Adding Loans to Traditional Agg-based Portfolio to Reduce Risk / Improve Returns?

By design, insurance company portfolios are never fully diversified. Most allocate their portfolios heavily towards investment-grade fixed income to account for policy holder obligations, reserves and sufficient risk capital. We spoke with Aristotle Pacific Capital to discuss how Bank Loans (or 'leveraged loans) may be an opportunity of diversification and return for insurers.

Pete Slattery, CAIA | Senior Vice President, Institutional Services | Aristotle Pacific Capital
pslattery@aristotlecap.com | Learn More >>

SAA: How do leveraged loans historically correlate with core fixed income sectors represented in the Barclays Agg (e.g., Treasuries, MBS, IG credit)?

Aristotle: Leveraged loans, also known as bank loans, have historically shown low to moderate correlation with the major fixed income sectors that make up the Bloomberg Barclays U.S. Aggregate Bond Index (“the Agg”). For instance, their relationship with U.S. Treasuries, which comprise about 46% of the Agg, typically ranges from low to slightly negative (around –0.2 to 0.2). With agency mortgage-backed securities, representing roughly 25% of the index, the correlation is somewhat stronger, falling in a moderate range of 0.2 to 0.4. The connection with investment grade corporate bonds, which account for about 22% of the Agg, is more pronounced, ranging from moderate to moderately high (0.4 to 0.6). This spectrum of correlations highlights how leveraged loans behave differently across the fixed income landscape, offering a unique return profile relative to traditional bond sectors.

Because of these characteristics, leveraged loans can play a valuable role in diversifying a core bond portfolio. Their lower sensitivity to interest rates helps reduce duration risk, which is particularly beneficial in environments where rising rates weigh on rate-sensitive assets like Treasuries or mortgage-backed securities. At the same time, they often provide higher yields than investment grade bonds, potentially enhancing portfolio income. However, these advantages come with an important trade-off: leveraged loans are more exposed to credit risk. When used thoughtfully, they can improve overall returns and broaden diversification while balancing the risks inherent in more traditional fixed income allocations.

Aristotle Pacific Capital takes a Capital Preservation First approach to the Loan market, which focuses on investing in both the highest quality, as well as the largest/most liquid, sectors of the market. That approach has helped seek lower default risk, alongside improved/balanced risk-return outcomes.

SAA: How would the addition of leveraged loans impact the portfolio’s duration profile and interest rate sensitivity compared to the Agg?

Aristotle: Adding leveraged loans to a portfolio benchmarked to the Bloomberg U.S. Aggregate Bond Index (the Agg) is a potential avenue towards meaningfully reducing the portfolio’s duration profile and overall sensitivity to interest rate movements. The Agg currently carries an effective duration of about 6.2 years, reflecting its composition of long-duration U.S. Treasuries, which make up around 45% of the index, as well as intermediate-duration sectors such as mortgage-backed securities at roughly 25% and investment-grade corporate bonds at about 22%. This structure leaves portfolios benchmarked to the Agg exposed to shifts in interest rates, particularly in periods of rising yields.

Leveraged loans, on the other hand, are floating-rate instruments tied to benchmarks like SOFR or Prime and reset their rates every 30 to 90 days. As a result, they exhibit near-zero duration, typically less than a quarter of a year, making them far less sensitive to changes in interest rates compared to traditional fixed-rate bonds. Incorporating them into an Agg-based portfolio reduces duration in direct proportion to their allocation. For example, a 10% allocation to leveraged loans could lower the overall portfolio duration by about 0.6 years, offering investors a more defensive stance against interest rate risk while still maintaining credit exposure. Aristotle's Bank Loan Strategy, that has a track record spanning over 18 years, has a current effective duration of .31 years.

Source: Strategic Asset Alliance, Aristotle Pacific Capital. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.