Market Watch | leveraged loans | Fidelity (2024)

For income-seeking investors, these are interesting times. Bond yields have risen over the past year, partly because the Federal Reserve has kept raising interest rates. But prices, which move in the opposite direction of yields, have not risen much. Now, the Fed's leaders say that inflation is still too high and that they may keep raising rates until it comes down, particularly if the economy continues to grow.

Eric Mollenhauer, manager of Fidelity® Floating Rate High Income Fund (FFRHX) says that in this environment, leveraged loans have been providing income-seeking investors with higher returns than other types of bonds and he expects that could continue in the months ahead. From June 2022 to June 2023, for example, leveraged loans returned 10.97%, compared to investment-grade bonds' −0.94%.

"If you're looking for income from non-investment-grade-type companies, you want an economy with slow, steady growth. We are experiencing modest growth and if this continues, I expect interest rates to stay higher for longer, producing a favorable backdrop for leveraged loans," says Mollenhauer.

If you are seeking higher yields 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 loans.

What are leveraged loans?

Leveraged loans—also known as floating-rate loans or bank loans—are loans made by banks or other financial institutions that are then sold to investors. Companies may use the money they get 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 June 2023, as large as the US high-yield bond market. The growth of the loan market has attracted larger and more established borrowers, such as Charter Communications, United Airlines, and Caesars Resorts, who might have otherwise raised capital by selling bonds.

Why invest in loans?

Leveraged loans not only offer potential inflation protection, they are also a hedge against rising interest rates. That's because, unlike most bonds, 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 rising-rate environments.

Past performance is no guarantee of future returns. Leveraged loans based on Morningstar LSTA Leveraged Performing Loan Index; investment-grade bonds based on Bloomberg Barclays US Aggregate Bond Index. Source: Bloomberg Finance LP, Fidelity investments, data as of 6/30/23.

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. 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).

Fidelity funds

Fidelity^® Multi-Asset Income Fund (FMSDX)

Fidelity^® Floating Rate High Income Fund (FFRHX)

Non-Fidelity funds

T. Rowe Price Floating Rate Fund (PRFRX)

BlackRock Floating Rate Income Portfolio (BFRAX)

PGIM Floating Rate Income Fund (FRFAX)

The Fidelity screeners are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsem*nt by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.