Since January 2021, many investors have come around to the view that the US appears poised for a strong rebound in economic growth, driven by fiscal stimulus, vaccine administration, and economic reopenings. Meanwhile, bottlenecks in global supply chains have made it more challenging to meet increased demand for goods and services, causing input costs to rise across a number of industries.
Taken together, these developments have led to mounting inflation expectations and upward movements in interest rates. Year to date through 12 April 2021, the 10-year US Treasury yield has risen 75 basis points (bps) to 1.67%. The spread between the fed funds rate and the US 10-year Treasury note, a general proxy for yield-curve steepness, is also up meaningfully.
I believe the risk of further rises in inflation expectations and interest rates is not yet fully priced into markets. There are steps fixed income investors can take now to manage this growing risk to their portfolios. One way to do so may be via allocations to higher-income, shorter-duration assets such as floating-rate loans (FRLs).
The “duration rotation” is underway
In today’s low-yield world, a steepening yield curve can have a material negative impact on fixed income returns. Figure 1 shows several widely used fixed income benchmarks, their yields and durations as of 31 December 2020, and their year-to-date 2021 returns. Not surprisingly, traditional longer-duration, interest-rate-sensitive market sectors produced negative total returns through the first few months of 2021. For example, the Bloomberg Barclays US Aggregate Bond Index (the “Agg”), a widely used fixed income benchmark, has lost 2.9% year to date as Treasury rates have risen.
On the other hand, the S&P/LSTA Leveraged Loan Index, a proxy for the FRL market, which generates high current income with virtually zero duration risk, has gained 2.2% year to date. Moreover, when the US Federal Reserve (Fed) starts to raise short-term interest rates (which I believe will occur in 2022), the floating-rate nature of bank-loan coupons should provide another tailwind for the asset class. By contrast, the Agg and other duration-sensitive areas of fixed income will be susceptible to further price declines if rates continue to rise.
These recent performance trends are driving what I’m calling a “duration rotation” that is likely to persist in the period ahead. In a nutshell, many investors are rotating out of duration-sensitive assets into assets like FRLs, looking for higher levels of income without interest-rate risk.
In my opinion, the “duration rotation” has begun. With their strong fundamental outlook, the market has already started turning to FRLs in response to the steepening yield-curve threat. The nascent economic recovery, additional fiscal stimulus, and easy monetary conditions all give me confidence that loan defaults will be relatively benign, trending below historical averages and helping to make loans an attractive asset class over the next 12 – 18 months.
Inflows into floating-rate funds have reached around US$11.0 billion year to date, the briskest pace in four years. In my view, this is just the beginning of the duration rotation. Investors searching for income and total return with less rate risk may want to consider shorter-duration assets, such as FRLs, for their portfolios.