- Leveraged loans currently offer higher yields than other fixed income assets and have also outperformed stocks so far this year.
- Yields on leveraged loans have historically risen along with inflation and interest rates.
- As inflation and interest rates rise, leveraged loans may be worth considering as additions to portfolios.
- In exchange for higher yields and inflation protection, leveraged loans pose credit and liquidity risk.
For income-seeking investors, these are challenging times. Yields on familiar fixed income assets are rising but not nearly as fast as inflation, which is at its highest level in 40 years. "Real yields"—the yield minus the rate of inflation—on many fixed income investments are still below zero, even though rates have moved upward. And while bonds can still play an important role as ballast against volatile stocks, bond markets have also been more volatile than their historical averages this year.
What to do? If you are seeking higher yields and inflation protection and are willing to take on more risk than with highly rated bonds, it may be a good time to learn more about investing in leveraged loans, which are one of only a handful of investment options whose yields have kept pace with inflation this year.
What are leveraged loans?
Leveraged loans are loans made by banks or other financial institutions to companies who often use them to refinance their debt, fund mergers and acquisitions, or finance projects. The companies that receive these loans typically have credit ratings that are below investment grade. These loans usually have a term of between 5 to 7 years, though the borrower can repay them at any time. They are secured by collateral such as the borrower's real estate and equipment, as well as intellectual property including brands, trademarks, and customer lists.
Unlike bonds that pay fixed rates of interest, bank loans pay interest at rates that adjust periodically, based on a publicly available, short-term interest rate. One of the most commonly used rates for setting interest rates on leveraged loans is the Secured Overnight Financing Rate, known as SOFR.
Loans as investments
In the past, when banks would make leveraged loans, they would be added to the bank's balance sheet. Over time, banks began to form syndicates in which several banks could jointly lend to a borrower and offer the loans for sale to investors such as insurance companies, pension funds, and mutual funds and ETFs. Since 2010, the value of outstanding leveraged loans has risen from $500 billion to roughly $1.4 trillion as of August 2022, almost as large as the $1.5 trillion US high-yield bond market. The growth of the loan market has attracted larger and more established borrowers, such as Dell, United Airlines, and Caesars Resorts, who might have otherwise raised capital by selling bonds.
Eric Mollenhauer, manager of Fidelity® Floating Rate High Income Fund (FFRHX) says, "There's more opportunity today to have principal appreciation in the loan market than there was a year ago. Many loans are trading at prices that are below their par value and we can use research to find those that have the potential to gain in value as well as paying interest. It's credit picker's market and there's little risk that most loan coupons will be repriced downward."
Why invest in loans?
Leveraged loans offer potential inflation protection and a hedge against the rising interest rates that inevitably accompany inflation. Bond prices typically fall when interest rates rise. Higher inflation almost always eventually leads to higher rates because rate hikes are central banks' preferred way to manage inflation. Unlike most bonds, though, the interest rates on leveraged loans adjust upward along with rises in key consumer interest rates. That means loans are less likely than most fixed income investments to lose value when inflation and interest rates rise. While past performance is no guarantee of future results, loans historically have performed better than longer-duration fixed income bonds in a rising-rate environment.
Floating-rate loans have generally fared well amid rising rates
Another benefit of loans is that they typically offer relatively high yields. Like high-yield bonds, they represent promises to pay by non-investment-grade borrowers, and their lenders expect higher compensation in return for taking that risk. Loans can also help diversify portfolios. Because of their relatively low sensitivity to interest rates and attractive levels of income, leveraged loans have historically been positively correlated with inflation and negatively correlated with Treasurys. Keep in mind that diversification and asset allocation do not ensure a profit or guarantee against loss.
Risks of investing in loans
While loans may offer more protection from inflation and rising rates than bonds might, experienced investors know that there is no "free lunch." That means that no investment is free of risk. "I believe the fundamental outlook for the market is more cloudy today than it was a year ago," says Mollenhauer. Because leveraged loans are typically made to companies with below-investment-grade credit ratings, they pose a meaningful risk that the borrower may eventually become unable to make interest and principal payments. However, this credit risk may be offset somewhat by the fact that lenders are among the first in line to be paid if a borrower declares bankruptcy, ahead of most bond or stockholders.
While mutual funds that hold loans may be attractive to investors who seek income and capital preservation, it's important to keep in mind that like bond funds and money market funds, they are not guaranteed by banks or the Federal Deposit Insurance Corporation (FDIC) and should not be considered as cash alternatives or cash equivalents.
Also, unlike bonds, loans are unregistered securities and are traded over-the-counter rather than on exchanges. That may mean the loan market occasionally encounters periods when the number of buyers and sellers becomes unbalanced and trading at fair value becomes difficult.
How to invest in them
While most investors in the loan market are large institutions, professionally managed mutual funds or exchange-traded funds can help you add leveraged loan exposure to your portfolio. Funds provide you with access to an asset class normally available only to institutional investors, plus daily liquidity, and diversification across borrowers and industries. You can run screens using the Mutual Fund Evaluator on Fidelity.com. Below are the results of some illustrative mutual fund screens (these are not recommendations of Fidelity).
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