Are You Buying Bonds or Loans Right Now?

Year-to-date the HY CEF sector is down about 12% in total NAV terms versus only about 6% for the Loan CEF sector. This dynamic as well as the long-awaited rise in interest rates has made most investors position away from interest-rate sensitive assets such as bonds and toward floating-rate assets like Loans.

However, one of the behavioral biases that investors have to be aware of is the tendency to extrapolate current trends. For instance, it is very tempting to ditch all duration securities such as bonds or preferreds and go all into floating-rate assets like loans. However, in our view, the recent rise in risk-free rates as well as the increase in recession estimates argue for some allocation to bonds, even an increase from current levels.

Let’s take a look at two arguments why many investors may want to pile into floating-rate instruments. One argument goes that in a period of rising rates loans should outperform bonds as their prices are bid up in anticipation of higher coupons and as they start to deliver higher coupons with rising rates.

We can look back to the previous hiking period starting at the end of 2015 which lasted till the end of 2018 when it was cut short by the market.

FRED

If we look at the period from the start of 2017 (starting roughly when the Fed funds rate was at about the same level as it is now) to the end of 2018 we see that, at least judging by CEF total NAV returns, high-yield bonds actually either outperformed or kept pace with Loans for most of this period.

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When a recession started to get seriously priced in late 2018 investors began to worry about a yield curve inversion. This period was characterized by falling long-term rates which accelerated during the COVID crash.

FRED

In this period High-Yield CEF Sector total NAV return significantly outperformed that of the Loans sector.

Systematic Income

That’s all well and good, some investors might say, but the second argument is that Loans will really shine when economic push comes to shove and companies start defaulting. For that scenario let’s take a look at how the sectors performed during the GFC. It is true that Loans had a lower default rate and a higher average recovery than bonds but it wasn’t enough to drive a higher total NAV return.

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The COVID crash saw pretty similar performance across the two sectors though High-Yield bonds managed to pull away at a later stage.

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The key point here is not that High Yield bonds are always going to outperform Loans but that Loans will not always necessarily outperform bonds during periods where they should outperform bonds. This is also not to say that investors shouldn’t have some Loan exposure or that High Yield Bonds will not be hurt if Treasury Yields keep rocketing higher.

However, now that 1) Treasury yields appear to have made the bulk of their expected move higher and 2) the likelihood of recession is quite sizable (and hence the likelihood of a drop in longer-term rates is similarly sizable), High Yield Bond allocations should not be ruled out in income portfolios.

When thinking about High Yield or Loan CEF allocations, two key points are worth keeping in mind. First, what are the relative yields between the two assets? And two, how much of the likely move in rates is behind us?

The fact that HY bonds are at a yield advantage versus Loans gives it a performance advantage, all else equal. And two, with 5Y Treasury yields having risen from 0.8% to 2.8% in the last 8 months, very likely the bulk of the rate move is behind us and, hence, the underperformance of the HY sector vs. Loans.

Thanks for reading.

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