Thus, as the US economy heads into a low-growth phase, bank loans are at greater risk of default than high-yield bonds. Further, the share of the high-yield bond market that is secured—31% as of December 31, 2022—is relatively high, which may translate into higher recovery rates for high-yield bonds in the event of default.
Three Reasons to Strike a Better Balance
The way we see it, investors may consider ditching bank loans in favor of a balanced approach to income investing. Among the most effective active strategies are those that pair government bonds and other high-quality, interest-rate–sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio.
This barbell approach can help investors get a handle on the interplay between rate and credit risks and make better decisions about which way to lean at a given moment. The ability to rebalance negatively correlated assets helps generate income and potential return while limiting the scope of drawdowns when risk assets sell off.
In today’s environment, lifting a barbell strategy provides three key benefits:
1) Income generation. Yields across risk assets are higher today than they’ve been in years, giving income-seeking investors a long-awaited opportunity to fill their tanks. Investors should aim to diversify not only globally but also by sector. Sectors such as high-yield corporates, emerging-market debt and securitized assets—including commercial mortgage-backed securities and credit risk-transfer securities—can also serve as a buffer against inflation by providing a bigger current income stream. In our view, investors should favor higher-quality credit, be selective and pay attention to liquidity. Lower-rated credits in any sector are most vulnerable in an economic downturn.
2) Duration. While high-yield bank loans typically have little to no duration—a measure of sensitivity to changes in interest-rate levels—government bonds can be an excellent source of duration. And we think a moderate amount of duration from high-quality government debt could be an especially good thing in portfolios today. As inflation ebbs and the economy slows, duration tends to perform well, acting as an offset to the volatility of growth assets.
3) Negative correlations. In 2022, equity and fixed-income markets broke with convention and fell in tandem, leaving almost nowhere for investors to hide. Some market observers wondered whether the days of negative correlations between US Treasuries and risk assets were behind us. But recent market events have proved that thesis wrong. As risk assets sold off in March, US Treasuries enjoyed a strong rally, reestablishing the negative correlation between the asset classes in a risk-off environment. We expect this restored relationship to persist.
Take Care as the Cycle Turns
As the credit cycle enters its twilight stage, income-seeking investors should carefully weigh their options. In our view, a barbell strategy that balances rate and credit risks may succeed where bank loans will not. Above all, we think this is an ill-advised time to bank on bank loans. As the tide advances, investors may just find that floating-rate bank loans are castles in the sand.
