Fixed Income Portfolio Allocation in the Time of Inflation and Rising Rates
Written By: Brandon King
“We will take the necessary steps to ensure a return to price stability. In particular, if we conclude that it is appropriate to move more aggressively by raising federal funds rate by more than 25 basis points at a meeting or meetings, we will do so. And if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well.”
—Federal Reserve Chairman Jerome Powell on March 21, 2022
On March 16, 2022, the Federal Reserve indicated that they would raise their target Fed Funds rate by 0.25 percentage points for the first time since 2018. Based on recent comments by Fed Chair Jerome Powell and other Federal Reserve Presidents along with the recently released Fed Dot Plot which outlined six more rate increases by year’s end, it appears likely that U.S. investors are in for a rising rate environment, for the foreseeable future, as the Fed looks to actively combat inflation. Given this strong positioning by the Fed, current inflation dynamics, and equity market volatility, we believe it is prudent for investors to take an active look at their portfolio’s current fixed income allocations and ensure they are strategically positioned to navigate this new environment.
Looking at historical performance under different rate environments, leveraged loans, as represented by the S&P/LSTA 100 Index (“LSTA”), have generally outperformed bonds, as represented by the Bloomberg U.S. Aggregate Bond index (“Agg”), on a relative basis during rising rate environments. In 12-month periods where the Fed Funds rate was rising, leveraged loans outperformed bonds by ~2%, on average, from 1997 to current. Additionally, one can see the historical tendency for loans to outperform bonds during periods where the 5-year Treasury yield is increasing.
Performance In Different Rate Environments – Rolling 12-Month Periods: 1997 - 2021
Source: Bloomberg, Board of Governors of the Federal Reserve System (US). Loans represented by S&P/LSTA U.S. Leveraged Loan 100 Total Return Index and Bonds performance represented by Bloomberg US Agg Total Return Value Unhedged USD Index. Time frames are rolling 12-month periods. Performance represents average performance over aggregate periods. Rising interest rate periods represent 12-month period where Federal Funds Rate increased by 25 basis points or more and falling interest rate period represents period where Federal Funds Rate fell by 25 basis points or more
Performance Relative to 5-Year Treasury Yield - Rolling 12-Month Periods: 1997 - 2021
Source: Bloomberg, Board of Governors of the Federal Reserve System (US). Loans represented by S&P/LSTA U.S. Leveraged Loan 100 Total Return Index and Bonds performance represented by Bloomberg US Agg Total Return Value Unhedged USD Index. Time frames are rolling 12-month periods.
Along with the performance shown in the rolling 12-month chart above, in months where the 5-year Treasury yield rose, leveraged loans outperformed bonds on a single-month return basis ~85% of the time.
In addition to looking at loan performance in relation to rising rates, we also analyzed the performance of leveraged loans against bonds during periods where inflation was above the long-term 2.0% goal set by the Federal Reserve. As shown in the chart below, leveraged loans outperformed bonds in these periods as well.
Performance In Different Inflationary Environments – Rolling 12-Month Periods: 1997 – 2021
Source: Bloomberg, Board of Governors of the Federal Reserve System (US), U.S. Bureau of Labor Statistics. Loans represented by S&P/LSTA U.S. Leveraged Loan 100 Total Return Index and Bonds performance represented by Bloomberg US Agg Total Return Value Unhedged USD Index. Time frames are rolling 12-month periods. Inflation represented by CPI
Given these historical return profiles along with the Federal Reserve’s recent signaling and current inflationary environment, we remain overweight leveraged loans.
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