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August 2013 Viewpoints Three reasons floating-rate loans are on the top of investors’ minds T.J. Settel Portfolio Manager Western Asset Management Company John Hancock Floating Rate Income Fund Through the first half of 2013, the lion’s share of new capital has been flowing to a somewhat esoteric corner of the bond market: floating-rate loans. With investors increasingly concerned over the potential for rising interest rates, floating-rate loans can provide a nice hedge against such risks. But even without the threat of rising interest rates, there are a number of reasons why investors may want to consider floating rate loans as a longer-term allocation, and not simply a short-term trade. Floating rate diversifies core bond holdings better than many other fixed-income sectors Most investors understand the importance of broadly diversifying their portfolio with stocks and bonds, but diversification1 within asset classes is just as essential, and in this regard, floating-rate loans can be particularly useful. Unlike traditional bonds, floating-rate loans’ coupons periodically reset to reflect changes in underlying short-term rates. For that reason, loans are much less sensitive to changes in interest rates and are more commonly tied to changes in the financial health of the underlying issuer, supply-and-demand dynamics, and the condition of the economy at large. As measured by correlation,2 the performance of floating-rate loans has been essentially independent of the performance of the broad-based bond market, as represented by the Barclays U.S. Aggregate Bond Index. 10-year correlations as of 6/30/13 Barclays U.S. Aggregate Bond Index Floating-rate notes 0.00 High-yield bonds 0.28 Emerging-market debt 0.64 Short-term credit 0.74 Mortgage-backed securities 0.91 Floating-rate offered a correlation to investmentgrade bonds of zero. The asset class may be less risky than you think Although floating-rate bank loans have become increasingly popular in recent years and the market has matured, there is still much about the loan asset class that remains misunderstood. For example, one misconception is that the risk of default associated with floating rate is significantly higher than that of traditional corporate bonds. While it’s true that the vast majority of the floating-rate loan universe is 1 Diversification does not guarantee investment returns and does not eliminate risk of loss. 2 Correlation is a statistical measure that describes how investments move in relation to each other, which ranges from -1.0 to +1.0. The closer the number is to +1 or -1, the more closely the two investments are related. Source: Morningstar as of 6/30/13. Emerging-market debt is measured by the JPMorgan Emerging Markets Bond Index (EMBI) Global Diversified Index, which tracks U.S. dollar-denominated Brady bonds, loans, and Eurobonds of external debt instruments in the emerging markets. High-yield bonds are measured by the BofA Merrill Lynch U.S. High Yield Master II Index, which is composed of U.S. currency high-yield bonds issued by U.S. and non-U.S. issuers. Barclays U.S. Aggregate Bond Index is an unmanaged index of dollar-denominated and nonconvertible investment-grade debt issues. Mortgage-backed securities are measured by the Barclays U.S. Mortgage-Backed Securities Index, an unmanaged index comprising of 15- and 30-year fixed-rate securities backed by the mortgage pools of Ginnie Mae, Freddie Mac, and Fannie Mae. Floating-rate notes are measured by the Credit Suisse Leveraged Loan Index, an unmanaged index that tracks the investable market of the U.S. dollar-denominated leveraged loan market. It consists of issues rated “BB” or lower, meaning that the highest-rated issues included in this index are Moody’s Investors Service/Standard & Poor’s Rating Services ratings of Baa1/BB+ or Ba1/BBB+. All loans are funded term loans with a tenor of at least one year and are made by issuers domiciled in developed countries. Short-term credit is measured by the Barclays Credit 1-5 Year Index, an unmanaged index representing the performance of U.S. government, investment-grade corporate, and investment-grade international dollar-denominated bonds that have maturities of between one and five years. It is not possible to invest directly in an index. composed of companies rated below investment grade, loans benefit from being senior in a company’s capital structure and secured by specific collateral. This means that in the event of a bankruptcy, bank loans will be repaid first, before stockholders and before any unsecured bondholders. In addition, as bank loans are secured by collateral, loans tend to recover roughly twice as much as high-yield bonds and other unsecured debt. For example, the recovery rate of floating rate loans has been almost 70% over the past 20 years (Moody’s 2012), while unsecured bonds have recovered in the 40-45% range. And not only is the recovery rate higher for bank loans, but also the quality of the assets recovered is typically better. For example, loan holders often receive cash or additional secured debt through a restructuring or bankruptcy proceeding, while unsecured debt holders often receive additional unsecured debt or equity. While defaults are always of concern when investing in below-investment-grade companies, defaults have in fact been infrequent: On average, only 3.02% of companies defaulted annually during the 10-year stretch ended in 2012 compared with 4.13% of traditional high-yield bond issuers. We don’t foresee that trend changing in the near term. Our analysis suggests defaults through 2014 should remain around their current level of about 3% given the strength of corporate balance sheets and the relatively small amount of debt that comes due over the next 24 months. Ultimately, this combination of features has historically given bank loans one of the highest risk-adjusted return profiles of most major asset classes. Bank debt is at the top of a company’s capital structure High s Senior secured loans Senior debt Priority of claim on cash Unsecured, or “mezzanine,” debt flow and assets Preferred equities Low s Common equities The asset class may benefit doubly from an improving economy With a recovery in the housing market well under way and consumer confidence on the mend, the economy in the United States appears to be improving, and that’s typically good news for corporations that borrow funds in the bank loan channel. As the balance sheets and profits of borrowers improves, the risk of default generally decreases, and loan prices tend to rise. Moreover, in an improving economy, interest rates often rise, too, and the result is higher coupon payments to floating-rate loan holders. That potential for price appreciation and higher coupon payments can make for an attractive combination, particularly in an environment where other fixed-coupon segments of the bond markets may experience price pressure. In fact, as recently as May and June of 2013, bank loans outperformed other credit-linked asset classes in an environment in which interest rates rose and investors generally reduced their risk exposures. The opinions expressed are those of T.J. Settel, portfolio manager at Western Asset Management Company, and are subject to change. Any portfolio holdings information discussed reflects holdings as of the prior month end. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if the creditor is unable or unwilling to make principal or interest payments. Investments in higher-yielding, lower-rated securities involve additional risks as these securities include a higher risk of default and loss of principal. Past performance is not indicative of future results. A fund’s investment objectives, risks, charges, and expenses should be considered carefully before investing. The prospectus contains this and other important information about the fund. To obtain a prospectus, contact your financial professional, call John Hancock Investments at 800-225-5291, or visit our website at jhinvestments.com. Please read the prospectus carefully before investing or sending money. John Hancock Funds, LLC Member FINRA, SIPC 601 Congress Street Boston, MA 02210-2805 800-225-5291 jhinvestments.com Not FDIC insured. May lose value. no bank guarantee. not insured by any government agency. MF153451 328VP 8/13