Barring unforeseen macro or market developments, we believe the bank loan asset class looks poised to deliver positive total returns in 2022. Here’s why:
Inflationary pressures have raised the risk of tighter monetary policy
As we move into 2022, inflation risks remain paramount from an investment standpoint. We expect many investors to grapple with the potentially adverse effects on their portfolios, particularly as ongoing repercussions from the COVID-19 pandemic continue to exacerbate labor shortages and supply chain disruptions worldwide. Broadly speaking, we think mounting inflationary pressures have ratcheted up the risk of tighter monetary policy on the part of the US Federal Reserve (Fed) and other global central banks.
Moreover, US President Biden recently tapped Jerome Powell to lead the Fed for a second term. Because Powell is perceived as being more of a policy “hawk” than other candidates for the job, following his reappointment as Fed Chair, the market-implied number of Fed interest-rate hikes increased to three hikes by the end of 2022 and five by the end of 2023.
Bank loans have historically outperformed in periods of rising interest rates
Rising-rate environments have historically been challenging for traditional fixed income assets. However, there are certain sectors that have often performed well during such periods. Case in point: bank loans. As floating-rate instruments whose coupons reset higher as rates rise (thereby offsetting the typical negative price impact from rising rates), bank loans may be well positioned to benefit from increases in short-term rates.
In fact, the bank loan asset class has historically outperformed fixed-coupon, longer-duration investment-grade-rated bonds during periods of rising rates (Figure 1). This could happen again in 2022.
During each of the four Fed rate-hiking cycles since the inception of the Credit Suisse Leveraged Loan Index in January 1992, bank loans materially outperformed investment-grade bonds.
Bank loans offer attractive yields and are trading below par
Along with providing limited duration risk, we believe bank loans offer attractive levels of current income and are trading at reasonable valuations as of this writing, with modest price appreciation potential relative to other fixed income sectors. For example, as of 31 December 2021, the Credit Suisse Leveraged Loan Index had a 3-year fixed yield-to-maturity of 5.26% and an average price of $98.39.
The fundamental picture is also supportive of bank loans
Bank loan issuers as a group have fortified their balance sheets since the onset of COVID-19, with interest-coverage ratios generally high and liquidity profiles strong. Encouragingly, as issuers have improved their credit profiles, bank loan downgrades and default rates (currently well below 1.0%) have declined meaningfully. Going forward, we anticipate that bank loan defaults will remain benign in 2022.
Last year, we saw healthy investor demand for bank loans in the form of brisk retail fund inflows – a technical tailwind that we expect to persist in 2022 as more investors begin to seek protection from rising rates in the months ahead. Indeed, our overall outlook for bank loans is constructive over the next 12-24 months. Now may be an opportune time to initiate or enlarge exposure to the asset class.
The tactical argument aside, we think investors should consider having a longer-term, strategic allocation to bank loans. In our view, relatively low correlations to other asset classes, combined with the potential power of compounding high income and defense against rising rates (and inflation), can make bank loans a valuable addition to many long-term portfolios.