funds have reached $19.5 billion year-to-date,² the highest in four years, and we do not expect this trend to reverse anytime soon. The Federal Reserve (Fed) is striving for near full employment and 2% average inflation, and is keeping monetary policy extremely easy. With the help of more fiscal spending and a recovering economy, we believe the Fed may get the inflation they want, which should keep rates moving higher and continue to fuel a “duration rotation” toward bank loans (see FIGURE 1).

Looking beyond the immediate steepening yield-curve risk, there is also the prospect of short rates rising. For now, the Fed has firmly anchored the short end of the curve. However, we expect the Fed to begin tapering its asset purchases around the end of 2021. The market may begin to price in the first rate hike 9-12 months later. This could directly benefit the floating-rate nature of bank loans and adds to our bullishness for the asset class as we think it suggests a second wave of demand on the horizon.

Bank Loan Fundamentals Are Strong, Defaults Are Low, Risks Are Declining

In the Hartford Floating Rate Funds, we are focused on collecting income, avoiding defaults, and underwriting one loan at a time. We see default risk as low today and moving even more “out of the money” over the next 12 months. The Fed continues to flood the world with liquidity, the US government is adding trillions in fiscal spending, and the effective vaccine rollout is enabling the economy to re-open and unleash pent up savings and demand. These are all strong tailwinds for credit and bank-loan fundamentals. As FIGURE 2 shows, defaults for the loan market are declining and we believe heading well below long-term averages. As fundamental risks decline, bank loans may be an attractive asset class, even without the current tailwind from rising rates.

Bank Loans Offer Both a Strategic and Tactical Benefit to Portfolios

In this paper, and our recent commentary on Floating Rate Notes, we have made a strong case for why allocators should tactically consider bank loans during periods of rising rates like today. However, we also believe investors should consider bank loans as a long-term strategic allocation in their portfolios.

Power of Compounding Income

FIGURE 3 says it all. The bank-loan asset class has only had two negative return years in its more than 25 year history. In 2015, the return was only modestly negative (-0.7%), with 2008 representing the only other negative return year for the asset class. However, the conditions and leverage that precipitated that extreme crisis do not exist today. Since 2000, bank loans, as referenced by the S&P/LSTA Leveraged Loan Index, have returned 4.81% on an annualized basis,³ with the majority of that return coming from income. Compounding that income year-after-year can be hugely additive to portfolios. Furthermore, this income stream can be a great diversifier to equities in down fundamental years, as well as to fixed income in rising rate/strong fundamental years like we are experiencing today.

Diversification

Modern Portfolio Theory tells us that introducing low or negatively correlated assets to portfolios may reduce risk and be beneficial to returns. Thanks to consistent income, bank loans have historically had low correlations to assets such as equities (0.5) and investment-grade credit (0.4), and have been negatively correlated with Treasuries (-0.4).⁴ In addition to income without rate risk, bank loans have had a powerful diversification benefit in client portfolios. We believe clients should consider a long-term strategic allocation to bank loans to potentially reduce portfolio risk and enhance returns.

Summary

In summary, the duration rotation has begun. With a strong fundamental outlook, we have seen the market begin to look to bank loans to respond to the steepening yield-curve threat. Taken in combination with additional fiscal stimulus and easy monetary conditions, we also expect loan defaults to be well below historical averages. Further, we think investors should consider bank loans as a strategic allocation in their portfolios. Low correlations to other asset classes and the power of compounding high income and positive total returns make the asset class attractive from a long-term perspective.

We thank you for your continued trust and support of the Hartford Floating Rate Funds.