Rising interest rates can “shatter” fixed income portfolios. Investing for income while not losing principal in a rising rate environment can be challenging, but senior loans may help fixed income investors achieve their investment objectives in a wide variety of market conditions. That is especially true in a rising rate environment because of their high relative yields relative to other fixed income assets and senior loans’ very limited exposure to interest rate risk. Looking ahead to 2016, we believe senior loans may be a strong performer, relative to other fixed income asset classes for the following reasons:
1. Performance Potential During Periods of Rising Interest Rates
Structurally, senior loans pay interest based on floating rates, so loans have significantly less duration (or interest rate risk) than most fixed income categories. Historically, senior loans have performed very well during rising, short- and long-term interest-rate environments.
2. Attractive Valuations
Senior loan prices have traded off and are now offered at a fairly rare discount to their par value. While some of the loans in the market ultimately may become distressed and sustain credit losses, the majority will recover and be paid off or refinanced at par, if history serves as a guide. Senior loans have senior-ranked priority in the event of default by the issuing company and are usually secured by all of the company’s collateral. Therefore, recovery rates on senior loans in the event of a default have historically averaged approximately 70%, or 70 cents on the dollar, and losses from defaults for the category have been modest.
3. High Income Potential
We believe the high levels of income alone typically produced by senior loans should keep them competitive in terms of total return prospects for 2016, relative to other fixed income categories. The senior loan market, like any other capital market, is subject to a certain amount of price volatility based on investor sentiment, technical factors of supply and demand, and/or valuations. Yet senior loans have historically proven to be an effective tool for investors seeking income generation and capital preservation.
We believe senior loans should be a core allocation in all fixed income portfolios and, for the reasons cited above, we believe senior loans may be an especially appealing option for 2016.
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