Fixed income investors are parsing every word that the Federal Reserve utters and, not surprisingly, getting a little nervous. Even though the Fed had been telegraphing higher rates for months, it now appears that it will wind down its bond purchases more quickly than projected and possibly ratchet up interest rates several times in the coming year.

Nobody knows how fast and how far the Fed will ultimately raise rates. In the end, the determining factor will be the economy, and more specifically, the inflation and employment data. However, one thing does seem certain. The 2022 backdrop for fixed income investors will be challenging. 

Given that the Fed was signaling its intentions throughout 2021, we’ve already seen some volatility with overall yields trending higher. In turn, this has taken a bite out of various fixed income asset classes. Consider that returns for the Bloomberg US Aggregate Bond Index—the default proxy for what is considered a diversified domestic fixed income portfolio—have been negative for the year. An even more conservative approach represented by the Bloomberg US Treasury Long Bond Index has fared even worse. The accompanying chart details how various fixed income asset classes have performed in this year’s rising rate environment. Does this offer a harbinger for what could happen if rates continue to rise? Of course, there are many important differences between these asset classes, such as credit worthiness and duration, that help explain the differences in relative performance. 

In contrast to many of the bond asset classes that face headwinds, it’s worth pointing out that floating-rate bank loans (represented above by the S&P/LSTA Leveraged Loan TR Index) have demonstrated the ability to maintain or increase in value in a rising rate environment. This is primarily a function of how these loans are structured and how the asset class works, though we all know that past performance does not guarantee future results.  

The interest rate on floating rate loans generally resets every 90 days based on a short-term interest rate benchmark, such as the three-month London Interbank Offered Rate (LIBOR). This important feature should not be overlooked at a time when some investors are seeking both higher yields and a shorter duration in order to protect against the possibility of rising interest rates. 

And it’s not just the working mechanics of this asset class that may be appealing today. A strong argument can be made that even though these loans carry higher credit risk because they are below investment grade, strong corporate earnings and falling default rates are setting a positive tone for leveraged loans during despite growing inflation fears and lingering COVID-19 concerns. 

In fact, many corporations are emerging from the COVID-19 pandemic with increasing free cash flow, accretive M&A activity, and a desire to refinance debt to take advantage of low interest rates. In such an environment, the various rating agencies have reported that credit-rating upgrades have materially outpaced downgrades during 2021. Thus, the default rate outlook, which is something all investors in the bank loan asset class should monitor, continues to improve, and we expect it to be well below historical averages at similar points in past economic recoveries.

So while the current rate backdrop is worrisome for investors who typically desire both portfolio stability and income from their fixed income portfolio, there are sectors of the fixed income universe that are poised to help navigate what looks to be a tumultuous period. The bank loan asset class might be worth a look for investors who are reconfiguring portfolios at year-end.